Wealth preservation remains a challenge despite the increases in the federal estate tax exclusion, which is equal to $5,340,000 in 2014. The challenge comes from higher trust income tax rates. Taxpayers have, over the years, funded trusts with gifts of property with carryover basis. Over time, inflation and appreciation increased the fair market value (FMV) of property in excess of basis. The planning paradigm for years was to transfer future appreciation to the next generation either outright or in trust. Today, the government’s target is the income tax resulting from the sale of low basis property held in trust. The federal estate tax rate is 40% and trust income tax rate is 39.6% on $12,150 of taxable income plus the 3.8% surcharge makes income tax. New Jersey taxes trust income up at a rate of 8.97% on $500,000 of income. Thus, the effective income tax rate exceeds the estate tax rate. It is no wonder that income tax planning for trusts is so important.
Consider that property transferred by gift to a trust has carryover basis. Credit shelter or bypass trusts established by a Will may have been funded years ago. Although assets obtained a stepped-up basis at that time, there may now have substantial appreciation, and thus face hefty income taxes. Various techniques are being examined for the potential to increase basis and thereby reduce the income tax bite. Planning with Grantor trusts, particularly those trusts giving the grantor the power to substitute assets of equivalent value, involved the switch low basis assets out of trust and into the hands of individuals who will provide a step-up to FMV at death. Not all trusts contain grantor trust powers or give the power to a responsible person. In other instances, the estate tax exclusion of the very wealthy may be insufficient to offset estate tax if assets are substituted. For these and other reasons other techniques are considered.
One technique involves triggering the Delaware Tax Trap (“DTT”). Any discussion of the technique requires an explanation of the common law Rule Against Perpetuities (RAP), the DTT and its consequences falling into the trap. The RAP states that property must vest (come out of trust) within lives in being plus 21 years. States have enacted statutory variations of the RAP. The common law RAP was intended to prevent perpetual trusts but today’s statutory enactments have a tax component. The DTT is triggered when a holder of a special power of appointment (First Power) creates a power in another person (Second Power) which postpones vesting. When the DTT is triggered, any property subject to the First Power must be included in the estate and gift base to the person exercising the First Power.
Unlike other states, Delaware measured the RAP from the date of creation of the new power. In effect, Delaware restarted the clock upon each exercise so property could remain in trust and not violate the RAP. Congress, offended by revenue loss from property remaining outside the estate and gift tax system in perpetuity, eliminated this possibility. When the federal estate tax exclusion was much lower, triggering the DTT caused severe harm.
Today, triggering the DTT may not be an issue if the individual exercising the First Power has sufficient estate tax and Generation Skipping Transfer Tax (GSTT) exclusions to offset those taxes. Thus, if a person exercising the First Power has sufficient unused or excess estate and GSTT exclusions, trust property will receive a basis step-up and can be sold without income taxation.
Finally, not all states have a RAP statute that resets the clock and triggers the DTT. Some states measure from the date of the original trust, not the exercise of the power and thus do not rigger the DTT. Therefore, any use of this technique depends heavily on state law.