By John S. Lueken
Have you reviewed your clients’ estate plans since the Tax Cuts and Jobs Act of 2017 (“Tax Act”) took effect? Among its myriad changes, the Tax Act drastically increased the federal estate tax exemption from $5.49 million per individual in 2017 to $11.18 million per individual in 2018. Of course, married couples have double the amount of federal estate tax exemption. For 2019, the federal estate tax exemption sits at a robust $11.4 million per individual ($22.8 million for married couples). This elevated federal estate tax exemption amount is scheduled to sunset at the beginning of 2026, at which time the federal estate tax exemption is scheduled to return to $5 million per individual, adjusted for inflation.
A hot topic in estate planning in recent months has been the modification of “irrevocable trusts” to take advantage of this higher federal estate tax exemption. Placing assets in irrevocable trusts was one vehicle by which high-net-worth individuals and families could pass assets to the natural objects of their bounty, while simultaneously minimizing estate tax obligations.
Typically, assets held in an irrevocable trust are excluded from the transferor-settlor’s gross estate for federal estate tax purposes. A downside to excluding assets from one’s estate, however, is that the ultimate recipient of the asset would take the transferor’s tax basis in the asset. By contrast, the recipient of an included asset (i.e., one that is included in the transferor’s estate) receives the asset with a tax basis equal to the asset’s value on the date of the transferor’s death. Generally speaking, the benefits of avoiding estate tax are preferable to the benefits of basis step-up because the tax rate on capital gains is approximately one-half of the federal estate tax rate. Moreover, the tax on capital gains is not realized until the asset is sold, thereby potentially providing many years of tax-deferred growth.
Depending on factors such as the client’s overall net worth, the amount of lifetime exemption the client has utilized and the amount of asset appreciation in the client’s portfolio, it may be worth modifying an irrevocable trust to cause inclusion. This article explores utilizing a formula testamentary general power of appointment to modify an existing irrevocable trust to cause inclusion in a decedent’s estate, thereby obtaining a step-up in basis of the trust assets at the beneficiary’s death, but only to the extent such inclusion does not result in federal estate tax being due.
For years, estate planners and clients have worked together to create irrevocable trusts designed to shelter assets from taxes, including federal estate and generation-skipping transfer taxes. By placing assets into an irrevocable trust, many clients have been able to reduce estate tax obligations, thereby maximizing wealth transfer to or for the benefit of future generations.
In recent years, the federal estate tax exemption amount has steadily increased. In 2005, the amount was $1.5 million per individual. Today, the federal estate tax exemption amount is $11.4 million per individual.
Because of the many changes in trust law, including, without limitation, the increased federal estate tax exemption, many states have simplified the procedure for modifying irrevocable trusts. Many practitioners view this as a fair and favorable development. Placing assets in an irrevocable trust was a prudent wealth transfer strategy based on the tax laws in effect when the trust was drafted.
Now, after the landscape of tax law has undergone drastic and unforeseeable changes, it hardly seems fair to force the prudent client to be stuck with an irrevocable trust, the terms of which are not necessary or even beneficial under the today’s estate tax landscape.
Many irrevocable trusts were specifically designed to exclude assets from a settlor’s gross estate for federal estate tax purposes. Now, because only a relatively small number of individuals have a taxable estate, most clients are better served by including trust assets in their estates, so that their descendants will receive the stepped-up basis discussed above. The benefits of inclusion are further magnified due to the tremendous gains in the stock market over the last few years, because many irrevocable trusts now hold assets with significant amounts of unrealized appreciation.
Modifying existing irrevocable trusts
Despite the name, irrevocable trusts can be modified under certain circumstances. If the trustee has discretion to encroach upon trust corpus, many states, including Indiana, permit the trustee to “decant” the existing trust into a new or existing trust containing more desirable terms; however, most state decanting statutes greatly limit the permissible differences between the original and the decanted trust.
Under Indiana law, an irrevocable trust may be modified if the court determines the proposed modification will further the purposes of the trust. In many cases, the purpose of the trust was to enjoy favorable tax treatment; thus, modification to cause inclusion is necessary to further the purposes of the trust.
Maximizing basis step-up
Among the most effective ways for a client to benefit from the increased estate tax exemption without disrupting his or her existing estate plan is to grant a formula testamentary general power of appointment at the death of the oldest living settlor or beneficiary of the trust. In some states, it is even permissible to modify a trust retroactive to the settlor’s death.
In many cases, it is not necessary for the powerholder to exercise the said formula general power of appointment; the mere existence of the general power is sufficient to cause inclusion in the powerholder’s estate. Further, it is permissible for the same individual to hold both a general and a special power of appointment. One obvious danger of granting a general power is that all assets subject to the general power would be includable in the powerholder’s estate at his or her death, possibly causing estate tax to be due. To mitigate the risk of “overinclusion,” it is preferable to limit the assets subject to the general power based on a formula provision.
By employing a formulaic approach, inclusion of trust assets occurs only to the extent that inclusion does not result in estate tax being due. Further, the formula provision can direct a trustee to allocate the powerholder’s remaining estate tax exemption first to those assets with the highest ratio of unrealized appreciation.
In sum, by granting a formula testamentary general power of appointment, the client (or more correctly, the client’s descendants) can enjoy a basis step-up for those assets with the most built-in gains, while simultaneously avoiding estate tax at the powerholder’s death.
Higher exemption set to sunset
It is important to remember that the increased estate tax exemption is set to expire at the end of 2025 and revert to the 2017 level of $5 million, adjusted for inflation. Each client’s wealth management plan differs, and you’ll need to keep in mind their assets and their value, the goals for their wealth, and the current and future tax laws.
Utilizing the formula testamentary general power of appointment is one way by which you can help your clients enjoy the benefits of today’s higher federal estate tax exemption while simultaneously protecting against overinclusion.•
• John S. Lueken — JLueken@BGDlegal.com — is a partner and chair of Bingham Greenebaum Doll’s estate planning department. Opinions expressed are those of the author.