The Delaware Tax Trap is the nickname for twin gift and estate tax Code provisions, sections 2514(d) and 2041(a)(3). For simplicity, this Article will refer only to the estate tax provision, section 2041(a)(3).
Before explaining how the Delaware Tax Trap works, it is useful to view it in a broader context. The Delaware Tax Trap is a subsection of section 2041, which is the statute that deals with the estate tax implications of powers of appointment. By way of background, there are two types of powers of appointment for tax purposes. The first type is a general power of appointment. With limited exceptions, a general power of appointment exists when the powerholder has the ability to appoint trust assets to himself, his estate, his creditors, or the creditors of his estate.1 Importantly, with a general power of appointment, the trust assets that are subject to the power will be included in the powerholder’s estate for estate tax purposes, whether or not the power is exercised.2
The second type of power of appointment is a limited power of appointment (also sometimes referred to as a special or non-general power of appointment). A limited power of appointment exists when the powerholder does not have the ability to appoint trust assets to himself, his estate, his creditors, or the creditors of his estate, or when, for some other reason, the power is not a general power.3 Despite its name, a limited power of appointment can be incredibly broad. The powerholder may have the ability to appoint to anyone who is not himself, his estate, his creditors, or the creditors of his estate, and it will still be a limited power of appointment.4
The advantage of a limited power of appointment is that, typically, it will not cause the assets of the trust to be included in the powerholder’s estate for estate tax purposes. The only circumstance in which a limited power of appointment will cause trust assets to be subject to estate tax is when the Delaware Tax Trap applies.5
III. History of the Delaware Tax Trap
According to section 2041(a)(3), the Delaware Tax Trap causes estate tax inclusion with respect to property over which the decedent exercises a limited power of appointment that was created after October 21, 1942, “by creating another power of appointment which under the applicable local law can be validly exercised so as to postpone the vesting of any estate or interest in such property, or suspend the absolute ownership or power of alienation of such property, for a period ascertainable without regard to the date of the creation of the first power.”6
To make sense of the foregoing statutory language, it helps to understand the history behind it. That history began in Delaware in the 1930s. At that time, almost every state, including Delaware, followed the common law rule against perpetuities,7 which says that in order to be valid, trust interests must vest within twenty-one years following the death of someone who was alive at the time the trust was created.8
A lesser-known aspect of the common law rule against perpetuities is something called the relation back doctrine. The relation back doctrine is key to understanding the Delaware Tax Trap. This doctrine provides that if an individual exercises a limited power of appointment or a general testamentary power of appointment over a trust (referred to hereafter as the “Original Trust”) to create one or more additional trusts, the rule against perpetuities period that applies to those additional trusts is measured from the date the Original Trust became irrevocable, not from the date of the exercise of the power of appointment.9
Under the common law rule, the only type of power of appointment that the relation back doctrine does not apply to is presently exercisable general powers of appointment.10 A presently exercisable general power of appointment is equivalent to an immediate withdrawal right.11 It is so much like actual, outright ownership that the rule against perpetuities period is measured from the date the power is exercised.12 In other words, the exercise of a presently exercisable general power of appointment re-starts the rule against perpetuities period.
In 1933, Delaware lawmakers decided that it was time to allow perpetual trusts.13 However, they were not prepared to discard the rule against perpetuities altogether.14 Accordingly, they came up with a clever work-around. They preserved the “lives in being plus twenty-one years” aspect of the Rule but eliminated the common law relation back doctrine.15 This meant that every exercise of a power of appointment (whether limited or general) would re-start the rule against perpetuities period.16 As a result, as long as beneficiaries continued to exercise successive powers of appointment, the trust could last indefinitely.17 Moreover, if those successive powers were limited powers, then because (absent the Delaware Tax Trap) limited powers of appointment do not cause estate tax inclusion and because there was no generation-skipping transfer (GST) tax at that time, not only could the trust last indefinitely, but its assets could also escape transfer tax indefinitely.
Congress may have gotten used to the idea of trust assets escaping transfer tax for the lives in being plus twenty-one years period, but escaping transfer tax forever was something else entirely. Therefore, in 1951, Congress enacted the predecessor to section 2041(a)(3) as an anti-abuse provision to shut down this loophole for Delaware trusts.18
IV. Description of the Delaware Tax Trap
With that background in mind, the following description of the Delaware Tax Trap should make more sense. Put simply, the Delaware Tax Trap will apply if (1) the powerholder exercises a power of appointment (the First Power), (2) that exercise creates another power of appointment (the Second Power), and (3) the Second Power can be exercised in a way that both (a) re-starts the rule against perpetuities and (b) extends the life of the trust.
If all three of these conditions are met, then the assets over which the powerholder exercised the First Power will be includible in her estate for estate tax purposes. In some cases, this will produce a disastrous result.
Example 1: B is the beneficiary of a large GST-exempt trust that her father created for her benefit and over which she has a limited power of appointment. B has significant wealth outside of the trust as well, so much so that she has already made large taxable gifts and used all of her gift and GST tax exemption. If B inadvertently triggers the Delaware Tax Trap, the trust assets, which otherwise would not have been subject to any transfer tax at her death, will now be subject to federal estate tax at a 40% rate. Depending where B is domiciled, the trust assets may be subject to state estate tax as well. If that were not bad enough, because B has already used her own GST exemption, the new trusts created through the exercise of her limited power of appointment will not be GST exempt, and therefore, they will be subject to GST tax when the assets pass to her grandchildren or more remote descendants.
In contrast, there are some situations in which application of the Delaware Tax Trap could result in significant tax savings. As exemption amounts have increased, those situations are becoming more frequent.
Example 2: The facts are the same as those described in Example 1 except that (1) the trust at issue is GST non-exempt, (2) B has no wealth outside of the trust, and (3) B has not used any of her gift or GST tax exemption. Under normal circumstances, the trust assets would be subject to a 40% GST tax when they pass to B’s children at her death. However, if the Delaware Tax Trap were to apply, the trust assets would instead be includible in B’s estate for tax purposes but would be fully covered by her remaining estate tax exemption. Therefore, no federal estate tax would be due. If B is domiciled in one of the thirty-eight states that has no estate tax,19 then no state estate tax should be due either. Even if B is domiciled in a state that has an estate tax, the assets should be fully or partially shielded by her exemption. Finally, B’s personal representative will be able to allocate GST exemption to the continuing trusts created by B’s exercise of her power of appointment because B will now be considered the “transferor” for GST tax purposes.
Example 3: M is domiciled in the District of Columbia. She has a $3 million estate, $10 million of federal estate tax exemption remaining, and is the beneficiary of a $2 million credit shelter trust created at her husband’s death. The trust has $1 million of built-in gain. If M’s children, who are D.C. residents, inherit and immediately liquidate the trust assets at their mother’s death, they will collectively pay as much as $327,500 of combined federal and D.C. income tax.20 However, if the Delaware Tax Trap were to apply, the assets would receive a step-up in basis, so no tax would be due upon liquidation. In addition, because the trust assets would be fully shielded by M’s remaining federal and D.C. exemption amounts, no estate tax would be due.
Unfortunately, the Delaware Tax Trap is not available in every circumstance in which it would be beneficial to cause estate tax inclusion. There are two frequently encountered obstacles that will prevent its application. First, there may be language in the original trust agreement that blocks the Delaware Tax Trap. Second, state law may be an impedi-ment. The remainder of this Article addresses these obstacles in detail.
V. Obstacle 1: The Terms of the Original Trust Agreement May Prevent the Delaware Tax Trap from Applying
If the instrument governing the Original Trust (the trust agreement or, with respect to a testamentary trust, the Will) prohibits exercise of a power of appointment in a way that could extend the life of the trust past the initial rule against perpetuities period, then the powerholder cannot trigger the Trap—neither deliberately nor inadvertently. Any such exercise would necessarily be invalid and, therefore, could not fall within section 2041(a)(3), which requires that the Second Power can be “validly” exercised to re-start the rule against perpetuities period and extend the life of the trust.21
This obstacle to triggering the Delaware Tax Trap, if it exists, is typically found in the perpetuities savings provision of the governing instrument. The perpetuities savings provision is an article or paragraph included in every well-drafted trust that ensures it complies with the applicable rule against perpetuities.22 How this provision is drafted impacts whether or not the Delaware Tax Trap is available as a planning option.
The following is an example of a perpetuities savings provision that would prevent the Delaware Tax Trap from applying: “The trustee shall terminate and forthwith distribute any trust created hereby, or by exercise of a power of appointment hereunder, and still held twenty-one years after the death of the last to die of myself and the beneficiaries in being at my death.”23
In contrast, the following is an example of a perpetuities savings provision that would allow the Trap to apply:
All trusts hereunder shall terminate twenty-one years following the death of the last to die of my parents’ issue who were living on the date of this Agreement. The foregoing sentence shall also apply to trusts created by the exercise of a power of appointment, unless the exercise of the power of appointment commences a new rule against perpetuities.24
The key difference between the foregoing examples is that the first applies to trusts created through the exercise of any and all powers of appointment and the second applies only to trusts created through the exercise of powers of appointment that do not re-start the rule against perpetuities. In other words, the termination date in the second example does not apply in instances where the powerholder exercises the power in a way that re-starts the perpetuities period.
Unfortunately, not all perpetuities savings provisions are straightforward in terms of their application to trusts created through the exercise of powers of appointment and their resulting interaction with section 2041(a)(3). For example, the following provision is ambiguous with respect to whether it precludes the triggering of the Delaware Tax Trap: “All trusts hereunder shall terminate twenty-one years following the death of the last to die of my parents’ issue who were living on the date of this Agreement.”
It is uncertain whether the phrase “all trusts hereunder” includes trusts created through the exercise of powers of appointment that would otherwise re-start the rule against perpetuities period. As a result, whether the Trap can be sprung is unclear. Attorneys confronting such language may recommend a construction proceeding to clarify the phrase’s meaning before advising the client to deliberately trigger the Trap.25
A judicial determination as to the construction of the perpetuities savings provision should be binding on the Internal Revenue Service (Service), provided the determination is obtained (and any right to appeal expires) before the Trap is triggered.26 If the judicial determination is obtained after the Trap is triggered, then its impact is less certain. Under Commissioner v. Estate of Bosch,27 the Service would essentially make its own determination as to the proper construction of the trust instrument under state law.
As with any action to modify or construe a trust, one must be careful of potential tax consequences. If the trust at issue is GST non-exempt, then altering the trust’s GST tax status is not a concern. For trusts that are not subject to the GST tax because they were irrevocable on September 25, 1985, the regulations provide a safe harbor whereby such trusts will not become subject to the GST tax as a result of a construction proceeding, provided “(1) [t]he judicial action involves a bona fide issue; and (2) [t]he construction is consistent with applicable state law that would be applied by the highest court of the state.”28 Because the highest court of the state is unlikely to have ruled on the perpetuities savings language at issue, the safe harbor is of limited utility.
VI. Obstacle 2: State Law May Prevent the Delaware Tax Trap from Applying
The ability to trigger the Delaware Tax Trap is dependent, in part, on state law. No clear consensus exists as to which states allow the Trap to be sprung. This confusion is largely due to uncertainty over how section 2041(a)(3) applies in states that permit perpetual trusts.
Currently, twelve states have no rule against perpetuities.29 Some commentators argue that the Delaware Tax Trap cannot apply to trusts governed by these states’ laws30 because, on its face, section 2041(a)(3) can only apply if the Second Power can be exercised in a way that “postpone[s] the vesting” of any interest in the trust property.31 In other words, under a literal interpretation of the statute, the Delaware Tax Trap can only apply if the Second Power can be exercised in a way that extends the life of the trust. These commentators argue that one cannot extend the life of a trust that is already perpetual and, therefore, the Delaware Tax Trap cannot apply.32 If these commentators are correct, then springing the Trap would also be impossible in situations when the trust instrument opts out of the rule against perpetuities, which is permitted in at least six states and the District of Columbia.33
In direct contrast to the foregoing argument, other commentators suggest that rather than prevent the Trap from applying, the absence of a rule against perpetuities will cause the Trap to apply every time a First Power is exercised to grant a Second Power, unless the state has a so-called “alienation rule” or there is savings language in the trust instrument or in the instrument that exercises the First Power.34 An alienation rule is a rule that “voids property interests in which the power of alienation (sale) is suspended beyond a permissible period.”35 Originally, alienation rules were interpreted to mean that all trusts had to terminate within a certain period of time so that the beneficiaries could convey full ownership of the underlying property.36 Under that interpretation, an alienation rule was similar to a rule against perpetuities in that both prevented perpetual trusts. Now, however, alienation rules are typically considered satisfied if the trustee has a power of sale, even if the trust will last indefinitely.37
If a state has no rule against perpetuities and no alienation rule, according to these commentators, the Trap applies because there is no fixed period during which property interests must vest.38 James P. Spica explained the argument as follows:
In a state with no RAP-like rule] the Second Power can be exercised to postpone the vesting of interests in personal property held in trust forever, and the period that runs forever from the date of the Second Power’s exercise is certainly ascertainable, if at all, without regard to the date of creation of the First Power—and, therefore, the Trap is sprung!39
While other commentators have strongly refuted the foregoing argument, including, most prominently, Richard W. Nenno,40 numerous states have taken the finite period requirement seriously enough that, rather than repeal their rule against perpetuities, they have enacted very long perpetuities periods—360 years in Florida, 500 years in Arizona, and 1,000 years in Colorado, for example.41 It is unclear, however, whether such artificially long periods are any different in a practical sense than full repeal of the rule against perpetuities. Therefore, there is some doubt as to whether they successfully avoid the Trap.42
Other states have dealt with the risk of inadvertently triggering the Trap by enacting or codifying an alienation rule.43 For example, nearly every state that permits drafters to elect out of the rule against perpetuities in the trust instrument requires that the trustee have a power of sale or alienation for the election out to be effective.44 This requirement implicitly recognizes the existence of an alienation rule.45
Opining on the merits of the foregoing contradictory arguments is beyond the scope of this Article. The point is that there is significant ambiguity with respect to the Delaware Tax Trap in states that have eliminated their rule against perpetuities and with trusts that opt out of the rule against perpetuities. This ambiguity is not surprising given that the predecessor to section 2041(a)(3) was enacted well before the trend toward extending and repealing the rule against perpetuities. Accordingly, its drafters never anticipated these fact patterns, and its language does not make clear sense in this context.
The application of section 2041(a)(3) is more certain in states that have not repealed their rule against perpetuities. In those states, the general rule is that one can only trigger the Delaware Tax Trap by exercising the First Power to confer a presently exercisable general power of appointment.46 Said differently, there are very few states where the Delaware Tax Trap can apply if the Second Power is a limited power of appointment.47 This is because most states still follow the common law relation back doctrine mentioned earlier that says, in relevant part, that the exercise of a limited power of appointment does not restart the rule against perpetuities.48 Instead, the rule against perpetuities period continues to be measured from the date the Original Trust became irrevocable, which prevents the Delaware Tax Trap from applying.
Because of the foregoing, in many states, the only option for triggering the Trap is to exercise the First Power to confer an immediate withdrawal right.49 This may be a nonstarter for many clients, as it eliminates all of the benefits of using a trust, including creditor protection, spending restraints, and estate tax exclusion. The powerholder can take the money and run.
As discussed below, there is a potential loophole under the Uniform Statutory Rule Against Perpetuities (USRAP) that would allow the Trap to apply to successive limited powers. However, the loophole is not without added complexity.
VII. Possible USRAP Solution: Appoint to an Existing Irrevocable Trust
In his article USRAP Surprise Trigger of Delaware Tax Trap, attorney Les Raatz sets forth a creative solution for triggering the Delaware Tax Trap without conferring a presently exercisable general power of appointment.50 This solution would seem to be available in all of the twenty-six jurisdictions that have adopted the USRAP.51 It involves exercising the First Power to appoint assets to an irrevocable trust that is already in existence, which irrevocable trust confers a limited power of appointment.
Section 2(c) of the USRAP provides, “For purposes of this [act], a nonvested property interest or a power of appointment arising from a transfer of property to a previously funded trust or other existing property arrangement is created when the nonvested property interest or power of appointment in the original contribution was created.”52 This section is relevant to trusts funded in tranches. Under section 2(c), subsequent contributions to an irrevocable trust do not change the date that measures its rule against perpetuities period. Instead, only one rule against perpetuities period applies to the entire trust, beginning with the date of the initial contribution (assuming the trust was irrevocable at that time). This provision is intended to simplify administration of the trust by avoiding the need to track a different perpetuities period for each separate contribution.53
As a result of section 2(c), if a powerholder exercises his limited power of appointment over the Original Trust to appoint assets to an existing trust that contains a limited power of appointment (the Second Power), the rule against perpetuities period will be measured from the existing trust’s creation date. If the existing trust postdates the Original Trust, the Second Power can be exercised in a way that restarts and extends the rule against perpetuities. Consequently, the Delaware Tax Trap should apply.
Example 4: A is the beneficiary of a large GST non-exempt trust that her father created for her benefit (Trust One) and over which she has a limited power of appointment. A has no wealth outside of the trust and has not used any of her gift or GST exemption. As a result, it would make sense to subject the trust assets to estate tax, rather than GST tax, via the Delaware Tax Trap.
Trust One is governed by D.C. law, a jurisdiction that has adopted the USRAP.54 Under section 2(a) of the USRAP, the common law relation back doctrine continues to apply, meaning the exercise of a limited power of appointment does not restart the rule against perpetuities. As a result, in general, one can only trigger the Delaware Tax Trap with respect to a D.C. trust by conferring a presently exercisable general power of appointment. This is a problem for A, whose only child is not responsible with money.
Luckily, A’s attorney is aware of an exception to the general rule, which is set forth in section 2(c) of the USRAP. On advice of counsel, A creates an irrevocable trust for the benefit of her son (Trust Two) and funds it with $10,000. The son has a limited power of appointment over Trust Two. A can now trigger the Delaware Tax Trap by exercising her power of appointment over Trust One to appoint the assets to Trust Two.
The foregoing is a relatively new technique that, to the author’s knowledge, is untested. However, no obvious reason exists for the technique not to work.
The Delaware Tax Trap can be a great tool for generating tax savings under the right circumstances. However, the Delaware Tax Trap is not as readily available as one might think. Practitioners must keep the above-described obstacles in mind in determining whether springing the Delaware Tax Trap is an option for their clients.