Steve Akers of Bessemer Trust has called this post-2017 Tax Act period “déjà vu on steroids.” Once again practitioners find themselves on the other side of a sea-change of the transfer tax regime only to have “stability” for a number of years. As in 2012, the current tax environment presents unique planning opportunities. However, at the stroke of midnight on December 31, 2025, Cinderella’s coach turns back in to a pumpkin and we are back to a $5 million basic exclusion amount, indexed for inflation from 2011.
This paper will examine techniques to best take advantage of the increased basic exclusion amount while we have it, and to build flexibility in to our planning so that our client’s needs are still met if and when the law changes. The first part of this paper will address testamentary planning, from disclaimer plans to more sophisticated planning using marital and non-marital trusts. The second part of this paper will explore planning techniques for lifetime transfers.
Although this paper focuses on transfer and income tax planning, it is important to remember that these considerations should be second to the goals and needs of the client, regardless of the size of the client’s estate. Planners should consider family dynamics such as whether there is a blended family, whether there are any concerns for undue influence over a surviving parent, any disabilities or incapacities of descendants, asset protection considerations, successive spouse considerations, and the nature and liquidity of the client’s assets.
B. Current Transfer Tax Regime
1. Tax Cuts and Jobs Act of 2017
The Tax Cuts and Jobs Act of 2017 (the 2017 Tax Act) significantly changed our approach to planning. Before the 2017 Tax Act, the first $5,000,000 (as adjusted for inflation in years after 2011) of transferred property was exempt from estate tax, gift tax, and generation-skipping tax. For estates of decedents dying and gifts made in 2018, this "basic exclusion amount" as adjusted for inflation, would have been $5,600,000 ($11,200,000 for a married couple). With proper planning, the unused portion of a deceased spouse's exclusion amount (DSUE) could be added to that of the surviving spouse for purposes of the estate tax and gift tax. We refer to this as portability of the DSUE.
For decedents dying and gifts made from 2018 through 2025, the 2017 Tax Act doubles the base estate and gift tax exemption amount from $5,000,000 to $10,000,000. Indexing for inflation brings this amount to $11,400,000 for 2019, ($22,800,000 per married couple), with the same basic portability techniques available. The 2017 Tax Act doesn't specifically mention the generation-skipping transfer tax (GST), but because the GST exemption amount is based on the basic exclusion amount, the GST exemption amount is similarly adjusted.
With the passage of the 2017 Tax Act, essentially practitioners are planning around two, and in some cases three, estate tax exclusion amounts. This paper will refer to the first exclusion amount as the “Old Exclusion Amount.” This is the exclusion amount under I.R.C. § 2010(c)(3), before the change made by the 2017 Tax Act (i.e. $5,000,000, indexed). The second exclusion amount (the “New Exclusion Amount”) is the § 2010(c)(3) amount as altered by the § 2010(c)(3)(C),(i.e., $10,000,000, indexed). The third exclusion amount is any deceased spousal unused exclusion (“DSUE”) available to a surviving spouse. In planning with the DSUE, not that the 2017 Tax Act augmented DSUE does not vanish January 1, 2026. Treas. Regs. §20.2010-2(c)(1).
As noted, on January 1, 2026 the New Exclusion Amount "vanishes" and we are left with the Old Exclusion Amount. In the interim, the Old Exclusion Amount and the Combined Exclusion Amount (Old plus New Exclusion Amounts) will both increase with chained CPI indexing. The increase in the Old Exclusion Amount and Combined Exclusion Amount over the next seven years, assuming a CPI increase of 1% per year is as follows:
The doubling of the basic exclusion amount by the 2017 Tax Act set the stage for yet another clawback debate. The concern was what effect would the sunset of the applicable provisions of the 2017 Tax Act have on gifts made during the time that the basic exclusion amount was doubled. Would those gifts, although covered under the New Exclusion Amount, be clawed-back in to a decedent’s estate if he died after the New Exclusion Amount disappears? Congress partially addressed clawback, adding a new I.R.C. Section 2001(g)(2) which provides as follows:
The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out this section with respect to any difference between:
(A) the basic exclusion amount under section 2010(c)(3) applicable at the time of the decedent's death, and
On November, 20, 2018, the Treasury released proposed regulations to address the clawback concern. Section 20.2010-(c)(1) of the Regulations provides that if the credit attributable to the basic exclusion amount for determining the gift tax payable on any post-1976 gift is greater than the credit attributable to the basic exclusion amount allowable in determining the estate tax liability, then the basic exclusion amount used in computing the donor’s estate tax liability will be the higher basic exclusion amount attributed to determining the gift tax payable. The proposed regulations contain the following example:
Individual A (never married) made cumulative post-1976 taxable gifts of $9 million, all of which were sheltered from gift tax by the cumulative total of $10 million in basic exclusion amount allowable on the dates of the gifts. A dies after 2025 and the basic exclusion amount on A's date of death is $5 million. A was not eligible for any restored exclusion amount pursuant to Notice 2017-15 [addressing same-sex married couples]. Because the total of the amounts allowable as a credit in computing the gift tax payable on A's post-1976 gifts (based on the $9 million basic exclusion amount used to determine those credits) exceeds the credit based on the $5 million basic exclusion amount applicable on the decedent's date of death, under paragraph (c)(1) of this section, the credit to be applied for purposes of computing the estate tax is based on a basic exclusion amount of $9 million, the amount used to determine the credits allowable in computing the gift tax payable on the post-1976 gifts made by A.
What these regulations do not provide is an “off the top” option for the use of the New Exclusion Amount. In other words, there is no direction that making a $5 million gift in 2018-2026 will first use the New Exclusion Amount, leaving the Old Exclusion Amount (after sunset of the 2017 Tax Act) to be applied against the estate tax at the donor’s death. Consider the following example.
Bill has an Old Exclusion Amount of $5,700,000 and a New Exclusion Amount of $5,700,000.00. Combined, he has a Basic Exclusion Amount of $11,400,000.00. The New Exclusion Amount "vanishes" January 1, 2026. Assume no inflation adjustment to the Basic Exclusion Amount. Assume Bill has $11,400,000 of wealth.
Bill gives away $5,700,000 of wealth prior to 2026. He pays no gift tax because his Basic Exclusion Amount of $11,400,000 covers the gift. Bill dies in 2026 owning $5,700,000. What is the estate tax occasioned at Bill’s death in 2026?
Estate Tax Calculation
Taxable Estate: $5,700,000
Adjusted Taxable Gifts: $5,700,000
Tax Base: $11,400,000
Tentative Tax (40%) $4,560,000
2026 Applicable Credit $2,280,000 [attributable to the Old Exclusion Amount]
Tax Due: $2,280,000
Do gifts during the period that a donor has both the Old Exclusion Amount and the New Exclusion Amount use the New Exclusion Amount first? According to the proposed Regulations, the answer is no. If a donor who has not previously made any taxable gifts makes a $5,700,000 gift in 2019, and if the donor dies after the New Exclusion Amount sunsets, the donor effectively will be treated as having used the $5,700,000 of the Old Exclusion Amount, and the donor will not have made any use of the New Exclusion Amount. To take advantage of this “window of opportunity” in case the New Exclusion Amount later disappears, the donor must make a gift in excess of the $5,700,000 Old Exclusion Amount.
Contrast this approach with the one that taken by the portability Regulations. The portability Regulations provide that a surviving spouse is considered to apply her DSUE amount from her last deceased spouse to a taxable gift before the surviving spouse’s own basic exclusion amount. Treas. Regs. §25.2505-2(b). In effect, this allows a donor to use the exclusion amount received from donor’s last deceased spouse before using her own exclusion amount.
3. Planning and Drafting
How do you plan and draft facing such uncertainty? One way to evaluate planning and drafting opportunities for our clients is in relation to their wealth. Consider the following categories.
a. Couple with combined wealth not exceeding one Old Exclusion Amount (<$5,700,000).
There is no way this couple can leave their wealth in a fashion that will generate a transfer tax. However, while are no transfer tax planning implications to their estate plan, there are income tax/basis implications. This couple will never need the New Exclusion Amount.
b. Couple with combined wealth exceeding one Old Exclusion Amount; but not exceeding two Old Exclusion Amounts; i.e. not exceeding the Combined Exclusion Amount (between $5,700,000 and $11,400,000).
This category is almost as straight-forward was the one above. There is only one way to generate transfer tax - the first spouse to die, having wealth in excess of one Old Exclusion Amount, must leave all of his wealth in a fashion that does not qualify for the marital deduction and/or charitable deduction. Of course, the surviving spouse has an Elective Share right to potentially generate a marital deduction sufficient to result in no transfer tax. Absent that one occasion, there is no need to divide assets between spouses for transfer tax purposes. If the first spouse to die leaves everything to surviving spouse, the DSUE is available to the surviving spouse. If the first spouse to die transfers sufficient property to credit shelter trust (thereby using his Old Exclusion Amount), there will be no estate tax liability as one Old Exclusion Amount will be sufficient to shelter her wealth. This couple will never need the New Exclusion Amount.
c. Couple with combined wealth exceeding: (i) two Old Exclusion Amounts; plus (ii) one New Exclusion Amount; but not exceeding twice the Combined Exclusion Amount (between $11,400,000 and $22,800,000).
Two Old Exclusion Amounts will not cover all of this couple's wealth. At a minimum, they will need: (i) two Old Exclusion Amounts; plus (ii) at least one New Exclusion Amount. Therefore, this couple will need to use at least one New Exclusion Amount via an inter vivos and/or testamentary transfer. Obviously, the only way to use one New Exclusion Amount via testamentary transfer is for one spouse to die prior to January 1, 2026. Dying makes available the New Augmented DSUE to the surviving spouse. It also allows for the decedent to fund a credit shelter trust using the Old Exclusion Amount and the New Exclusion Amount of the decedent. At the death of the second to die, the wealth exposed to estate tax should not exceed one Old Exclusion Amount, or one Old Exclusion Amount, plus available DSUE.
If neither spouse will die in 2025, they will need to make an inter vivos transfer to use one New Exclusion Amount. As noted above, a donor must use all of his Old Exclusion Amount to get to the New Exclusion Amount. That is, he must make a gift of at least $11,400,000 to fully use one New Exclusion Amount. Both spouses giving $5,700,000 would accomplish nothing because each would only use his or her Old Exclusion Amount. One spouse must give $11,400,000. Of course, other techniques for reducing the combined estates are available, in particular "perfect gifts". Perfect gifts are gifts which do not constitute "adjusted taxable gifts". That is, perfect gifts are gifts that qualify for the annual exclusion, medical exclusion and/or tuition exclusion. Techniques for freezing the combined estates are also available.
d. Couple with combined wealth exceeding twice the Combined Exclusion Amount afforded by the Old Exclusion Amount and the New Exclusion Amount (over $22,800,000).
Now, the couple needs to use both New Exemption Amounts via either inter vivos and/or testamentary transfers. As to testamentary transfers, both spouses need to die prior to January 1, 2026. Absent a willingness on behalf of the spouses in this regard, both spouses need to make gifts fully utilizing their New Exemption Amount prior to January 1, 2026. The considerations noted in paragraph 3 above apply, with equal force.
C. Testamentary Planning
1. Disclaimer Plan
Facts: Harold and Wilma have been married 35 years and have three children together. There are no children from prior relationships. Each child is a responsible adult, in a good marriage and the family gets along well with each other. The value of Harold and Wilma’s combined gross estates is less than the Old Exclusion Amounts available to both of them today, but would exceed the projected Old Exclusion Amounts in 2026, if the current tax law was to sunset.
In this scenario, Harold and Wilma are well below the combined Old and New Exclusion Amounts, so using the New Amount before it sunsets on December 31, 2025 is not a concern. Therefore the planner may want to use an approach that provides flexibility in the case of death after December 31, 2025 – the disclaimer plan. Under this plan, assets are directed to the surviving spouse, but language is built in to the governing document directing any assets that are disclaimed by the surviving spouse to a credit shelter trust which will be excluded from the surviving spouse’s gross estate at her later death. An obvious advantage of this approach is that it allows the surviving spouse and her advisors to assess the couple’s financial situation and the tax environment in existence at the death of the first spouse and plan accordingly. It also ensures that a credit shelter trust will not be unnecessarily funded and that those assets will not be denied a second step-up in basis at the surviving spouse’s later death.
Any discussion with clients about a disclaimer plan should also include a discussion of portability. It is important to educate clients about these options so that when the time comes to make a decision (a time that will be very difficult on its own) all parties are informed as to the options. Even if the death of the first spouse occurs after the sunset of the provisions of the 2017 Tax Act, the surviving spouse’s Old Exclusion Amount along with the DSUE may obviate the need for her to disclaim any assets.
Planners must be cautious in relying on a disclaimer plan. There is no guarantee that the surviving spouse will be competent or willing to make the necessary disclaimer. To address the first situation, planners may include a specific power in the spouse’s durable general power of attorney that allows the agent to disclaim assets on behalf of the spouse.
It is also important to advise clients that the surviving spouse may not access any account that she may want to disclaim later. In order to be a qualified disclaimer for transfer tax purposes, the disclaimant must not have accepted the disclaimed property or any benefit of the disclaimed property. Treas. Regs. §25.2518-2(a)(4). This may be particularly confusing for a spouse who has just lost her partner of many years and is caught up in trying to gather and administer assets as quickly as possible. It is important that the spouse understands that she should not access any account, other than perhaps an account previously held jointly with her spouse, before talking to her attorney and CPA.
It is incumbent upon the planner to ensure that the couple’s assets are properly titled, as failing to do so can render the best drafted disclaimer plan worthless. Ideally, the value of husband and wife’s combined estates would be split as evenly as possible and in the separate names of husband and wife (or their respective revocable trusts). Also, beneficiary designations should be properly prepared naming the spouse as the primary beneficiary and the credit shelter or family trust as the contingent beneficiary. That way, if a spouse disclaimed assets from a retirement account or life insurance policy, those assets would pass to the proper trust.
Finally, the surviving spouse may not exercise, nor be granted, a power of appointment over the disclaimed assets. Treas. Regs. §25.2518-2(e)(1)(i) provides that the requirements for a qualified disclaimer are not met if “[t]he disclaimant, either alone or in conjunction with another, directs the redistribution or transfer of the property or interest in property to another person (or has the power to direct the redistribution or transfer of the property or interest in property to another person unless such power is limited by an ascertainable standard).” Drafters have long heeded this warning and generally do not include a power of appointment in a trust to which a surviving spouse may disclaim assets.
Interestingly, one commentator argues that drafters have missed the mark, and agreat planning opportunity in this respect. Edwin P. Morrow, III relies upon Treas. Regs. § 25.2518-2(e)(2) for this argument. That regulation provides,
[i]n the case of a disclaimer made by a decedent's surviving spouse with respect to property transferred by the decedent, the disclaimer satisfies the requirements of this paragraph (e)(2) if the interest passes as a result of the disclaimer without direction on the part of the surviving spouse either to the surviving spouse or to another person. If the surviving spouse, however, retains the right to direct the beneficial enjoyment of the disclaimed property in a transfer that is not subject to Federal estate and gift tax (whether as trustee or otherwise), such spouse will be treated as directing the beneficial enjoyment of the disclaimed property, unless such power is limited by an ascertainable standard.
Mr. Morrow argues that a general power of appointment can be retained by the surviving spouse and not disqualify her disclaimer for federal transfer tax purposes, because her right to direct the beneficial enjoyment would be one that is subject to Federal estate tax. Optimal Basis Increase and Income Tax Efficiency Trust, Edwin P. Morrow, http://ssrn.com/abstract=2436964 (2017). Consequently, Mr. Morrow argues that the surviving spouse could be given a formula general power of appointment over assets in the credit shelter trust in order to obtain a later step-up in basis. Id. at 78. This paper will address planning with formula general powers of appointment later.
This author believes it would be too risky to allow the surviving spouse to retain a general power of appointment over disclaimed property, Mr. Morrow’s interpretation of the above-cited regulations appears to be at odds with the plain language of I.R.C. § 2518, which states that the disclaimed property must pass without the direction of the disclaimant. Certainly the exercise of a general power of appointment would be a direction by the disclaimant. Additionally, this author believes that the language in Treas. Regs. § 25.2518-2(e)(1) regarding the “power to direct redistribution” is not the same as the “right to direct beneficial enjoyment” in Treas. Regs. § 25.2518-2(e)(2). Canons of statutory construction tell us that Treasury would not have used different language in consecutive sections of this regulation to mean the same thing. The more likely interpretation is that the “power to direct redistribution” means a power of appointment (limited or general) and the “right to direct beneficial enjoyment” means the power as a trustee or other fiduciary.
If reliance on Treas. Regs. § 25.2518-2(e)(2) is misplaced, then the surviving spouse would have made a taxable transfer of the disclaimed property AND would then subject the property to estate tax at her later death, by virtue of I.R.C. § 2041. This would certainly not be the intended result.
In order to avoid this possibility, planners should always review the language of the governing document to make sure that the trust into which the spouse is disclaiming does not give the spouse a power of appointment, limited or general. If it does, that power of appointment must be disclaimed as well. Most documents will contain a savings clause, like the one below, to ensure that any missed power of appointment is also disclaimed.
2. Marital Trusts
With portability came a new era in estate planning and a new exclusion amount to utilize in planning. Married couples can now pass twice as much to the next generation without incurring an estate tax and without the trouble of a trust though the use of the Old Exclusion Amount and the DSUE. Many practitioners have questioned whether the days of trust planning are gone, in favor of the more straightforward approach of an outright distribution to the surviving spouse. However, the benefits of trust planning go far beyond simply mitigating or eliminating estate tax liability. The drawbacks of relying only on portability for a client’s estate plan include the following:
a) No asset protection from creditors, including a successive spouse
b) The deceased spouse’s unused exclusion amount is not indexed for inflation
c) Portability does not apply to the generation-skipping transfer tax exemption
d) Must file an estate tax return to elect portability
e) The deceased spouse’s unused exclusion amount is lost if the spouse remarries and survives second spouse
f) The surviving spouse can waste the deceased spousal unused exclusion amount if she agrees to split gifts with new husband.
Morrow at 4-9.
Assuming a planner wants to avoid these shortcomings and include a marital trust in a couple’s estate plan, the following types of trusts may be used.
a. General Power of Appointment Trust
Facts: Harold and Wilma have been married 50 years and have three children together. There are no children from prior relationships. The value of Harold and Wilma’s combined gross estates is less than the Old Exclusion Amounts available to both of them, and is expected to remain so even after the sunset of the 2017 Tax Act. Harold and Wilma wish to leave assets in trust for each other for non-tax reasons.
Use of the New Exclusion Amount is not important here because Harold and Wilma’s assets are not expected to exceed the value of the Old Exclusion Amount. What is important to Harold and Wilma is using a trust for the surviving spouse for non-tax reasons and obtaining a second step-up in basis at the second death. A general power of appointment marital trust may be a good option.
We rarely see general power of appointment trusts because they do not provide the type of protection most spouses are trying to achieve. A general power of appointment trust is described in I.R.C. § 2056(b)(5) and requires that: (1) the surviving spouse be entitled to all income payable annually or in more frequent intervals; (2) the spouse have the power to appoint the assets of the trust to herself or her estate; and (3) no other person has the power to appoint any interest in the trust. Note that the power in the spouse to appoint assets to her creditors or the creditors of her estate, although a general power of appointment, will not qualify the trust for the marital deduction under I.R.C. § 2056(b)(5).
Because of the requirement that the surviving spouse have the power to appoint trust assets to herself or her estate, this trust is of limited usefulness. The protection from creditors or a successive spouse that most grantors are trying to achieve is thwarted by the power of appointment. However, in cases where clients are older, married and have only children of the marriage, a general power of appointment trust may be useful because assets can be left to the spouse in a marital deduction trust without filing an estate tax return to make the QTIP election. The assets in the marital trust will receive a second step-up in basis at the surviving spouse’s death. Of course, assets in the martial trust may receive a step-down in basis at the surviving spouse’s death.
b. Standard QTIP
Facts: Harold and Wilma have been married 20 years and have two children together. Harold also has a child from a previous marriage. The value of Harold and Wilma’s combined gross estates is less than the Old Exclusion Amounts available to both of them, and is expected to remain so even after the sunset of the 2017 Tax Act.
Again, use of the New Exclusion Amount is not the driver of this plan because the Old Exclusion Amount should suffice to shelter assets from estate tax. What is most important is protecting assets for all of Harold’s children and obtaining a second step-up in basis at Wilma’s later death. This is there a typical QTIP marital trust would come into play. Assets could be left to a trust for the surviving spouse that qualifies for the marital deduction, but the spouse would have no power to direct assets. This would prevent her from being able to disinherit Harold’s child from a previous marriage.
Section 2056(b)(7) of the Internal Revenue Code sets out the requirements for a valid QTIP trust. The spouse must have the right to all the income from the trust, payable annually or more frequently; no other person may have an interest in the trust; and the executor must make the election to have the trust treated as a QTIP trust on a timely filed estate tax return.
For some time, practitioners have not used QTIP trusts in the above scenario because they thought the IRS would determine that the QTIP election was not necessary (because the decedent’s estate was not subject to estate tax and no marital deduction was needed), and therefore disregard the election entirely. This fear stemmed from Rev. Proc. 2001-38 which was issued to provide relief for surviving spouses when a predeceased spouse’s estate made a QTIP election that did not reduce the estate tax lability. Revenue Procedure 2001-38 was designed to help taxpayers and outlined circumstances under which the IRS would ignore the unnecessary QTIP election. However, some practitioners feared that the IRS would use this Revenue Procedure offensively to disregard a QTIP election that did not reduce the estate tax due in the estate of the first spouse to die, but was nevertheless still intentionally made. Thankfully, in 2016 the IRS issued another Revenue Procedure clarifying that the IRS would continue to disregard unnecessary QTIP elections but only for estates which did not elect portability. Rev. Proc. 2016-49.
There are several drawbacks to this type of planning. First, assets in the QTIP trust may get a step-down in basis at the surviving spouse’s death. (I.R.C. § 1014). Another drawback is with valuations. Consider a husband and wife owning 50% each in a closely held business. At the husband’s death, his 50% interest passes to a QTIP trust for wife, with wife retaining her 50% interest in her own name. At wife’s later death, the interest in the QTIP trust and the interest in wife’s individual name will be valued as two separate interests and therefore subject to discounts (See Mellinger v. Comm’r, 112 T.C. 26 (1999)). This will reduce the value of the interests and necessarily reduce the amount of step-up in basis for those interests. On the other hand, if the wife had died owning 100% of the business interests in her sole name, no discount would apply. Morrow at 15. Note that this would likely not be an issue with a general power of appointment trust because the surviving spouse would have effective control over the assets in that trust, eliminating the basis for a discount.
c. Clayton QTIP
Facts: Harold and Wilma have been married 20 years and have two children together. Harold also has a child from a previous marriage. The value of Harold and Wilma’s combined gross estates is less than combined basic exclusion amounts available to both of them, but may be more than the basic exclusion amounts when the provisions of the 2017 Tax Act sunsets
In this situation, the key drivers of the plan are the same as with the QTIP trust above; however, Harold and Wilma also need the flexibility of a credit shelter trust if the value of their assets will exceed the Old Exclusion Amount available to them after December 31, 2025. Here, a Clayton QTIP may be useful.
The Clayton QTIP derives its name from a 1991 Tax Court case which denied the marital deduction for a trust, the terms of which provided that if the decedent’s executor did not make the QTIP election, the property would pass to a separate trust. Clayton v. Comm’r, 97 T.C. 327 (1991). In Clayton, the decedent directed an amount equal to his available exclusion amount to “Trust A” - a credit shelter trust - and left the residue of his estate to “Trust B”, a trust designed to qualify for the marital deduction. The language of Mr. Clayton’s will provided as follows:
In the event my executors fail or refuse to make the election under Section 2056(b)(7)(B)(II)(v) of the [Internal Revenue Code], with respect to my Trust B property on the return of tax imposed by Section 2001 of the [Internal Revenue Code] then the property with respect to which such election was not made shall pass to and become part of the corpus of Trust A for the benefit of my Trust A beneficiaries.
Clayton at 328.
The Tax Court held that because the terms of the instrument provided that if the executor did not make the election, the assets would pass to a trust which was not a qualified terminable interest, the Executor essentially had the power to direct assets away from the marital trust to the non-qualified trust. According to the Court, this violated I.R.C. § 2056(b)(7)(B)(ii)(II) which provides that no person may have the power to appoint any of the trust property to any person other than the surviving spouse. The Court also noted that because the Executor had the power to direct assets from the marital trust to the non-qualified trust, it meant that the surviving spouse would technically not be entitled to all the income from the property in the marital trust, as required under I.R.C. § 2056(b)(7)(B)(ii).
Several Circuit Appeals Courts reversed the Clayton decision and the Tax Court ultimately reversed itself in Clack v. Comm’r, 106 T.C. 131 (1996). In Clack, the Tax Court acknowledged that it will no longer disallow the marital deduction for interests that are contingent upon the executor’s election under I.R.C. § 2056(b)(7)(B)(v). In light of this ruling, the IRS promulgated a new regulation – Treas. Regs. § 20.2056(b)-7(d)(3)(i), which provides in relevant part that a “qualifying income interest for life that is contingent upon the executor's election under section 2056(b)(7)(B)(v) will not fail to be a qualifying income interest for life because of such contingency or because the portion of the property for which the election is not made passes to or for the benefit of persons other than the surviving spouse.”
The Clayton QTIP offers flexibility like the disclaimer option in that the decision as to if and by how much to fund the marital trust may be left until after the first spouse’s death. However, that decision may be made up to 15 months after the death of the first spouse, instead of the nine-month widow a survive spouse has to make a qualified disclaimer. Also, the credit shelter trust under the Clayton QTIP plan may give the spouse a limited power of appointment, which is not available under the disclaimer plan. Morrow at 11.
One word of caution, an estate plan with a Clayton QTIP provision should have an independent executor. Id. If the surviving spouse has the ability to reduce or eliminate her mandatory income interest, there is an argument that she could be making a gift of that interest. (See Regester v. Comm’r, 83 T.C. 1 (1984) holding that when donor who had an income interest in a trust, exercised her limited power of appointment over the trust corpus to appoint the corpus, donor made a gift of the income interest).
3. Non-Marital Trusts
Consider situations in which a practitioner may not want to use a traditional marital trust. One reason may be that the planner wants to allow for distributions to children and grandchildren during the life of the surviving spouse. That would not be allowed under the terms of a marital trust because in order to qualify for the marital deduction, the spouse must be the only permissible beneficiary during her lifetime. Planners should become familiar with techniques that allow for the possibility of estate inclusion for the assets in a non-marital trust for the surviving spouse to cause estate inclusion.
These techniques may also be useful when considering whether to modify existing irrevocable trusts to allow for possible estate inclusion. This may come up in two situations. First, when the beneficiary of the irrevocable trust will have no estate tax liability, even with the inclusion of trust assets, by reason of the Old Exclusion Amount it would be a good idea to trigger inclusion for the second step-up in basis. Secondly, if you have a beneficiary that will likely not survive the sunset of New Exclusion Amount, it may be a good idea to trigger estate inclusion so that you do not lose the benefit of the New Exclusion Amount.
a. Independent Trustee with Power of Distribution
Perhaps the easiest way to build in flexibility for a second step-up in basis at the surviving spouse’s death is to give an independent Trustee the power to distribute principal to the surviving spouse. This also allows the Trustee to pick the appropriate appreciated property, leaving behind any property which may be subject to a step-down in basis.
Of course, the ideal time for a Trustee to make such a distribution would be as close to the death of the surviving spouse as possible. However, absent a clairvoyant trustee, it will be very difficult for a Trustee to know the best time to make a distribution. Waiting too long could result in a lost opportunity due to the unexpected death of the surviving spouse. Making a distribution too soon could thwart the intent of the grantor by leaving assets susceptible to the whims and creditors of the surviving spouse.
Because of these unknowns, it may be difficult to find a trustee willing to exercise this power. It puts pressure on the trustee to keep tabs on the physical and financial health of the surviving spouse in order to determine the best time to make a distribution.
b. Contingent General Power of Appointment
The terms of the credit shelter trust could grant the surviving spouse a contingent power of appointment which could be triggered if necessary to include all or a portion of the assets in the credit shelter trust in the surviving spouse’s estate. The contingent nature of the power would be achieved through the use of a formula which would apply the power only to extent that the surviving spouse has any unused exemption amount. Ideally, the power would apply first to assets with the most appreciation.
Estate planners commonly use formulas in planning – in funding credit shelter and marital trusts, disclaimers, and partial QTIP elections. The Service has also sanctioned the use of formula general powers of appointment in the past. In PLR 200403094, husband’s trust contained the following provision:
At my wife’s death, if I am still living, I give to my wife a testamentary general power of appointment, exercisable alone and in all events to appoint part of the assets of the Trust Estate, having a value equal to (i) the amount of my wife’s remaining applicable exclusion amount less (ii) the value of my wife’s taxable estate determined by excluding the amount of those assets subject to this power, free of trust to my deceased wife’s estate or to or for the benefit of one or more persons or entities, in such proportion, outright, in trust, or otherwise as my wife may direct in her Will.
The Service ruled that wife possessed a testamentary general power of appointment over assets equal to her remaining applicable exclusion amount. Accordingly, if wife predeceased husband, the value of the property over which she held the general power of appointment would be included in her gross estate. (See also PLR 200604028 holding that a power of appointment over property equal to husband’s available applicable exclusion amount, less the value of his taxable estate, was a general power). Lester B. Law and Howard M. Zaritsky, Basis after the 2017 Tax Act – Important Before, Crucial Now, Heckerling Institute on Estate Planning (2019), at 86-87.
Interestingly, in both of these Rulings, the Service never questioned the fact that the assets subject to the general power of appointment were determined by reference to the spouse’s available applicable exclusion amount after subtracting the value of his or her taxable estate (less the property subject to the power), which could only be determined after death. Id.
As with the independent Trustee’s power discussed above, this technique allows for the selection of appreciated assets for inclusion in the surviving spouse’s estate and leaving loss assets so as to not receive a step-down in basis. However, this technique may be preferable to the power to distribute trust principal in that: (i) it can be structured as a self-adjusting formula clause which will not require an independent party to keep tabs on the physical and financial health of the surviving spouse; and (ii) it requires no action on the part of the Trustee. Id. at 90.
There are disadvantages to this technique to keep in mind. First, any time planners incorporate a formula in drafting, they must be very precise to make sure it operates in the manner the planner and the client intend. Secondly, this technique should not be used along with a disclaimer plan as the spouse should have no contingent power of appointment over property she previously disclaimed.
c. Use of Trust Protector
In 2012, North Carolina added Article 8A to the North Carolina Uniform Trust Code. That Article allows a trust agreement to appoint a “power holder” who has authority to take certain actions with respect to the trust, but who is not the trustee. (N.C. Gen. Stat. § 36C-8A-1). The powerholder is also sometime called a trust protector. North Carolina law specifically provides that a trust protector may have the power to (1) direct investments and discretionary distributions; (2) modify or amend the trust agreement under certain circumstances; (3) remove and appoint trustees; and (4) grant a power of appointment to one or more beneficiaries. N.C. Gen. Stat. §36C-8A-2.
The terms of the credit shelter trust could give a trust protector the broad power to grant a general power of appointment to the surviving spouse. This power of appointment could be tailored to apply to only appreciated assets, leaving any depreciated assets out of the surviving spouse’s estate and thereby avoiding a step-down in basis. This technique also eliminates the need for a formula. However, the same issues are raised as with the power in an independent trustee to make distributions to the surviving spouse: it may be difficult to find a trust protector willing to wield this type of power, and it is difficult to know the best time to grant such a power of appointment. Id. at 99.
Also, for the reasons mentioned above, this technique should not be employed in a disclaimer plan.
1. Spousal Lifetime Access Trusts
Gift planning before the sunset of the provisions of the 2017 Tax Act will focus on using a donor’s New Exclusion Amount before it disappears. Take, for example, a married couple with assets in excess of the sum of the Old Exclusion Amount and the New Exclusion Amount. They will want to take advantage of the New Exclusion Amount, but as noted above, in order to reap the full benefits of the New Exclusion Amount, a donor will need to make a gift that exceeds his Old Exclusion Amount. This means that one spouse will need to make a gift of $11,400,000 in 2019.
Many couples are reluctant to part with this amount of wealth. For those couples, a spousal lifetime access trust (“SLAT”) may be the solution. In this trust, the grantor would make a large gift to a trust for wife and children. Wife could be Trustee of the SLAT, make distributions to herself pursuant to an ascertainable standard and make discretionary distributions to her children. As long as the couple is together, husband will still indirectly have the benefit of the funds.
To add in more flexibility, clients may also incorporate any of the techniques discussed above with regard to non-marital trusts in order to provide for later estate inclusion in the wife’s estate in case that the New Exclusion Amount is made permanent or the estate tax is repealed completely.
2. Lifetime QTIP Trust
When there is a disparity in wealth between two spouses, a lifetime qualified terminable interest trust (“Lifetime QTIP”) may be a useful solution to making sure the New Exclusion Amount of the poorer spouse is fully utilized. Richard S. Franklin and George D. Karibjanian, The Lifetime QTIP Trust – the Perfect (Best) Approach to Using Your Spouse’s New Applicable Exclusion Amount and GST Exclusion, Estates Gifts & Trusts Journal, May 14, 2019. Section 2525 of the Internal Revenue Code allows for an unlimited deduction against the gift tax for transfers to a spouse. However, as with the estate tax, that deduction is not allowed for a transfer of a terminable interest unless certain criteria are met. One option to qualify such transfer for the gift tax marital deduction is to make the transfer to a trust, in which the spouse has the right to all income from the trust and the donor makes the election on a timely filed gift tax return I.R.C. § 2523(f).
As with the SLAT, as long as the couple is married, both spouses may, in effect, enjoy the use of the property. However, contrary to a SLAT, distributions cannot be made to children during the lifetime of the spouse. The Lifetime QTIP will also protect the assets from the claims of the donee spouse’s creditors.
Upon the death of the beneficiary spouse, the assets remaining in the Lifetime QTIP will be included in her estate by virtue of I.R.C. § 2044 and will receive a second-step up in basis. Also, the spouse’s executor will be able to allocate the spouse’s GST Exemption to the trust assets. For this reason, it is important NOT to make the reverse QTIP election when the Lifetime QTIP is established.
What if, in 2025, the couple decides that they need to take advantage of the New Exclusion Amount before it sunsets. At that time, beneficiary spouse could transfer her income interest in the Lifetime QTIP to a trust for the couple’s descendants. That transfer would trigger the application of I.R.C. § 2519, which provides that “any disposition of a qualifying income interest for life in any property [for which a deduction was allowed a deduction under § 2523(f)] shall be treated as a transfer of all interest in such property other than the qualifying income interest.” The disposition of the income interest would cause the beneficiary spouse to be deemed to have made a gift of the entire interest in the Lifetime QTIP, therefore using her increased exclusion amount. Id. The beneficiary spouse would allocate her GST exemption to the transfer on a timely filed gift tax return.
One downside to the use of the Lifetime QTIP is that care must be taken to ensure that the step transaction doctrine does not apply. If the poorer spouse wishes to make a lifetime transfer of her interest in the QTIP to use the increased exclusion amount before it disappears on December 31, 2025, there should be NO prearranged plan for the transfer, and the transfer should not happen close in time to the creation of the Lifetime QTIP.
3. Upstream Gifts
One technique that is a bit at odds with traditional estate planning is to make a gift to a person in an older generation. This type of gift would not necessarily be to use the donor’s New Exclusion Amount, but to use the older person’s Exclusion Amount and obtain a step-up in basis. Other than being a poor use of the donor’s New Exclusion amount, the drawbacks to this planning include exposure to the older person’s direction and creditors and the possibility that the older person dies within 1 year and leave the gifted property to the donor, thereby eliminating the basis step-up under I.R.C. § 1014(e). Law and Zaritsky at 110.