I am currently working with an elderly client named John who is the beneficiary of a $6 million trust established by his father. Upon his death, half of the trust will be distributed to his daughter; the other half will be distributed in equal shares to the children of his deceased son. The trust owns a lot of stocks that were transferred to the trust upon his father’s death in 1989. These stocks have a very low basis in comparison to the current fair market value of the stocks. The trust is exempt from GST taxes and will not be subject to estate tax or GST tax upon his death. Because the trust will not be subject to estate or GST tax, there will not be any change in the basis in the stocks of the trust upon his death. Therefore, when the daughter and grandchildren eventually sell the stocks, they will incur substantial capital gains taxes. John would like for his daughter and grandchildren to receive a higher basis in the stocks, if that is possible.
One approach is for the trust to distribute low-basis stocks worth approximately $3.4 million to John. Since he already owns assets of $2 million, the distribution would give him a combined estate of $5.4 million, which is below the current federal estate tax exemption of $5.43 million. His Will distributes his estate consistently with the trust. Therefore, distributing assets out of the trust to John will not change the ultimate beneficiaries of the assets. Because the stocks will be in his estate, they will receive a stepped-up basis upon his death.
The danger with this approach is that the stocks will appreciate, which could result in estate taxes being owed upon John’s death. Another danger is that the federal estate tax exemption could be decreased by future law change. For example, the President has proposed a decrease of the exemption to $3.5 million.
In order to accomplish John’s goals, while hedging against the appreciation and legislative risks, I have proposed the following solution:
Step One – The Trustee of the trust will establish a new trust that is identical to the 1989 trust, except that John will have a power in his Will to appoint a portion of the trust assets to creditors of his estate. The amount that can be appointed will equal the maximum amount that does not result in estate taxes being payable. The power of appointment will apply in sequential order to the most highly appreciated assets.
Step Two – The Trustee of the 1989 Trust will distribute approximately $4 million in appreciated assets to the new trust. Tennessee law allows the transfer of assets between trusts for the same beneficiaries in certain circumstances. This process is referred to as “Decanting.”
The power of appointment will have the following consequences upon John’s death. John does not have any creditors, therefore, there is very little risk that he will exercise his power of appointment in favor of creditors. Even though the power is virtually meaningless, the Internal Revenue Code requires the amount that could be appointed to be included in John’s estate for estate tax purposes. However, since the amount that can be appointed is limited to the amount that will not cause estate taxes, no estate tax will be owed. Once the formula amount is determined, the Trustee will then determine which assets had the most appreciation and, thus, which assets are subject to the power of appointment. These assets will receive a stepped-up basis upon John’s death. His daughter and grandchildren would then be able to sell those assets without any capital gains (except for appreciation that may occur following John’s death). Based upon the current disparity between basis and fair market value of the stocks in the trust, there would be approximately $2.7 million of additional basis gained by this technique. John’s daughter lives in California (which has state income taxes on capital gains), while the grandchildren live in Tennessee. Based upon the maximum federal and state income tax rates, the increased basis could reduce future income taxes by as much as $800,000.
Your $5.43 million federal estate exemption is a very generous gift that Congress has provided to you. You should look for opportunities to leverage the exemption to give your heirs a higher basis for income tax purposes.