Estate Planning under the Tax Cuts and Jobs Act Basis Step-Up Planning

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Estate tax planning for decades has revolved primary around maximization of the estate and gift tax applicable exclusion amount.  The Tax Cuts and Jobs Act (“TCJA”), signed into law December 22, 2017, significantly increased the estate and gift tax applicable exclusion amount.  With the recent enactment of the TCJA, the applicable exclusion amount has increased from $675,000 per taxpayer in 2001 to $11.18 million per taxpayer in 2018.  The applicable exclusion amount of $11.18 million has significantly reduced the impact of the estate, gift, and generation-skipping transfer taxes. As a result, the focus of tax planning as part of estate planning will continue to focus on income tax planning opportunities.  Step-up in income tax basis planning for family assets at the death of the client is now one of the primary tax planning goals.

Mechanisms of Basis Step-Up Planning

Internal Revenue Code (“IRC”) § 1014 provides for a step-up in income tax basis to assets acquired from a decedent or passed from a decedent.  Although not directly stated in 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.

Being treated as owned by the decedent at death is where the basis step-up planning occurs.  The owner of the assets under state law is different from the decedent, but the decedent is treated as the owner for estate tax purposes.  This mismatch usually occurs with trusts but can also occur under different scenarios such as life estates.

Basis step-up planning can differ depending 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 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, for a beneficiary of a trust, the options for basis step-up planning are more limited.

Usually, in order to trigger estate tax 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 marital deduction previously applied, or hold a nongeneral power of appointment which is eligible for the “Delaware Tax Trap”.  Otherwise, the trust must be terminated outright, with title to the beneficiary’s share of the trust assets being distributed to him or her.

One strategy that is being implemented more and more is adding a parent, who has enough estate tax exemption available, and provide the parent with a general power of appointment over the trust assets.  This will allow for the trust assets to obtain a step-up in basis. The parent will need to be notified of the general power of appointment and the risk is that the parent would exercise the general power of appointment and appoint the assets to others than the trust beneficiaries.

Newer trusts are being created to allow an independent trustee or a trust protector to add a general power of appointment to a beneficiary of the trust.  One of the risks of a general power of appointment is that creditors can typically collect against a general power of appointment. By allowing an independent trustee or trust protector to add a general power of appointment later on to a beneficiary’s interest in the trust, the beneficiary’s creditor issues, if any, can be examined at that time along with the current estate and gift tax laws.  

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 the interest in the trust.  Such technique is known as the “Delaware tax trap”.

Assets Benefiting the Least and Most From Basis Adjustment

Assets that receive no benefit from basis adjustment under IRC § 1014 include income in respect to decedent (“IRD”) and retirement accounts.  Assets receiving minimal to moderate benefit from basis adjustment include qualified small business stock and high basis stock.  Assets receiving the most benefit from basis adjustment are negative basis real estate, assets taking bonus depreciation on qualified property, and creator-owned copyrights, trademarks, patents, and artwork.

Swap or Purchase of Grantor Trust Assets

A common grantor trust provision in a trust is the ability of the grantor to swap assets of equivalent value.  To the extent possible, the grantor should consider swapping high basis assets owned by the grantor for low basis assets held by a trust created by the grantor, assuming the trust will not allow for a step-up in basis at the grantor’s death.  The easiest way to accomplish this swap is for the grantor to transfer cash to the trust in exchange for the low basis assets. If the grantor does not have the necessary cash, the grantor could consider the use of a promissory note to complete the swap for the low basis assets.  

Grantor Use of Trust Property

Another way to cause estate tax inclusion is to allow the grantor to use the trust property that would reflect an implied agreement of retained enjoyment under IRC § 2036.  For example, the grantor using real property held by the trust without paying rent. This would be a good option where the term has ended for a qualified personal residence trust.

Conclusion

Basis step-up planning is a significant part of estate planning under the TCJA.  The estate and gift tax exclusion amount has increased from $675,000 to $11.18 million per taxpayer in less than 20 years.  Few Americans are subject to federal estate or gift tax with the exclusion amount under the TCJA, so income tax planning strategies are now more prevalent in estate planning.  A significant opportunity to reduce income tax is to fully utilize the step-up in basis to fair market value of the assets that are owned by the decedent or deemed to be owned by the decedent.

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