The Tax Cut and Jobs Act (“TCJA”) enacted some sweeping changes to our nation’s tax laws. One major change was the modification of Section 2010 to increase in the individual estate tax exemption from $5M, indexed for inflation ($5.49M in 2017), to $10M, indexed for inflation ($11.2M in 2018, 11.4M in 2019).1 Thus couples went from having almost $11M of estate tax exemption to over $22M. In light of the changes made by the TCJA estate tax is no longer the driving force in most of the planning we do. Instead, income tax, and in particular, obtaining a stepped-up basis for income tax purposes2, has taken on a much bigger role in planning. This is particularly true when considering that our current income tax rates, when combined with state income tax rates, may exceed the 40% federal estate tax rate. The increased exemption amount sunsets at the end of 2026 and reverts back to $5M (adjusted based on 2010 dollars), and Congress could change the law at anytime before then, so retaining flexibility in documents is still of the utmost importance.
Prior to 2010, when the estate tax exemption was less than $5M, and we did not have portability of the exemption amount between spouses,3 estate tax played a much more important role in most of the planning we do. However, now that we have historically high exemption amounts, combined with portability of such exemption amounts between spouses, that is no longer always the case, and it becomes beneficial in many instances to trigger estate inclusion to obtain a stepped up basis for income tax purposes on such assets included in the estate4. My colleague Josh Sage wrote a great article discussing estate inclusion and the stepped-up basis along with some examples showing the tax savings that can be had with such planning, including analysis showing that it may be beneficial to pay estate tax to obtain the stepped up in basis in certain cases. Josh’s article can be found here. Since Josh has done a great job discussing the benefits of estate inclusion and a stepped up basis, I will avoid going into that here, but instead will elaborate on some of the techniques that may be used to trigger this estate inclusion and thus obtain the stepped up basis for income tax purposes.
Estate Planning Techniques to Provide Flexibility and Step Up Potential
As mentioned above, due to the sunset of the TCJA provisions at the end of 2026, as well as the potential that Congress may change the exemption amount at anytime prior to 2026, flexibility remains a key aspect of a good estate plan. Below are few techniques that can be used to retain flexibility in an estate plan and provide step up potential in the future.
Grant an Independent Trustee the Power to Make Discretionary Distributions
In a typical trust, the trustee will have the power to make distributions to the beneficiary for health, education, maintenance and support (“HEMS”). This HEMS language is referred to as an ascertainable standard, and the reason the HEMS standard is used is to prevent the assets of the trust from being included in the estate of the beneficiary5 and to maintain spendthrift and creditor protection from the beneficiary’s creditors.6 However, since the assets of the trust which can only make HEMS distributions are not included in the beneficiary’s estate, there is no step up in basis for such assets at the beneficiary’s death as Section 1014 is not applicable
However, an independent trustee, that is a trustee who is not related to or subordinate to the beneficiary, can have the power to make distributions to the beneficiary for any reason without regard to the HEMS standard and still avoid estate inclusion7 and retain creditor protection. Providing this power to an independent trustee adds great flexibility to a trust and also provides the potential for a stepped up basis. The independent trustee could exercise this power to distribute certain assets, or all assets, to a beneficiary so that the beneficiary would own the asset at death and could then obtain the stepped up basis on such distributed assets at the beneficiary’s death.
Grant an Independent Trustee the Power to Confer a General Power of Appointment on the Beneficiary
Another method to provide flexibility and step up potential to estate planning documents is granting an independent trustee the power to confer a general power of appointment8 to the beneficiary. The assets of the trust will not be included in the beneficiary’s estate solely because to the independent trustee has this power to confer a general power of appointment to the beneficiary, but if the independent trustee does choose to exercise this power and confer a general power of appointment to the beneficiary, the assets of the trust will be subject to inclusion in the beneficiary’s estate under Section 2041 and thus will receive a stepped up basis at the beneficiary’s death. This power granted to the beneficiary can require the consent of a non-adverse third party which may add some comfort if there is worry the beneficiary may exercise the power in a manner inconsistent with the grantor’s goals or wishes.
Grant the Beneficiary a Formula General Power of Appointment
Granting the beneficiary a formula general power of appointment equal to his or her remaining unused estate tax exemption is another technique to obtain stepped up basis at least for a portion of such assets. This method can also be taken a step further with the formula power of appointment not being limited to the beneficiary’s remaining unused estate tax exemption, but instead being based on the best tax result when combining both income tax and estate tax. The formula can be drafted to apply on an asset by asset basis depending on the effective tax rate of each particular asset. For example, it may be beneficial to have certain assets that are subject to recapture at ordinary income tax rates and state income tax included in the estate even if it means paying estate tax. These formulas can get complicated quickly but are a great technique to achieve the best overall combined tax result. When considering whether to implement an asset by asset formula, the taxpayer has to consider other factors as well such as whether the assets are likely to be sold in the near future, or ever, and the time value of money.
Delaware Tax Trap
The so called “Delaware Tax Trap” is another strategy of achieving a stepped up basis that relies on a power of appointment. However, this strategy differs from those discussed above in that it can be achieved through the use of a limited power of appointment rather than a general power of appointment. This strategy was previously seen as a pitfall, hence the name of the Delaware Tax Trap. However, planners have come to realize that this so called trap can instead be beneficial to cause estate inclusion and achieve a stepped up basis. In short, when a limited power is exercised in a manner that restarts the rule against perpetuities for the assets and the new vesting period for the restarted rule against perpetuities is not based on the date the original power of appointment was created, the assets are included in the estate of the individual who exercised the power9, thus achieving a stepped up basis. Discussing the rule against perpetuities is beyond the scope of this article, but to summarize, the rule against perpetuities is a complex rule of state statutory law that governs how long assets may remain in a trust, among other applications.
Planning with Assets Currently Held
Upstream Planning and the Upstream Sale to a Power of Appointment Trust (“UpSPAT”)
Upstream planning is a great method of obtaining a step up in basis for assets currently held by taxpayers which have experienced significant appreciation or are likely to experience significant appreciation in the future. This method involves using the taxpayer’s parent’s estate tax exemption in order achieve the stepped up basis and have the assets pass back to or for the benefit of the taxpayer at the parent’s death. Of course, this method is not a one size fits all method of achieving a stepped up basis. In order for this method to work, the parent or parents must have ample available estate tax exemption that will not be used by the parent’s own assets and will ultimately go unused absent the upstream planning.
The UpSPAT is one method for such upstream planning where a taxpayer will sell assets to a grantor trust10 with the trust issuing a promissory note in return. The trust will grant the taxpayer’s parent a testamentary general power of appointment which causes estate inclusion in the parent’s estate under Section 2041. At the parent’s death, the trust assets are included in the parent’s estate and receive a stepped up basis. The assets can then be used to pay off the promissory note owed by the trust to the taxpayer. The taxpayer now takes the assets back with a stepped up basis with little to no adverse consequences. Don’t overlook the possibility that the plan can have unintended consequences should the parent decide to exercise the power of appointment. The UpSPAT is a great planning tool when taxpayer wants the stepped up basis but is not concerned about the assets being included in his or her estate. Additionally, taxpayers utilizing this method need to take into account the one-year rule of Section 1014(e) which states that a transfer of property from the grantor to another which then comes back to the grantor within one year is not eligible for the stepped up basis.
Accidentally Perfect Grantor Trust (“APGT”)
Another method for achieving the stepped up basis during life is the APGT, a similar method to the UpSPAT discussed above. The APGT involves the taxpayer setting up a grantor trust with his or her parent(s) as the beneficiary. The taxpayer then funds with the trust with a seed gift. Following the seed gift, the trust then purchases assets with significant appreciation or potential for the same from the taxpayer in exchange for a promissory note. The trust grants the parent a general power of appointment. Following the parent’s death, the trust may hold the assets for the benefit of the taxpayer or the taxpayer’s family, or alternatively, the parent may exercise the power to a new trust for the taxpayer’s or the taxpayer’s families benefit. This method does use some of taxpayer’s gift tax exemption with the seed gift but uses less than would otherwise be used if the taxpayer gifted the property to the parent outright. Additionally, this structure allows some flexibility following the parent’s death in how the assets pass, and it may be possible for the assets to remain in a grantor trust as to the taxpayer. As with the UpSPAT, taxpayers using the APGT need take into account the one-year rule of Section 1014(e).
Use of Debt
Another tool for achieving a stepped up basis without causing additional estate tax is through the use of debt. This method is easily explained with an example which I will borrow from my colleague Gray Edmondson.
Consider a taxpayer who owns fully depreciated commercial real property worth $10M and $0 adjusted basis. Without deductions, the taxpayer will include $10M of property in his taxable estate, and the property will get a step-up in basis to $10M. But what if the taxpayer took out a loan for $9M, pledging the property as collateral, and uses the $9M in cash to buy an asset currently held in a grantor trust with $0 basis. Both the $10M and $9M property receive a step-up in basis. The gross estate would be $19M, reduced by $9M in debt, resulting in the same taxable estate of $10M, but this time, there is an additional $9M of stepped-up basis.
Partnerships provide a great deal of flexibility with regard to planning and shifting basis. This can be achieved through distributions without requiring death or a taxable event as is required in the methods discussed above. Partnership tax law is an extremely complex area of the law which is contained in Subchapter K of the Internal Revenue Code, including concepts such as the unitary basis rules, inside basis, outside basis, the “mixing bowl” rules, the application of Section 704(c), the application of Section 751 to so called “hot assets”, and the Section 754 election. A discussion of Subchapter K is beyond the scope of this article, but below are a few examples of methods that can be used for basis planning. Keep in mind there are special rules specific to partnership tax law that must be navigated with each method, but with a careful planning, a step up basis can often be achieved without any negative consequences.
Cash distributions from partnerships only trigger gain if the distribution exceeds the receiving partner’s outside basis.11 If the distribution of cash does exceed the partner’s outside basis, then gain is recognized only to the extent the cash receive exceeds the receiving partner’s outside basis reduces the partner’s outside basis. The cash in excess of basis is considered capital gain from the sale of the partner’s interest.12 Distributions of property do not cause gain or loss unless the property is a marketable security, in which case it is considered a distribution of cash13, the property is a “hot asset” under Section 751, or the distribution results in a shift in the ownership proportion of “hot assets.”14
Liquidating distributions are treated in the same manner as a non-liquidating distribution discussed above, except that in certain case, a loss may be recognized.15 A loss may only be recognized then the distribution consists solely of cash and/or “hot assets” under Section 751.16
Section 754 Election
A Section 754 election is made at the partnership level but is a powerful tool allowing a receiving partner to adjust his or her inside basis when the partner receives his or her interest as a result of the death of a partner or upon the sale or exchange of a partnership interest.17 If the deceased partner’s interest is worth more than that partner’s share of the basis of the partnership’s assets, and Section 754 election has been made, the basis adjustment will result in a step-up in basis in situations where the deceased partner’s partnership interest has a fair market value in excess of that partner’s share of the basis of partnership property.18 However, there may be situations where the Section 754 election is not beneficial. For example, when a Section 754 election has been made and the deceased partner’s partnership interest has a fair market value below that partner’s share of the basis of partnership property, a step down in basis will occur.
While this article provides a brief overview of some of the techniques and strategies that can be used to obtain a stepped up basis for assets, it is by no means an exhaustive list. Additionally, each strategy or technique discussed has its own nuances and pitfalls to be navigated, many of which are beyond the scope of this article. But with some savvy planning and proper analysis, there is a lot of potential to obtain a stepped up basis thereby avoiding income tax on appreciated assets with little to no cost or downside to the taxpayer.
As with any tax planning, it’s important to abide by the old saying “Don’t let the tax tail wag the dog.” While many of the techniques or strategies discussed above may be beneficial from a tax standpoint, keep in mind the reasons and the goals behind the taxpayer’s planning in the first place and don’t let the tax benefits override those goals. For example, when granting an independent trustee the power to confer a general power of appointment or perhaps a formula power of appointment to a beneficiary, this may go against some of the reasons the assets are in the trust in first place, such as protecting the beneficiary from his or herself in the case of spendthrift, or controlling the passing of the assets at the beneficiary’s death, which may be of particular importance in a blended families.
And of course, there’s always the downside to this basis step up planning that can result when assets that have depreciated in value are included in the estate of decedent by reason of one of the mechanisms discussed, the dreaded step down in basis. Throughout this article, I’ve referred to the step up in basis, but the rules go both ways, and the result can be negative if such assets have declined in value below their basis.
- §2010(c)(3)(C). Any reference to a Section or a § is to a Section of the Internal Revenue Code.
- The rules for obtaining a step up in basis as discussed herein are contained in Section 1014.
- §2010(c)(2)(B); Portability refers to the ability to port a deceased spouse’s unused exemption amount over to a surviving spouse to be used by the surviving spouse in his or her estate, and such amount “ported” over is in addition to the surviving spouse’s own exemption amount.
- Treas. Reg. §20.2041-1(c)(2).
- The creditor protection mentioned here is provided by state law and is determined on a state by state basis.
- Rev. Rul. 76-368.
- A power of appointment is a power which gives the powerholder the ability to appoint such assets subject to the power to a class of eligible appointees determined by the language of the power itself. These powers can be structured in any number of different ways, and are generally exercised in a Last Will and Testament or other signed and attested writing. For purposes of this article, all powers of appointment referred to are testamentary, exercisable only at death, but a lifetime power of appointment may also be granted. A general power of appointment is one that causes estate inclusion under §2041, while a limited power of appointment avoids such estate inclusion.
- A grantor trust is a trust in which the grantor is treated as the owner of all trust assets for income tax purposes under Sections 671 through 679. Since the grantor is also treated as the owner of a grantor trust, the grantor’s transactions with the trust, such as sales to and from the trust, are not taxable events.
- §731(a)(1), (a)(2).
- §§ 754, 743. Note that §743 provides for the actually basis adjustments, but a §754 election must be made before the provisions of §743 become applicable.