Estate tax planning has, for decades, revolved primarily around maximization of the estate and gift tax applicable exclusion amount, with tax reform also focusing primarily on increases to this amount. With the recent enactment of the Tax Cuts and Jobs Act, P.L. 115-97, we have seen this exclusion amount increase from $675,000 per taxpayer in 2001 to $11.18 million per taxpayer in 2018. This has dramatically reduced the impact of the estate, gift, and generation-skipping transfer taxes. As a result, the focus of tax planning will likely continue to shift to income taxation. One of the biggest modern goals of tax planning now is maximizing the opportunity to obtain a step-up in income tax basis for family assets at least at the death of the client. The recent doubling of the estate tax applicable exclusion amount is certain to increase this type of planning.
While such transfers are driven by a desire to save income taxes, practitioners may neglect the state law implications of this type of planning, which we will refer to in the remainder of this article as “basis step-up planning.” While the effects of such planning can differ from state to state, this article addresses some of the broad issues that should be considered before engaging in substantial basis step-up planning.
For purposes of this article, with respect to powers of appointment, reference is made primarily to the Uniform Powers of Appointment Act (UPAA), as published by the Uniform Law Commission in 2012. For purposes of analyzing powers of appointment, the following defined terms are derived from section 102 of the UPAA. The “donor” is the person creating a power of appointment, the “power holder” is the person in whom the power of appointment is created by a donor, “permissible appointee” means the person in whose favor the power of appointment may be exercised, and “appointive property” refers to the property over that the power of appointment can be exercised. A general power of appointment is generally defined in section 102 of the UPAA as being a power which can be exercised in favor of the power holder, the power holder’s estate, a creditor of the power holder, or a creditor of the power holder’s estate.
In addition, with respect to trusts, reference is made primarily to the Uniform Trust Code (UTC), as last amended by the Uniform Law Commission in 2010. Reference is also made to the Uniform Probate Code (UPC), as last amended by the Uniform Law Commission in 2010.
Mechanisms of Basis Step-Up Planning
In order to consider the state law impacts of basis step-up planning, it is helpful to consider the techniques commonly used to accomplish its goals. IRC § 1014 generally grants the step-up in income tax basis to assets acquired from a decedent or passed from a decedent. Although not directly stated within IRC § 1014, this basis step-up is generally limited to assets that were actually owned by the decedent at death or that were treated, for estate tax purposes, as being owned by the decedent at death.
The latter scenario is the starting point for basis step-up planning, as it illustrates a scenario where the owner of assets (for state law purposes) is different from the decedent. This mismatch is most often found in trusts but can also be found in different ownership scenarios, such as life estates. For purposes of simplicity, we will focus on trusts in this article.
Basis step-up planning can differ based on whether the step-up is sought by reference to the death of a trust’s settlor or the death of a trust’s beneficiary. In either case, basis step-up planning is generally accomplished by causing the assets to be included in the gross estate of the settlor or beneficiary in accordance with IRC § 1014. With respect to a settlor, there are a variety of ways in which this can be accomplished, such as retention of rights or powers over previously-transferred property under IRC §§ 2036-2038, or the grant of a general power of appointment under IRC § 2041. However, in the case of a beneficiary of a trust who is not also the settlor of the trust, the options for basis step-up planning are limited.
Generally, in order to trigger estate inclusion at the death of a beneficiary of a trust, while keeping the trust intact, the beneficiary must either die holding a general power of appointment over the trust assets, be the beneficiary of property in a marital trust to which the gift or estate tax marital deduction previously applied, or hold a nongeneral power of appointment which is eligible for the “Delaware Tax Trap” (as discussed below). Otherwise, the trust must be terminated outright, with title to the beneficiary’s share of the trust assets being distributed to him or her. The following illustrates some of the state law issues with both approaches.
Choice of Law and Powers of Appointment
Under section 103 of the UPAA, in the absence of trust terms to the contrary, the creation of a power of appointment is governed by the law of the donor’s domicile but the exercise of the power of appointment is governed by the law of the power holder’s domicile, in each case at the relevant time. This governing law should be contrasted with the law governing trusts.
It is often the case that a trust will contain language stating, at a minimum, that the terms of a trust will be governed by the law of the state in which the trust is created. In the absence of such a designation, or if such a designation is found not to be valid due to public policy, under section 107 of the UTC, the law of the state with the most significant relationship to the matter at issue with respect to the trust will govern. The terms governing the administration of the trust may differ, with the trust’s designation controlling unless there is not a sufficient connection between the trust and the place of administration or if the trustee’s selection of the place of administration is not appropriate to the trust’s purposes, administration, and interests of the beneficiaries.
This mismatch can create unintended consequences if the trust under which a power of appointment is created does not specify the law governing both the creation and exercise of such power. In such a case, it is possible that the laws of as many as four different states or jurisdictions could be in conflict (i.e., the state of creation of the trust, the state of the donor’s domicile, the state in which a trust is administered, and the state of the power holder’s domicile).
In order to minimize such conflicts, it is important for trusts that contain powers of appointment to be drafted in a manner that reflects the appropriate governing law. Section 103 of the UPAA generally gives deference to the terms governing choice of law for a power of appointment, but the choice of law for a trust may be limited under sections 107 and 108 of the UTC. Accordingly, a best practice may be to include terms that state that both the creation and exercise of a power of appointment will be governed by the law that governs the terms of the trust. It may be possible to also designate the laws of a friendlier state to govern the creation and exercise of the power of appointment. Although such a term may be permitted by the express terms of section 103 of the UPAA, it is possible that such a term could be invalidated under the same legal principles applicable to choice of governing law for trusts, i.e., public policy grounds or lack of significant connection to the governing state.
Another potential source of conflict arises from a slight difference in the definition of a general power of appointment under the UPAA, when compared to the IRC definition. As noted above, the UPAA definition lists “a creditor” of the power holder or the power holder’s estate as a permissible appointee. But the IRC definition of a general power of appointment contained in IRC §§ 2041 and 2514 uses the plural term “creditors.” There are no IRS rulings, or cases, that have expressly resolved this difference in definition.
In addition, the IRC and IRS rulings have permitted other mechanisms for creating a general power of appointment, such as the appointment of a beneficiary as trustee with the power to withdraw assets in excess of an ascertainable standard (IRC § 2514(c)(1)), the authority of a beneficiary to name anybody (including the beneficiary) as a trustee (Rev. Rul. 95-58), and the triggering of the grantor trust rules with respect to a beneficiary (IRC § 678). The circumstances under which these general powers of appointment are created for tax purposes may not be compatible with the UPAA definition of powers of appointment. Therefore, since the tax definition controls with respect to basis step-up planning, this is not likely to be an issue for tax purposes. But the state law implications need to be examined.
Given this difference, and the low potential for challenge by the IRS, it may be more advantageous for practitioners drafting trusts to draft powers of appointment that meet the definition of a general power of appointment for tax purposes but that may be defined as nongeneral powers of appointment under applicable state law. In doing so, however, practitioners may need to draft around state law provisions that limit the discretionary authority of beneficiaries as trustees. For example, section 15-1-1401 of the Colorado Revised Statutes limits the authority of a trustee who is also a beneficiary to make distributions in excess of an ascertainable standard unless elected to the contrary in a trust or other written instrument.
The grant of a general power of appointment to a beneficiary of a trust, or even the settlor of a trust, can have significant asset protection implications. In some states, a general power of appointment may be treated as a property interest (similar to IRC §§ 2041 and 2514), in which case a creditor of a power holder could compel the exercise of such power. Article 5 of the UPAA takes this approach. In other states, the general power of appointment is treated as a mere power, right, or expectancy that does not rise to the level of being a property interest. For example, in University National Bank v. Rhoadarmer, 827 P.2d 561, 562-63 (Colo. Ct. App. 1991), the Colorado Court of Appeals held that a general power of appointment does not create a property interest subject to garnishment by a creditor of the power holder. In so finding, the court distinguished the possession of the power, under which the power holder acts as a conduit or agent for the donor to change title to property, from the actual exercise of the power resulting in the vesting of title to the appointive property in the name of the power holder, which would allow the appointive property to be subject to garnishment.
In cases where the power holder creates the general power of appointment, the claims of a creditor rely primarily on the applicable state fraudulent transfers or voidable transfers laws. If the creation of a general power of appointment is treated as a fraudulent or voidable transfer, the creditor may make a claim against the appointive property so long as the power has not yet been exercised. If the transfer is not found to be voidable or fraudulent, the rights of creditors of the power holder are then based on state law treatment of the general power of appointment.
Similar treatment of powers of appointment can be found in the UTC. For example, section 505 of the UTC subjects a settlor’s interest in a trust to claims of the settlor’s creditors but also treats a beneficiary as a settlor to the extent such beneficiary has a power to withdraw trust assets (which meets the definition of a general power of appointment). Section 504(c) of the UTC also provides that an abuse of a discretionary distribution standard could expose trust assets to a court’s jurisdiction to order payment of child support, alimony, or separate maintenance. This principle could be interpreted to cause a beneficiary who is also a trustee to be deemed to have a general power of appointment, notwithstanding the terms of the trust.
Given the potential creditor issues, choice of law becomes an important inquiry. If the law under which a power is created has less favorable creditor protections, reliance on more favorable law should be sought (if such a change is available). For trusts that have already been drafted, such an approach may require decanting or judicial modification. As an alternative, a trust protector may have the power to convert general powers of appointment to nongeneral powers or to amend the governing law of the powers of appointment to reduce creditor risk.
Ironically, although the UPAA allows a reference to “a creditor” of the power holder as a permissible appointee of a general power of appointment, the UPAA does not restrict the rights of creditors to those that are permissible appointees. Instead, with respect to a general power of appointment, all creditors could make claims against appointive property, notwithstanding the limitation of the class of permissible appointees to a singular creditor. In states that treat the general power of appointment as a property right, this strategy of closing the class of permissible appointees may not be effective. However, it is possible that a creditor who is a permissible appointee could argue that that such creditor has a preferential claim.
On the other hand, if a creditor attempts to make a claim against appointive property, the status of the creditor as a permissible appointee could be used as a defense. Regardless of whether or not the general power of appointment is treated as a property right, a permissible appointee often does not have the power to compel an exercise of the general power of appointment in favor of such permissible appointee unless, as set forth in section 204 of the UPAA, the power is nonexclusionary and coupled with specific directions from the donor regarding the exercise of the power. Further, section 305(b) of the UPAA expressly notes that a general power of appointment exercisable in favor of creditors of the power holder or power holder’s estate may be exercised only in favor of those creditors. Such provisions may support restriction of creditor claims by closure of the class of creditors, even in states in which general powers of appointment are treated as property rights.
Section 102(12) of the UPAA generally states that a power holder acts in a nonfiduciary capacity when exercising a power of appointment. However, this general principle may conflict with the fiduciary duties of a trustee who is also a power holder, especially in the case of a general power of appointment. Although there is little or no guidance on this principle, it may be a good idea to limit a trustee’s authority sufficiently if the trustee is a power holder of a general power of appointment, or to prevent situations in which a trustee could unintentionally become a power holder of a general power of appointment.
A more significant concern may arise where a fiduciary, such as a trustee or a trust protector, is given the right to cause a beneficiary to have a general power of appointment for tax purposes. In the case of a trustee, drafters should specify that a trustee’s decision regarding the conversion to a general power of appointment is fully discretionary, and that the trustee shall not be liable to any beneficiary for the exercise or failure to exercise such authority. Similar principles may apply in the case of a trust protector in states, or in trusts, in which the trust protector is treated as a fiduciary. For example, section 808 of the UTC creates a presumption that a person other than a beneficiary with the power to direct the actions of a trustee or the administration of the trust will be treated as a fiduciary.
In the case of trust and estate administration, additional fiduciary exposure could result when it comes to disposing of claims of the creditors of the estate. A trustee who is authorized to work with the personal representative of the estate, or to reimburse the estate for expenses and creditor’s claims, may be well advised to take advantage of provisions of applicable probate law to dispose of creditor’s claims. For example, under section 6-102 of the UPC, creditors may make claims against nonprobate transfers (which, presumably, would include general powers of appointment that are treated as property interests under applicable state law) if the estate is not sufficient. In such a case, even if probate is not necessary, a probate administration may be advisable to shrink the period during which creditors may make claims.
Unfortunately, under the UPC and UTC, fiduciary duties often are not reciprocal between personal representatives and trustees. If the personal representative is not in possession of appointive property subject to a general power of appointment, the personal representative incurs no duty to disclose its existence to creditors of the estate under section 6-102(g) of the UPC. Further, the personal representative would have no duty to open probate if the appointive property could become subject to claims of creditors.
Trust Decanting, Modifications, and Terminations
In order to achieve basis step-up planning, a modification to the trust to add a general power of appointment, or a termination of the trust, is often required. Modifications can be achieved through decanting or through judicial modification of a trust. Terminations of a trust often require judicial approval.
In states that permit decanting, the distribution of trust assets to a new trust that grants a general power of appointment to one or more beneficiaries must satisfy the requirements of the applicable decanting statutes and procedures. In some cases, the grant of a general power of appointment in a new trust may not be possible, especially where the interests of beneficiaries of the old trust may be significantly altered. In such a case, any attempt to decant may create fiduciary liability for the trustee.
For example, section 12(c) of the Uniform Trust Decanting Act (2015) states that in cases in which a trustee has limited distributive discretion (as is the case with most trusts permitting discretionary distributions according to an ascertainable standard), each beneficiary must have an interest in the second trust that is substantially similar to the beneficiary’s interest in the old trust. For purposes of this provision, the term “beneficiary” includes a person holding a power of appointment over trust property. While existing powers of appointment could be expanded, it is likely that the grant of new powers of appointment or elimination of existing powers of appointment would not be permitted. Trustees should tread lightly with respect to decanting, so as to avoid fiduciary liability for a violation of any applicable decanting act or statute.
Where decanting is not an option, Article 4 of the UTC does permit modification of trusts by a court in certain circumstances, such as where a trust becomes uneconomical to administer (UTC 414) or to achieve the settlor’s tax objectives (UTC 416). The latter is the most intuitive ground upon which to seek modification of the trust and requires the smallest barrier to entry, as modification may be approved based on the settlor’s probable intent with respect to taxation. With respect to most well-drafted trusts, the four corners of the trust itself will often reveal, directly or indirectly, that the settlor intended to maximize tax savings.
If these options are not available based on the facts and circumstances, a court will often look to whether modification or termination of a trust will frustrate any material purpose of the trust. If the settlors of a trust are then living, section 411(a) of the UTC allows the settlors and all beneficiaries of a trust to agree, in writing, to modify or terminate such trust, even if such modification or termination is inconsistent with a material purpose of the trust. On the other hand, section 411(b) of the UTC limits the ability of beneficiaries to modify or terminate a trust without the consent of settlors, by requiring a court to determine whether or not a material purpose of the trust will be frustrated. If so, the court will typically deny the petition for modification or termination.
If, given applicable law and the domicile of the trustee or beneficiaries, the grant of a general power of appointment is found to be problematic, a termination of the trust may be an option as part of basis step-up planning. In making such an election, however, the trustee should compare a beneficiary’s creditor protection by virtue of holding a general power of appointment to the creditor protection (if any) afforded through holding outright title to the property. If the difference is not significant, trust termination may be defensible.
Some assets of the trust may not be eligible for basis step-up planning, such as qualified retirement plans (which are treated as income with respect to a decedent under RC § 691 and, as such, are denied the step-up in tax basis under IRC § 1014(b)(9)(A)). With respect to such assets, the grant of a general power of appointment may not provide any benefit, and in the worst case may cause such assets to become subject to claims of creditors that did not previously exist. For example, the U.S. Supreme Court’s holding under Clark v. Rameker, 134 S. Ct. 2242 (2014), that an inherited individual retirement account (IRA) is not exempt from the bankruptcy estate of an individual beneficiary, should serve as a caution against needlessly granting a general power of appointment to a trust that is a beneficiary of an inherited IRA if no other tax benefit is available. Of course, such an asset protection decision should be balanced with the application of the minimum required distribution rules of IRC § 401(a)(9) and grantor trust rules under IRC § 678(a).
If a general power of appointment could cause creditor protection issues to a beneficiary, an alternative to terminating the trust may be to transfer the assets of the trust to a pass-through business entity, such as a limited liability company (LLC). In doing so, state law creditor protections that are normally granted to members of a LLC may be substituted for the loss of creditor protection resulting from the grant of a general power of appointment. Of course, for purposes of basis step-up planning, the adjustment to the basis of the assets of the LLC under IRC § 754 must be elected and preserved in order to maximize the tax savings inherent in this planning technique.
Delaware Tax Trap
In some states, IRC §§ 2041(a)(3) or 2514(d) may permit basis step-up planning through the grant, and exercise, of a nongeneral power of appointment to create a new power of appointment that delays the vesting of an interest in trust. Such technique, called the “Delaware tax trap,” results from a unique provision of Delaware’s rule against perpetuities, 25 Del. Code Section 503(c), which allows the exercise of a power of appointment in trust to create a new power of appointment to reset the applicable perpetuities period. In states in which the applicable rule against perpetuities permits such treatment, this technique may allow basis step-up planning to be achieved without the need for decanting, modification, or termination of a trust, and may also prevent the asset protection issues that could otherwise be triggered by giving a beneficiary a general power of appointment.
A listing of states that permit such treatment can be found in Howard M. Zaritsky, The Rule Against Perpetuities: A Survey of State (and D.C.) Law, 2012, as published by the American College of Trust and Estate Counsel (Survey). The Survey notes that a majority of states follow the common law rule that an exercise of a power of appointment to create a new power of appointment does not reset the perpetuities period. In some states, there is an exception to the common law rule, which allows the resetting of the perpetuities period if a nongeneral power of appointment is exercised to create a general power of appointment. Such an approach may render the goal of preserving asset protection moot.
It may be possible, in some cases, to change the situs of trust administration in order to take advantage of an applicable rule against perpetuities to spring the Delaware tax trap. But such a change could be challenged based on lack of substantial connection to the new state of administration or on public policy grounds. Similarly, it is possible that the principles of the UPAA, or terms of a trust, dictating the law applicable to the exercise of a power of appointment could reduce or eliminate such a change in situs. Therefore, while basis step-up planning is possible through the Delaware tax trap, its availability may be very limited.
It is likely that basis step-up planning will become much more common in the next few years. Given the sheer number of different states whose laws may apply in the case of a trust, it is important to familiarize oneself with all applicable laws and outcomes before committing to a course of tax planning. The fact that the current tax law is set to sunset in 2026 also creates the need for flexibility, so practitioners should also explore any adverse effects to the permanency of basis step-up planning. Flexibility is always a goal, but maximum flexibility may not always achieve the desired tax results.