The Estate Trust Revival:
Maximizing The Full Basis Step-Up For Spouses
By David A. Handler and Kevin M. Chen Kirkland & Ellis, Chicago, IL
"Estate Trusts" are a means of obtaining a full, non-discounted basis step-up for all of the assets used in the strategy at the first spouse’s death, while providing a valuation discount at the second spouse’s death.
Married couples with high value/low income tax basis assets often face several dilemmas in their attempts to maximize the basis step-up in assets at death under Sec. 1014 of the Code. For example, they must decide how their assets should be held. As a general rule, most couples cannot divine which spouse will be the first to die. Thus, if all of the assets are held by one spouse and that spouse is not the first to die, then none of the assets will receive a basis step-up until the second spouse’s death. Alternatively, if each spouse holds half of the assets, then only half of the assets will receive a basis step-up under Sec. 1014(a) at the first spouse’s death.
If it becomes apparent which spouse will die first, the couple may attempt to transfer all assets to such spouse in order to benefit from a full basis step-up in all of the assets at such spouse’s death. However, Sec. 1014(e) provides that if appreciated property was acquired by the decedent by gift within one year of his or her death, and such property is acquired from the decedent by (or passes from the decedent to) the donor of such property (or the spouse of such donor), then the basis of such property in the hands of the donor (or spouse) is the adjusted basis of such property in the hands of the decedent immediately before his or her death. Thus, last minute attempts by a healthy spouse to transfer assets to the dying spouse will fail to provide a basis step-up for such assets if the property is bequeathed to or in trust for the benefit of the healthy spouse.
In addition, a married couple might consider implementing estate planning strategies that reduce estate taxes by creating valuation discounts, such as establishing a family limited partnership (FLP). These techniques will reduce the couple’s overall estate tax burden, but at the cost of significantly reducing the basis step-up for the interests held by the first spouse to die. This predicament can be illustrated by the following hypothetical, but not uncommon, scenario:
Illustration. A couple, husband and wife, own low basis assets. They contribute their assets to an FLP, each receiving a .5 percent general partner (GP) interest and a 49.5 percent limited partner (LP) interest, in order to obtain valuation discounts for gifts of LP interests made during life, as well as for estate tax purposes. Through the use of a simple "A-B" plan using a credit shelter trust and a QTIP marital trust, they will avoid estate tax on the first spouse’s death.
In the above illustration, if neither the husband nor the wife retains a controlling GP interest, when the first spouse dies, his or her LP interests will be stepped-up only to their discounted estate tax value. Alternatively, if one spouse, say the husband, retains a controlling GP interest and the wife dies first, the wife’s LP interests will be stepped-up only to their discounted value. Thus, because it generally cannot be determined which spouse will die first, a couple cannot create a plan that will enable the surviving spouse to benefit from a full, non-discounted basis step-up in the couple’s assets at the first spouse’s death.
An alternative is to establish the FLP after the first spouse dies. However, if the second spouse dies shortly thereafter, the creation of a limited partnership shortly before death is more likely to be challenged by the Service. See, e.g., TAM 9736004 (Sept. 6, 1997); TAM 9719006 (May 9, 1997). Moreover, the surviving spouse may not get around to establishing the FLP before death, or may no longer have the legal capacity to do so.
The Estate Trust Strategy
To resolve the estate tax and income tax dilemmas mentioned above, we have developed a strategy using so-called "Estate Trusts" and Code Sec. 2038 as a means of obtaining a full, non-discounted basis step-up for all of the assets used in the strategy at the first spouse’s death, while providing a valuation discount at the second spouse’s death.
What is an Estate Trust? An Estate Trust is a type of trust that qualifies for the marital deduction under Secs. 2523(a) and 2056(a), respectively, because: 1) the property passes to a trust for a spouse’s benefit and 2) upon the spouse’s death the property in the trust is paid to the spouse’s estate. Because the trust property is payable to the spouse’s estate at death (and thus no person besides the spouse receives an interest in the trust property), the trust does not create a "terminable interest" under Secs. 2523(b) or 2056(b). Therefore, an Estate Trust does not need to meet the requirements of a GPA marital trust or QTIP marital trust. Thus, Estate Trusts may have very flexible terms and need not mandate that all income be distributed to the beneficiary-spouse.
How is Sec. 2038 used? Sec. 2038 provides that if a decedent makes a transfer of property in trust and "the enjoyment thereof was subject at the date of his death to any change through the exercise of a power (in whatever capacity exercisable)… to alter, amend, revoke or terminate…" such property will be included in the decedent’s estate. While the goal of most estate planning strategies is to prevent property from being included in the decedent’s estate, our strategy intentionally triggers the application of Sec. 2038 in order to cause all of the assets used in the strategy to be included in the estate of the first spouse to die. Not only will this provide a basis step-up for all of the assets at the first spouse’s death, but it does so without a reduction in value due to discounts at the first spouse’s death. At the second spouse’s death, the strategy insures that valuation discounts will apply (e.g., the surviving spouse will not have a controlling GP interest at death), thereby reducing the estate tax liability at such time.
The following example of the strategy illustrates its use with an FLP to obtain a full, non-discounted basis step-up of all of the GP and LP interests held by both spouses at the first spouse’s death. However, the strategy can be used with any and all assets held by a couple in order to obtain a basis step-up in such assets at the first spouse’s death.
Step 1: Create an FLP. Husband (H) and wife (W) form an FLP, each receives a .5 percent GP interest and a 49.5 percent LP interest.
Step 2: Gift GP Interests to Children. H and W each gift a portion of their GP interests to their children (or to a trust for their benefit), but retain a combined controlling interest. Assuming they each gift a .24 percent GP interest, each spouse would have a .26 percent (minority) GP interest remaining, or a combined .52 percent, which is a controlling stake.
Step 3: Gift GP and LP Interests to Estate Trusts. H and W each transfers a .26 percent GP interest and a 49.5 percent LP interest to Estate Trusts they create for the benefit of the other.
Step 4: Create Basic A-B Estate Plan. H and W would each create a basic "A-B" estate plan – i.e., a credit shelter trust and a QTIP marital trust – so that no estate tax would be due upon the first spouse’s death. Each spouse’s estate planning documents would provide that the GP and LP interests that pass through his or her estate from the Estate Trust created for his or her benefit will pass to a QTIP marital trust for the benefit of the surviving spouse.
Retained Power to Control Time and Manner of Distributions. Each spouse would retain the power, in his or her individual capacity (as grantor) and with respect to the Estate Trust he or she created, to (i) amend the trust agreement to change the manner or time of the beneficiary-spouse’s enjoyment of the income or principal of the trust and (ii) direct the trustee to make or refrain from making proposed distributions of income or principal by the trustee (which power would be exercisable by his or her agent under a power of attorney in the event of incapacity).
Retained Power to Reacquire/Substitute Property. Each grantor-spouse would retain the power under Sec. 675(4)(c) (which power would also be given to his or her executor) to reacquire the trust property by substituting other property of an equivalent value.
Reciprocal Trust Doctrine. The two Estate Trusts would have different provisions in order to avoid the reciprocal trust doctrine.1 For example, one trust could provide for distributions in the trustee’s sole discretion, while the other permits distributions for health, support, happiness and welfare. The trusts could also have different trustees. Differentiating the trusts will help defend against an attack that the trusts are part of a "sham," form over substance transaction or were created solely for tax avoidance purposes. However, even if the reciprocal trust doctrine applied, it should not adversely affect the strategy, because the doctrine is applied only to identify the transferor of property for estate tax inclusion purposes. See, e.g.,
Estate of Green v. U.S., 68 F.3d 151 (6th Cir. 1995); Exchange Bank and Trust Company of Florida v. U.S., 694 F.2d 1261, 1269 (Fed. Cir. 1982)
("the reciprocal trust doctrine merely identifies the true transferor, but the actual basis for taxation is founded upon specific statutory authority"); U.S. v. Grace, 395 U.S. 316 (1969).
The Results – Why The Estate Trust Strategy Works
Estate Inclusion. Assume H dies first (although the results are identical if W dies first). The .26 percent GP interest and the 49.5 percent LP interest in the Estate Trust created by W for H will be paid to H’s estate, and will be includible in H’s estate under Sec. 2033. Moreover, the .26 percent GP interest and the 49.5 percent LP interest held in the Estate Trust created by H for W will be included in his estate under Sec. 2038 because H will have made a transfer where the enjoyment thereof was subject at the date of his death to a change through the exercise of a power to alter, amend, revoke, or terminate. Sec. 20.2038-1(a) of the Treasury Regulations provides:
Sec. 2038 is applicable to any power affecting the time or manner of enjoyment of property or its income, even though the identity of the beneficiary is not affected. For example, Sec. 2038 is applicable to a power reserved by the grantor of a trust to accumulate income or distribute it to A, and to distribute corpus to A, even though the remainder is vested in A or his estate, and no other person has any beneficial interest in the trust. [emphasis added]
Thus, H’s retained power to affect the timing or manner of W’s enjoyment of the property of the Estate Trust he created for W will cause the property of that trust to be included in his estate under Sec. 2038.2
No estate tax would be due at H’s death because H’s estate would receive a full marital deduction for the property included in his estate. The GP and LP interests H received from the Estate Trust that W created for his benefit would pass to a QTIP marital trust for W, which also qualifies for the marital deduction. Moreover, the GP and LP interests held by the Estate Trust H created for W qualify for the marital deduction because such interests passed to an Estate Trust which qualifies for the estate tax marital deduction under Sec. 2056(a). For such purpose, property is considered as having "passed" from a decedent to a surviving spouse "if such interest has been transferred to such person by the decedent at any time." See Sec. 2056(c)(4).
Basis Step-Up. As stated above, the GP and LP interests in the Estate Trust created by H and the GP and LP interests paid to H’s estate from the Estate Trust created by W are both included in H’s estate. Pursuant to Sec. 1014(a)(1), the basis of property in the hands of a person acquiring the property from a decedent (or to whom the property passed from a decedent) shall be the fair market value of the property at the date of the decedent’s death. Under Sec. 1014(b)(1) and (b)(3), property is considered to have been acquired from or to have passed from the decedent for purposes of 1014(a) if such property was:
(a) "acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent" (Sec. 1014(b)(1)); or
(b) "transferred by the decedent during his lifetime in trust to pay the income for life to or on the order or direction of the decedent with the right reserved to the decedent at all times before his death to make any change in the enjoyment thereof through the exercise of a power to alter, amend, or terminate the trust" [emphasis added] (Sec. 1014(b)(3)).
Sec. 1014(b)(1) would provide a basis step-up for the GP and LP interests paid to H’s estate from the Estate Trust created by W, and Sec. 1014(b)(3) would provide a basis step-up for the GP and LP interests in the Estate Trust created by H. Thus, all of the property transferred to the Estate Trusts will receive a basis equal to the fair market value of such property at H’s death.
Moreover, the GP interests in the Estate Trusts should be aggregated for estate tax valuation purposes (as explained below), giving H a .52 percent controlling GP interest. Because H is deemed to have a controlling GP interest, he (or his estate) controls the FLP and could liquidate his LP interests. Thus, H’s LP interests should not be subject to a valuation discount at his death and the basis of H’s LP interests should be stepped-up to their full non-discounted fair market value.
At W’s subsequent death:
The .26 percent GP interest and 49.5 percent LP interest held in the QTIP marital trust for W’s benefit is included in W’s estate under Sec. 2044.
The .26 percent GP interest and 49.5 percent LP interest in the Estate Trust created by H will be paid to W’s estate and included under Sec. 2033.
The .26 percent GP interest held by W’s estate and the .26 percent GP interest in the QTIP marital trust will not be aggregated for valuation purposes under Estate of Bonner v. U.S., 84 F.3d 196 (5th Cir. 1996); Estate of Mellinger v. Comm’r, 112 T.C. 26 (January 26, 1999); and Estate of Nowell, T.C. Memo 1999-15 (January 26, 1999). Instead, they will be valued as separate .26 percent GP interests.
Thus, neither the QTIP trust nor W’s estate owns a controlling GP interest, and the LP interests owned by each should be subject to valuation discounts in W’s estate, saving estate tax on the transfer of such interests to the children.
Completed Gift. We emphasize, however, that the grantor should retain enough power to cause inclusion under Sec. 2038, but not so much power as to cause the gift to the trust to be incomplete for gift tax purposes. Sec. 25.2511-2(b) provides: "As to any property… of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another, the gift is complete. But if upon a transfer of property (whether in trust or otherwise) the donor reserves any power over its disposition, the gift may be wholly incomplete, or may be partially complete and partially incomplete, depending upon all the facts in the particular case." For example, in the case of a traditional irrevocable trust, if the grantor retained a power to name new beneficiaries or change the interests of beneficiaries as between themselves, the gift would be incomplete. However, Code Sec. 25.2511-2(d) provides that a gift will not be considered incomplete if the donor reserves the power to change the time or manner of enjoyment of the trust property. Specifically, Sec. 25.2511-2(d) provides:
A gift is not considered incomplete, however, merely because the donor reserves the power to change the manner or time of enjoyment. Thus, the creation of a trust the income of which is to be paid annually to the donee for a period of years, the corpus being distributable to him at the end of the period, and the power reserved by the donor being limited to a right to require that, instead of the income being so payable, it should be accumulated and distributed with the corpus to the donee at the termination of the period, constitutes a completed gift.
In the case of the Estate Trust, the donor would simply retain the power to alter the manner or timing of the spouse’s beneficial enjoyment of the income and principal, and would not be able to name new beneficiaries or change the interests of beneficiaries as between themselves. Thus, the gifts by the spouses to the Estate Trusts will be completed gifts.
Confluence of Code Provisions. The three Code provisions relied upon to make the Estate Trust strategy work – Secs. 2038, 1014 and 2511 – all contain the similar language. All three provisions turn on powers to "change" or "alter, amend, revoke, or terminate" enjoyment of trust property. See Secs. 2038(a) and 1014(b)(3) and Reg. Sec. 25.2511-2(d).
The Law of Aggregation
If property includible in a decedent’s estate under Sec. 2033 is aggregated for estate tax valuation purposes with property included in his estate under other Code Secs. (e.g., Sec. 2038), the total estate tax value of such property may be higher than it would be without aggregation. In the example above, when the .26 percent GP interest in the Estate Trust included in H’s estate under Sec. 2038 is aggregated with the .26 percent GP interest included in H’s estate under Sec. 2033, the total GP interest is .52 percent, or a controlling interest. As a result, the value of H’s GP and LP interests are greater than they would be without aggregation. Conversely, at W’s death, the .26 percent GP interest in the QTIP Trust included in W’s estate under Sec. 2044 is not aggregated with the .26 percent GP interest included in W’s estate under Sec. 2033. Instead, those two interests are valued separately as minority, non-controlling interests. As a result, such interests are less valuable in W’s estate because neither could liquidate the partnership at will.
1. Aggregation of Property Includible Under Sec. 2038. The Service has consistently held that if separate property interests are includible in a decedent’s gross estate under separate estate tax "inclusion" Secs. (i.e., Secs. 2033 through 2045) such property should be aggregated for estate tax valuation purposes. For example, Rev. Rul. 79-7, 1979-1 C.B. 294 and TAM 9403002 (September 17, 1993) addressed whether property includible under Secs. 2035 and 2038, respectively, should be aggregated for estate tax valuation purposes with property includible under Sec. 2033, and both held in favor of aggregation. In Rev. Rul. 79-7, the Service held that where a block of voting stock of a closely-held corporation was includible in the decedent’s gross estate under Sec. 2035 (as a transfer made within three years of death), such property should be treated, for estate tax purposes, in the same manner as if the decedent held the property at death. In TAM 9403002, the Service, citing Rev. Rul. 79-7, concluded that where a block of stock was includible under Sec. 2038 (which block had been transferred to a trust over which the decedent possessed a power to alter the beneficial enjoyment), while the decedent lacked formal legal title to the block of stock held in trust, he retained a "sufficient nexus" to that stock for it to be treated for estate tax valuation purposes as if it had passed outright from the decedent at his death.
2. Aggregation of Property Includible Under Sec. 2044 Until recently, the Service has attempted to aggregate property held in QTIP marital trusts includible under Sec. 2044 with property includible under other inclusion Secs.. See, e.g., TAMS 9608001 (February 23, 1996), 9550002 (December 15, 1995) and 9140002 (October 4, 1991). However, in Estate of Bonner, Estate of Mellinger and Estate of Nowell, the Tax Court and the Fifth Circuit firmly established that property held in a QTIP trust is not aggregated, for estate tax valuation purposes, with other property includible in the surviving spouse’s estate. Thus, for example, if the QTIP trust and the estate each owns a 49 percent minority interest in a closely-held company, the two interests will not be aggregated for estate tax valuation purposes as a single controlling interest, and instead will be valued as separate minority interests. In AOD-1999-006 (Aug. 30, 1999), the Service acquiesced to these opinions.3
The Bonner, Mellinger and Nowell courts all concluded that nothing in Sec. 2044 or its legislative history indicates that the surviving spouse is treated as the owner of the QTIP property, but only that the value of the property in the QTIP trust will be included in the surviving spouse’s gross estate. The courts noted that the surviving spouse does not possess, control or have any power of disposition over the assets in the QTIP trust. Moreover, the Court in Bonner stated (which quote was cited by the later cases) that the surviving spouse’s estate did not have control over the trust assets "such that it could act as a hypothetical seller negotiating with buyers free of the handicaps associated with fractional undivided interests. The valuation of the assets should reflect that reality." Bonner, 84 F.3d at 199.
While the Service has acquiesced to the Bonner line of cases, it has not changed its position with respect to aggregating property includible under Secs. other than Sec. 2044. In the Estate Trust strategy, the QTIP trust is not created until after the first spouse dies; thus, Sec. 2044 would not apply at the first spouse’s death. Rather, at the first spouse’s death, the Service would most likely argue under Rev. Rul. 79-7 and TAM 9403002 that the property held in the Estate Trust that the deceased spouse created (which is includible under Sec. 2038) should be aggregated with the other property held in the deceased spouse’s estate (which is includible under Sec. 2033).
In the event of simultaneous deaths, the Estate Trust of one spouse should provide that the grantor-spouse is deemed to have predeceased the beneficiary-spouse for all purposes, and the Estate Trust of the other spouse should provide that the grantor-spouse is deemed to have survived the beneficiary-spouse for all purposes. If structured in this manner, the grantor-spouse who is deemed to have predeceased will have retained his or her Sec. 2038 powers, thereby causing aggregation of the GP interests in his or her estate, but the Sec. 2038 powers retained by the grantor-spouse who is deemed to have survived will terminate (but will not be "relinquished") before his or her death. Ultimately, the GP interests that were subject to the Sec. 2038 powers that were included in the estate of the first spouse to die will be included in the estate of the second spouse to die as part of a QTIP trust for his or her benefit. But as part of the QTIP trust, the GP interest would not be aggregated with the GP interest that became payable to that spouse’s estate pursuant to the terms of the Estate Trust for his or her benefit.
If the strategy is not structured properly, the Service would likely attempt to aggregate the property in the first spouse’s estate for estate tax valuation purposes, but then limit the amount of the marital deduction by applying a minority interest discount to the LP interests passing to the QTIP marital trust. This is known as a "reverse Chenoweth" situation. In Chenoweth v. Commissioner, 88 T.C. 1577 (1987), all the stock of a corporation had been owned by the decedent, who made a specific bequest of 51 percent of that stock to the decedent’s surviving spouse. The court permitted the estate to value the 51 percent block as a controlling block, and consequently allowed a marital deduction that was greater than simply 51 percent of the value of the stock included in the gross estate.
In a reverse Chenoweth situation, the decedent makes a specific bequest of a minority interest in an entity to his surviving spouse (or to a QTIP trust). Thus, while the decedent may own a controlling interest that is not subject to valuation discounts for estate tax purposes (and indeed may be subject to a valuation premium), the minority interest passing to the surviving spouse would be subject to a minority interest discount for purposes of funding the marital bequest and would thus reduce the marital deduction. See Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981) (holding that lower valuation of nonvoting stock for purposes of charitable deduction was proper because such shares that charity would receive were separated from voting power). The Chenoweth court indicated that such a result is proper, and the Service has concurred. See AOD-1999-006 (Aug. 30, 1999); TAM 9327005 (July 9, 1993).
The reverse Chenoweth situation arises only if the surviving spouse does not receive (outright or in trust) a majority of the GP interests and an optimum marital deduction formula is not used. If the Will or revocable trust leaves the first spouse’s assets between a marital trust and credit shelter trust pursuant to a formula designed to eliminate all estate tax at the first spouse’s death, Chenoweth will not apply (the marital bequest will not be underfunded).
In addition to the reverse Chenoweth risk, as mentioned above, if the beneficiary-spouse of an Estate Trust dies within one year of the trust’s creation, and pursuant to that spouse’s estate plan such assets pass to or in trust for the surviving spouse, the basis of such assets will not be stepped-up to fair market value. See Sec. 1014(e).
Nevertheless, notwithstanding any risks, in a worst case scenario the basis of a married couples’ assets will be stepped-up only to their discounted value, just as if the strategy had not been used in the first place. Thus, there is little to lose and much to gain.u
David Handler concentrates his practice on estate planning. He is affiliated with the American Bar Association: Member - Real Property, Probate and Trust Law Section. Mr. Handler also is an instructor for the Cannon Financial Institute.
Kevin Chen is an associate in Kirkland’s Chicago Trusts & Estates Group. Mr. Chen practices in the areas of wealth transfer planning, estate and trust administration and charitable giving.
1. A general power of appointment should not be used to differentiate the trusts, because such a power would require the trust, to qualify for the marital deduction, to meet the requirements of a GPA marital trust under Sec. 2056(b)(5). See Reg. Sec.20.2056(c)-(3); Rev. Rul. 75-128, 1975-1 C.B. 308 (holding that a "qualified estate trust" under the then-applicable Sec. 20.2056(e)-2(b)(1)(iii) that granted a testamentary general power of appointment to the surviving spouse would not qualify for the marital deduction because the trust did not meet the requirements of a GPA marital trust under Sec. 2056(b)(5)).
2. A GPA marital trust should not be used because all income would have to be paid to the surviving spouse. As a result, the spouse creating the GPA marital trust would not have the power to alter the time or manner of enjoyment of the income, and as a result the value of the income interest would not be includible in his or her estate. "Only the value of an interest in property subject to a power to which Sec. 2038 applies is included in the decedent’s gross estate under Sec. 2038." Reg. Sec.20.2038-1(a).
3. In AOD 1999-006, the Service acquiesced only to the conclusion that property (such as stock of a closely-held entity) held in a QTIP marital trust that is includible in a surviving spouse’s gross estate under Sec. 2044 should not be aggregated with such property held in the spouse’s revocable trust that is includible under the other inclusion Secs. of the Code. The Service has not extended the reasoning in the Bonner line of cases to other marital trusts (e.g., GPA marital trusts and Estate Trusts), nor has it indicated that it intends to do so.