Traditional estate tax planning often includes funding a credit shelter trust (also known as a bypass trust or family trust) up to the amount of a decedent’s unused estate tax exemption, then funding any assets in excess of the exemption amount into a marital trust for the benefit of the decedent’s surviving spouse. This type of planning was appropriate for many married couples who wished to maximize their remaining estate tax exemptions while leaving most assets for the support of a surviving spouse and deferring or avoiding estate taxation under the unlimited marital deduction. In the early 2000s, when the estate tax exemption sat at $1.5 million or less, the estate plan of a married decedent with $5 million would ultimately fund most of the decedent’s assets into the marital trust. The assets remaining in the marital trust would then be includible in the surviving spouse’s estate for estate tax purposes and therefore receive a basis adjustment at the surviving spouse’s death.
Now, in 2023, when the estate tax exemption is $12,920,000 per taxpayer, that same client’s entire $5 million estate would pass to the credit shelter trust, and no marital trust would be created. The problem with this result is that the assets in a credit shelter trust are not typically includible in the surviving spouse’s estate for estate tax purposes and do not receive a basis adjustment to their fair market values at the surviving spouse’s death. To get around this shortcoming of the traditional credit shelter trust and achieve an income tax basis adjustment under Internal Revenue Code (I.R.C.) § 1014, the surviving spouse may jump through any number of hoops, including having the trustee make an outright distribution of the credit shelter trust assets to the surviving spouse, intentionally triggering the Delaware Tax Trap by exercising a limited power of appointment over the credit shelter trust assets, or having a trust director grant a general power of appointment over the credit shelter trust assets to the surviving spouse.
In more recent years, practitioners have started using a formula testamentary general power of appointment (also known as an optimal basis increase trust (OBIT)) as an easier way to obtain a basis adjustment for credit shelter trust assets under I.R.C. § 1014 at the death of the surviving spouse.
How a Formula Testamentary General Power of Appointment Works
The surviving spouse is granted a general power of appointment over assets in the credit shelter trust to the extent that inclusion of the assets in the surviving spouse’s estate will not increase the death taxes owed by the surviving spouse’s estate. Death taxes may include federal, state, and local estate taxes and generation-skipping transfer tax.
Example. Seiko dies in 2023 with $10 million. The entire $10 million funds a credit shelter trust for Seiko’s surviving spouse, Hibiki. Under the terms of the credit shelter trust, Hibiki holds a formula testamentary general power of appointment. In 2026, Hibiki dies with $2 million of separate assets, the credit shelter trust has $15 million of remaining assets, and the estate tax exemption is $5 million. Hibiki’s unused estate tax exemption is $3 million ($5 million − $2 million). Exercising the formula testamentary power of appointment causes 20 percent of the credit shelter trust assets ($3 million in unused exemption over $15 million of credit shelter trust assets) to be included in Hibiki’s estate and, in turn, receive a basis adjustment under section 1014.
Designing a Formula Testamentary General Power of Appointment
Decision 1: Should the power be exercised over all assets, all appreciated assets, or specific individual appreciated assets?
Familiarity with the nature, value, and appreciation associated with the credit shelter trust assets is essential when making this decision. The main purpose and benefit of a formula testamentary general power of appointment is to get a basis adjustment and avoid income tax. For this reason, if a credit shelter trust held mostly cash, it would not benefit from a basis adjustment, so practitioners should consider whether granting a general power of appointment over cash is worthwhile.
Consider, for example, a trust instrument that provides that the powerholder can only exercise power over the appreciated assets of the credit shelter trust, which has $10 million in cash and real estate valued at $5 million and has a $2 million income tax basis. In addition, the surviving spouse beneficiary has $10 million in unused estate tax exemption at death. In this scenario, the surviving spouse would have a general power of appointment over only the real estate, because it is the only appreciated asset in the credit shelter trust.
Consider another example in which a trust instrument grants the powerholder a power of appointment over only appreciated assets in order of the asset with the highest appreciation to the asset with the lowest appreciation. The credit shelter trust in this example has $5 million in stock (with a $4 million basis), $5 million in art (with a $3 million basis), and $5 million in real estate (with a $2 million basis), and the surviving spouse has $6 million in unused estate tax exemption at death. In this scenario, the surviving spouse can exercise the power first over the real estate as the asset with the greatest appreciation of $3 million, followed by the art as the asset with the next highest appreciation of $2 million. However, the surviving spouse may only exercise the power to the extent that inclusion in the surviving spouse’s estate will not increase death taxes. Because the surviving spouse has only $6 million in unused estate tax exemption, they can exercise the power over just $1 million of the art.
Decision 2: Which type of death taxes should restrict the exercise of the formula testamentary general power of appointment?
Practitioners may wish to limit the powerholder’s exercise so that it does not increase the surviving spouse’s (1) federal estate tax, (2) federal or state estate tax, (3) federal or state estate tax or generation-skipping transfer tax, or (4) federal estate tax or generation-skipping transfer tax. This decision is based on the potential application of death taxes to a particular client’s estate.
Decision 3: Should specific assets be excluded from the formula testamentary general power of appointment?
A client may have certain assets that they do not want to be subject to the formula testamentary general power of appointment. For example, there may be a family home or business interests that the client wants to pass to specific beneficiaries, equally to the residuary beneficiaries, or upon certain terms or conditions. If these or similar circumstances apply, practitioners may consider excluding specific assets from the surviving spouse’s exercise of the formula testamentary general power of appointment.
Decision 4: If the formula testamentary general power of appointment must be limited to avoid exposure to creditors, which class of appointees is permissible?
If creditors should not be within the class of permissible appointees under the formula testamentary general power of appointment, practitioners may consider limiting the class to descendants only; descendants and charities; descendants and spouses; descendants, spouses, and charities; or some other combination.
Using Formula Testamentary General Powers of Appointment for Dynamic Estate and Income Tax Planning in Wealth Docx®
A formula testamentary general power of appointment may be designed in any of these ways in the Wealth Docx full-length individual and joint revocable living trusts and the standalone will. In addition, Wealth Docx offers drafting resources regarding this and many other optional provisions and allows users to easily customize their documents for clients’ unique estate planning objectives. To learn more, contact a Practice Development Consultant today to schedule a demo.
