Many clients today are focused on using their increased gift, estate and generation-skipping transfer (GST) tax exemptions before they sunset on Dec. 31, 2025 or a new administration introduces legislative changes that reduces them even earlier. Many of these same clients are the wealth creators in their families, whose parents or grandparents don’t have significant wealth. With these facts, clients may consider a planning technique that relies on the available exemptions of the senior generation to create income and transfer tax benefits.
The planning technique, sometimes known as “upstream power of appointment,” or, as we prefer, “senior powers of appointment” (SPA),1 grants a testamentary general power of appointment (GPA) to the senior generation (either parents or grandparents) over assets in trusts created by the client for the client’s children. The benefits, pitfalls and practical issues of the SPA are described below.
Benefits of the SPA
The SPA offers two potential benefits for the client, both resulting from the fact that a GPA will cause the trust assets subject to the GPA to be included in the estate of the senior generation.2
First, the estate tax inclusion should trigger a basis step-up under Internal Revenue Code Section 1014. IRC Section 1014(b)(6) provides a step-up for a GPA exercised by will, and Section 1014(b)(9) provides a step-up for property “acquired from the decedent by reason of death, form of ownership, or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof the property is required to be included in determining the value of the decedent’s gross estate.” With highly appreciated assets, the basis step-up represents significant future income tax savings.
Second, the senior generation will be able to allocate available GST tax exemption to the trust assets. When assets are included in the senior generation’s estate, the senior generation will become the “transferor” for GST tax purposes and, as transferor, may allocate available GST tax exemption.3 This allows an otherwise non-GST tax-exempt trust to become GST tax exempt, protected from transfer tax as long as it remains in trust.
Formula GPA
GPAs are routinely granted to beneficiaries (typically the grantor’s children) of non-GST tax-exempt trusts under a formula that will cause some or all of the assets to be included in their estates at death to avoid triggering GST tax when the assets pass from the client’s children to the grandchildren. This inclusion also achieves a basis step-up and allows the younger generation to allocate their GST tax exemption to trust assets. The SPA uses the same concept to obtain these benefits much earlier: on the death of the senior generation.
The SPA should be granted to the senior generation over the lesser of: (1) the GPA holder’s remaining GST tax exemption (the GST cap); and (2) the maximum amount of the trust which, if included in the GPA holder’s estate, wouldn’t cause any federal or state estate tax to be due, considering all other assets included in the GPA holder’s estate (the estate tax cap).
The formula is designed to achieve two results.
First, it’s important that the SPA not exceed the GPA holder’s remaining GST tax exemption, or the GPA could accelerate a GST.
For example, assume a grantor creates a trust naming the grantor’s children as the sole beneficiaries. If the senior generation has an SPA, the assets will be included in the senior generation’s estate, shifting the transferor for GST tax purposes from the client to the senior generation.4 The assets will be treated as passing from the senior generation to the trust, constituting a direct skip subject to GST tax unless the senior generation has enough GST tax exemption to allocate to the included assets. If the grantor’s spouse is a beneficiary of the trust, the GPA won’t trigger a direct skip but will trigger a GST when the spouse dies (a taxable termination) and on any distribution to the children before that date (a taxable distribution). However, the same distribution to the grantor’s child wouldn’t have been a GST if the client had remained the transferor for GST tax purposes (that is, absent the GPA); only distributions to the client’s grandchildren (or more remote descendants) would have been.
Second, it’s important that the SPA not exceed the amount that can pass free from federal and state estate taxes in the GPA holder’s estate—after taking into account the disposition of the rest of the GPA holder’s estate. If the GPA formula was simply equal to the GPA holder’s remaining applicable exclusion, it could wreak havoc with the GPA holder’s estate plan. For example, assume the senior generation’s estate was $6 million, which he leaves to his three children (including your client), the trust over which he has a GPA is worth
$10 million and the GPA was over his applicable exclusion, assumed to be $11 million. Without the GPA, his $6 million estate would pass estate tax free to his three children. But, the poorly drafted GPA formula increased his estate to $16 million, $5 million more than his applicable exclusion. Unnecessary estate taxes are triggered, and depending on the tax apportionment in the GPA holder’s will, some of the tax might be borne by his other children, who won’t be happy with your client (or you). Also, pay attention to whether the senior generation resides in a jurisdiction with an estate tax.
Although simple in concept, it’s worth considering a few nuances to the formula.
Mitigating federal and state estate tax return filing obligations. A formula GPA equal to the senior generation’s applicable exclusion could trigger a federal or state estate tax return obligation, as well as basis reporting for the senior generation’s estate, which otherwise wouldn’t have existed. Clients may be reluctant to implement an estate-planning technique that increases the administrative burden and costs on the death of a parent or grandparent, as well as the possibility of an audit. To avoid this result, the GPA could be granted in an amount equal to $100 (or some other dollar amount) less than the estate tax cap.
The executor of the GPA holder’s estate may still choose to file a federal or state estate tax return (for example, to manually allocate GST tax exemption). However, by drafting the formula to avoid increasing the GPA holder’s estate to the filing threshold, you preserve flexibility to do so or not. Further, even if the executor chooses to file an estate tax return when one isn’t required, there should be no basis consistency reporting obligations under IRC Section 6035.
If the executor of the GPA holder’s estate files or must file an estate tax return, then the trustee of the client’s trust should be directed to pay the expenses associated with the estate tax return filing and any resulting basis reporting obligations. You could limit this direction to the circumstance in which such returns wouldn’t have been required but for the GPA or expand the direction to include “voluntarily” filed returns.
Finally, even if no estate tax return ultimately is filed, appraisals may be required. The date-of-death fair market value (FMV) of illiquid or unmarketable assets held in the client’s trust (and in the GPA holder’s estate) will be needed to appropriately identify the amount of the trust subject to the GPA and to allocate GST tax exemption.
Exemption Allocation
It’s important that the assets subject to the GPA can be fully protected from GST tax (that is, they have an inclusion ratio of zero). As noted earlier, if they aren’t, then the grant of the GPA could accelerate GST by shifting the transferor to the senior generation.
Ideally, the GPA would be granted over a non-GST exempt trust (that is, a trust with an inclusion ratio of one to which the client hasn’t allocated GST tax exemption). This maximizes the benefits of the SPA. The SPA can achieve both the potential income tax savings from the basis step-up and the efficiency of using the senior generation’s unneeded GST tax exemption to make the client’s trust GST tax exempt. As importantly, granting the GPA over a non-GST exempt trust avoids duplicative use of the GST tax exemption by the client and the senior generation for the same assets. The GST tax exemption allocated by the client to assets subject to the GPA and includible in the GPA holder’s estate will be lost once the transferor shifts to the GPA holder, but they continue as GST tax exempt using the senior generation’s exemption.
If only part of the client’s non-GST tax-exempt trust is subject to a GPA, the trust will become two trusts for GST tax purposes after the GPA holder’s death: (1) a non-GST tax-exempt trust of which the client is the transferor; and (2) a trust of which the senior generation is the transferor (and to which the senior generation allocates GST tax exemption).5 There won’t be a trust with an inclusion ratio between 0 and 1, and a qualified severance won’t be needed.
The GPA holder’s GST tax exemption can be allocated manually or automatically. The GST tax exemption may be allocated manually at death on a timely filed federal estate tax return. If the GST tax exemption isn’t allocated on a timely filed federal estate tax return, then automatic allocation rules will apply.6
The automatic allocation rules first allocate GST tax exemption to direct skips occurring at the death of the transferor. This may include the client’s trust if the only beneficiaries are the client’s children and more remote descendants.7 However, if the client’s spouse is a beneficiary of the trust, then the trust wouldn’t be a skip trust. The automatic allocation rules could still apply, but would allocate to the assets subject to the GPA as a second priority and only after the GST tax exemption was fully allocated to any direct skips. Further, the GPA holder’s GST tax exemption would be allocated proportionately over all trusts created by such individual from which a GST could occur and not only to the client’s trust.8 As a result, the assets subject to the GPA could exceed the GST tax exemption allocated to the assets.
To avoid this result, practitioners either will want to ensure that the client’s trust is a direct skip so that the formula will appropriately absorb remaining exemption, even if automatic allocation rules are relied on or ensure that proper coordination with the GPA holder’s current estate plan and with the executor of the GPA holder’s estate will occur. This could lead to tension among the client and his siblings, each vying for the parent’s GST tax exemption to be allocated to trusts for the benefit of their own descendants.
For example, assume a client transferred $20 million to a trust for the client’s spouse and descendants. And, the client’s parent has a $2 million estate, and the client’s parent’s estate plan contributes all of the estate to a trust for the client (or the client’s sibling) and the remainder to the client’s (or the client’s sibling’s) descendants. Assume also that the client’s parent used $1 million of gift/estate tax exemption on a gift during life to a trust for the benefit of the client, the client’s sibling and their children and allocated no GST tax exemption to it, worth $2 million at the parent’s death. Assume the client’s parent will die resident in a state with no estate tax and with $10 million of remaining federal estate tax and $11 million of GST tax exemption. The formula will grant the client’s parent a GPA over $10 million (the lesser of the GST cap and the estate tax cap). Unless a federal estate tax return is filed, manually allocating the client’s parent’s available GST tax exemption, the automatic allocation rules will allocate the $11 million of GST tax exemption among all of: (1) the $10 million of assets subject to the GPA; (2) the client’s parent’s $2 million lifetime trust; and (3) the $2 million residue of the client’s estate, pro rata. Assuming no administration expenses are paid, then:
the $10 million of GPA assets will be allocated 10/14 of the available $11 million of GST tax exemption ($7.85 million);
the $2 million lifetime trust created by client’s parent will be allocated 2/14 of the available $11 million of GST tax exemption ($1.57 million); and
the $2 million residue of client’s parent’s estate will be allocated 2/14 of the available $11 million of GST tax exemption ($1.57 million).
None of the assets will have an inclusion ratio of zero.
Practitioners can avoid the above described result in a few ways.
First, you can file an estate tax return for the GPA holder’s estate to manually allocate GST tax exemption to fully protect the assets subject to the GPA. This approach certainly will require coordination with the executor of the GPA holder’s estate and likely will require coordination with the GPA holder’s estate plan. The GPA holder may need to direct her executor to make the manual allocation in this way at the GPA holder’s death to avoid liability issues for the executor and potential conflict at the GPA holder’s death.
Second, you could confirm that no other trusts that have GSTs could have been created by the GPA holder during her lifetime or will be created by her before or at her death. This would eliminate any competing trusts to which automatic allocation rules could apply, but would require coordination with the GPA holder’s estate plan and a commitment by the GPA holder not to change the estate plan without notice.
Third, you could draft the formula to reduce the GST cap by the value in any trusts created by the GPA holder during her lifetime or at her death that could have a GST. This may lead to an inefficient use of the GPA holder’s GST tax exemption. It could limit the amount of the GPA and shift allocation of GST tax exemption to assets that ultimately may be distributed to the GPA holder’s children (rather than grandchildren).
Finally, you can draft your client’s trust, over which the parent will be granted the GPA, to qualify as a direct skip trust. In that case, the GST cap will work appropriately and grant a GPA in an amount of remaining GST tax exemption, reduced by the other direct skips at the GPA holder’s death. The GPA assets will be fully protected from GST tax, even if GST tax exemption is allocated under automatic allocation. This approach likely is the most foolproof of the four, but would require your client’s spouse not to be a beneficiary (or not to be a beneficiary of the assets subject to the GPA).
Prioritizing Assets
One of the benefits of the SPA is that it triggers a basis step-up under Section 1014 because of inclusion in the GPA holder’s estate. However, not all assets in a trust will benefit equally from the basis step-up, and without direction, a fraction of all of the trust assets would be included in the estate (and get stepped-up). For example, if a trust has $1 million of cash and $1 million of low basis stock, and the senior generation has a GPA over $1 million (50%) of the trust, then the GPA would be over 50% of the cash and 50% of the stock, increasing the basis of only half the stock. Instead, the formula can prioritize assets over which the GPA is granted.
For example, consider granting the GPA first over trust assets that would realize a short-term gain if sold immediately prior to the GPA holder’s death and next over assets that would realize a long-term capital gain if sold immediately prior to the GPA holder’s death.
You also might grant the GPA over specific assets held in the trust first. For example, you may grant the GPA over stock in a closely held business or low or even negative basis real estate. After that, apply the GPA to short-term gain assets, then long-term gain assets, then to shares that qualify as qualified small business stock and then to full basis assets last. But in all events, you may wish to specify that the GPA won’t be granted over any assets with a basis greater than FMV. This will avoid a step-down in the asset’s basis, which could cost more than the benefit of making the assets GST exempt. This may be a particularly valuable limitation on the GPA in today’s economic environment, in which assets may be subject, in the short-to-mid term, to significant volatility. Additionally, you may wish to specify that the GPA won’t be granted over any policies of life insurance owned by the trust when a basis step-up isn’t material or over qualified opportunity zone investments if there’s a risk that the GPA could create a disposition event, accelerating gain realization on those investments. Given the possibilities for tailoring the GPA, you may consider giving the trustee the power to restrict the GPA in the future or may even consider a trust drafted in a way that doesn’t immediately incorporate the SPA but instead preserves the potential for it to be granted in the future. For example, the trustee may be given the discretion to eliminate a GPA entirely, or only over specific assets, or to limit the GPA to a percentage of the trust assets. This kind of planning flexibility may prove important to respond to changing economic and legislative environments.
Family Member Coordination
The SPA relies on the senior generation having insufficient assets, independent of the GPA, to trigger a state or federal estate tax or to fully allocate GST tax exemption. With current exemption levels as high as they are, the senior generation may have sizable assets but still be a candidate for the SPA. In that case, it’s important to consider how the SPA affects a client’s siblings to avoid disadvantaging them. For this reason, it may be safest to grant the SPA only to the surviving parent (or grandparent) in the senior generation, rather than to the first parent (or grandparent) to die. If you assume that the first spouse to die’s estate plan will benefit only the surviving spouse at his death, then the SPA may absorb estate and GST tax exemption at the death of the first spouse to die, which otherwise would have been shared with the client’s siblings.
For example, assume the client’s parents have a $7 million estate. The client’s father dies and leaves his entire estate outright to the client’s mother, and the estate elects portability at a time when the client’s father’s remaining estate and GST tax exemptions are $11.5 million. At the mother’s subsequent death, assume that the available estate tax exemption has decreased to $6 million. Absent the SPA, even with decreased exemptions, the client’s mother should be able to fully protect her estate from estate tax. She’ll have $17.5 million of exemption, after taking into account the $11.5 million deceased spousal unused exclusion from her husband’s estate. However, if the client’s father had been granted an SPA using up his estate tax exemption, portability wouldn’t have applied at the client’s father’s death. The client’s mother would have a $7 million estate and only $6 million of estate tax exemption. The step-up in basis and use of the client’s father’s GST tax exemption achieved by the SPA would come at the cost of the estate tax on the client’s mother’s estate (that is, the estate tax on the $1 million by which her estate would exceed available exemption). Of course, in weighing the possibilities, it’s important to contemplate the possibility that an estate that appears well below current exemptions could grow in value over time and exceed them by the time of the survivor’s death. Alternatively, legislative changes could reduce exemptions, creating the same issue.
Therefore, any grant of an SPA to the first spouse to die should include careful consideration of the senior generation’s estate plan and the consequences of the GPA to the intended beneficiaries of that estate plan.
Similarly, often, although a client may have been a wealth creator in a family, the client’s siblings may also have been successful. Under those circumstances, the client’s siblings may wish to benefit from the SPA in their estate planning as well. You’ll want to carefully coordinate drafting the formula GPAs to avoid granting separate GPAs that together exceed the GST tax exemption that can be allocated to the property. (The same caveat is true if the client wishes to create multiple trusts, each with an SPA included.)
Grantor Trust Treatment
If the client has a grantor trust, the mere grant of the GPA won’t alter that treatment. Only if the GPA holder actually exercised the GPA would the identity of the grantor for purposes of the income taxation of the trust assets change; a mere lapse of the GPA won’t change the grantor for income tax purposes.9 The grantor trust status allows the client, rather than the trust, to bear income tax liabilities on trust assets. That represents an important wealth transfer for the client and wealth accumulation for the trust. The grant of the SPA, assuming it isn’t exercised, doesn’t turn off grantor trust status.
Exercise of the GPA
Clients should recognize that the GPA is a significant power given to the holder.
The GPA, whether exercised or not, could expose the trust assets to claims by creditors of the GPA holder’s estate depending on the relevant state laws. If the estate has liabilities it can’t pay, the client’s trust might be liable to pay them. The client should consider this possibility carefully.
The mere grant of the GPA accomplishes the benefits of the planning technique, and no exercise of the GPA is needed (or even intended). However, the client should recognize that the GPA holder could exercise the power. You can draft the GPA to minimize the risk of exercise. For example, potential appointees can be limited to creditors of the GPA holder’s estate, and any exercise of the GPA can require the consent of a non-adverse party.10 The client can select a trusted non-adverse individual to protect against unwanted exercise of the GPA.
The client often will want to know if the senior generation can exercise the GPA in favor of a trust of which the client (the original grantor) is a beneficiary. Technically this is possible, but only with care.
First, the appointee trust should be governed by the laws of a jurisdiction that protects self-settled trusts from the grantor’s creditors, and the grantor shouldn’t be a trustee and shouldn’t have a power of appointment over its trust assets in order to avoid inclusion under IRC Section 2038.
Second, you should be careful to mitigate against a successful step transaction argument by the IRS. Any exercise by the senior generation of the GPA in favor of a trust of which the grantor is a beneficiary could be treated as a pre-arranged plan by which the grantor created the trust for himself. Best practice would be for the senior generation to consult with independent counsel before exercising the power and after some time has passed since the trust was created.
Unrelated GPA Holders
The article has focused on grants of SPAs to the senior generation of a client. However, a GPA can be granted to anyone to achieve either the step-up in basis or the GST tax exemption allocation efficiencies previously described in this article (or both). In theory, one could grant an SPA to the “oldest person in the world” or the “first person to die each January 1” to quickly and repeatedly obtain basis adjustments and allocation of others’ unused GST tax exemptions. Of course, you need access to information about their estates.
If the GPA is granted to someone in the client’s generation, then the formula doesn’t necessarily need to reference the GST cap. A shift of the transferor to an individual in the client’s generation won’t necessarily accelerate a GST, even if the GPA holder doesn’t have GST tax exemption to fully protect the assets. Assuming the client wasn’t otherwise going to allocate GST tax exemption to the property, the GPA shouldn’t trigger a worse result from a GST tax perspective (and may create income tax efficiencies). However, take care if the GPA holder isn’t a descendant of the client’s grandparents (or the spouse of one). Under those circumstances, generation assignment will be by age, rather than family tree placement. For GST tax purposes, an individual is of the same generation as another if they’re not more than 12.5 years apart in age, and thereafter, generations are triggered every 25 years. Therefore, if I’m more than 12.5 years younger than my friend, I’m one generation below him, and if my child is more than 37.5 years younger than him, then my child is two generations below him. Interestingly, if I’m more than 12.5 years younger than my friend, but my child is less than 37.5 years younger (that is, I had a child before age 25), both I and my child are considered to be one generation below my friend. Therefore, a child of the client could be treated as two or more generations below someone outside of the client’s family tree because of these presumptions. In that case, the GPA could accelerate a GST, and the formula should include the GST cap.
As you consider granting GPAs to individuals more or less remote to the client, remember that some degree of coordination with the GPA holder (or her estate) may be necessary for purposes of confirming available estate and GST tax exemptions and confirming assets otherwise includible in the GPA holder’s estate (or to which GST tax exemption may be automatically allocated). However, beyond that requisite coordination, no relationship is strictly required.
Spouse GPA Holders
Finally, some clients may want to grant an SPA to a spouse (not really “upstream” in this case). The spousal SPA can achieve the same benefits as an SPA granted to the senior generation. Inclusion in the spouse’s estate will trigger a basis step-up and will allow the spouse to allocate GST tax exemption to the assets subject to the GPA (although gift-splitting might achieve a similar result for the client without the SPA).
Because spouses are always assigned to the same generation for GST tax purposes, estate tax inclusion shouldn’t accelerate a GST. For this reason, the GPA could be subject to an estate tax cap and not a GST cap, if the intention isn’t necessarily to allocate GST tax exemption to the property.
The spousal SPA may only make sense when the combined estates of the two spouses are below available estate and GST tax exemptions.
For example, assume client (W) had $22 million, and W’s husband (H) had $8 million. Assume H’s estate plan leaves his entire estate to a credit shelter trust and that H has a GPA over $3.5 million of assets in a trust created by W. Assume H dies with $11.5 million of remaining estate tax exemption. H’s entire available estate tax exemption would be absorbed at his death by H’s
$8 million of assets and his GPA over $3.5 million in the trust. At W’s subsequent death, W will have $22 million of assets includible in her estate. Assuming she dies with $8 million of available estate tax exemption, $14 million of her estate will be subject to estate tax.
Instead, if you assume that H died with no GPA over assets in trust created by W, then W could have received $3.5 million of client’s available estate tax exemption via portability. Assuming no other changes, at W’s death, she would have $22 million of assets and $11.5 million of available estate tax exemption (her $8 million and her husband’s $3.5 million). Only $10.5 million then would be subject to estate tax, $3.5 million less than the previously described scenario.
There are additional special considerations to take into account when contemplating a spousal SPA.
First, gift splitting isn’t permitted when the donor’s spouse is given a GPA.11 Therefore, the spousal GPA will preclude gift splitting by the client and her spouse, including annual exclusion gifts. Thus, the SPA shouldn’t be used when the client intends to split any gifts to the trust during a time when the spouse has a GPA.
Second, a GPA in the client’s spouse will create a spousal estate tax inclusion period (ETIP), because assets will be includible in the spouse’s estate as a result of the GPA.12 GST tax exemption may not be allocated to trust assets during the ETIP, even assets not subject to the GPA. Therefore, a spousal SPA should be used only when the client doesn’t intend to allocate GST tax exemption to trust assets.
The result for both of the above-described concerns should be different if a spousal SPA was granted after the client contributed assets to the trust (in the case of gift splitting), or the client has allocated GST tax exemption. As mentioned earlier, there may be many instances in which including flexibility to grant GPAs may make sense. These are two examples.
However, in the case of the spousal ETIP, remember that the spousal SPA will shift the transferor for assets subject to the GPA. If it’s granted over assets to which the client already allocated GST tax exemption, that prior allocation will be lost on the spouse’s death. The spousal SPA may only be appropriate under those circumstances if the client’s spouse has no other assets to which to allocate his GST tax exemption.
Boost Estate Plan
With exemptions at a historic high, and significant uncertainty on whether and for how long they may remain as high, the SPA can afford clients with the right facts the ability to leverage senior generations (or others) to achieve income and transfer-tax efficiencies. The technique, while simple in concept, and relying on common planning principles, is fraught with traps for the unwary. We’ve outlined some important considerations in implementing a technique which, if used appropriately, can significantly boost a client’s estate plan.
Endnotes
1. All great estate-planning techniques need an acronym that can be pronounced.
2. Internal Revenue Code Section 2041.
3. IRC Section 2652(a)(1)(A); Treasury Regulations Section 26.2652-1(a)(2).
4. Ibid.
5. IRC Section 2654(b)(1).
6. IRC Section 2632(e)(1).
7. IRC Section 2613(a)(2)(A).
8. Section 2632(e)(2).
9. Treas. Regs. Section 1.671-2(e)(5).
10. IRC Section 2041(b)(1)(C)(ii).
11. IRC Section 2513(a)(1).
12. IRC Section 2642(f)(4).
