We have previously discussed the impact of increasing transfer tax exemptions on income tax planning.[1] Those considerations have been solidified after passage of the recent tax legislation known as the One Big Beautiful Bill Act which increased transfer tax exemptions to $15 million, annually adjusting for inflation, without any scheduled sunset date. This can make income tax planning more important than estate tax planning. For many individuals with minimally taxable estates, since the estate tax will have a smaller impact, income tax may be a more significant consideration. For individuals who do not expect any estate tax liability, income tax planning becomes the primary tax consideration. Income tax planning has always been relevant, now merely taking a more important role in the planning process for many clients.
Against this backdrop, “upstream” basis planning has emerged as a powerful tool. The central mechanism is a testamentary general power of appointment (“GPOA”) granted to a senior-generation family member (or one with a shortened life expectancy) over appreciated trust assets, causing those assets to be included in their taxable estate, which allows a basis adjustment.[2] In its most direct form, the strategy is known as the Upstream Power of Appointment Trust (“UpSPAT”). Other names for these and similar structures are Accidentally Perfect Grantor Trusts (“APGT”) and Power of Appointment Support Trusts (“POAST”). While there may be differences in how these trusts are described by commentators, the basic premise of using a GPOA to obtain an adjustment to income tax basis at death remains constant. I will simply refer to this structure as an UpSPAT, used without regard to some of those differences.
Statutory Support
IRC § 1014
The income tax basis of property acquired from a decedent is adjusted to the fair market value of such property as of the day of the decedent’s death.[3] That includes property included in the decedent’s taxable estate.[4] Therefore, the critical inquiry is whether holding a GPOA includes assets subject to the GPOA in the decedent’s estate.
IRC § 2041
This statute requires all property over which a decedent held a GPOA at death to be included in his or her taxable estate.[5] A GPOA is defined to mean “a power which is exercisable in favor of the decedent, his estate, his creditors, or the creditors of his estate.”[6] Three narrow exceptions apply being powers limited by an ascertainable health, education, support, or maintenance standard; powers exercisable only with the donor’s consent; and powers exercisable only with the consent of an adverse party.[7]
The result of these statutes is that granting an individual the power to appoint to themselves, their estates, their creditors, or creditors of their estate (notably, any of these permissible appointees will suffice) provides a fair market value adjustment to assets subject to the GPOA, without regard as to whether the GPOA is exercised or unexercised, as long as one of the exceptions does not apply. It is worth noting that this adjustment to fair market value can result in a “step-down” in basis for assets which have declined in value as of the date of the decedent’s death.
The UpSPAT Structure
A standard UpSPAT is an irrevocable trust created by a junior family member, typically for his or her descendants and/or spouse (more on the spouse as a beneficiary below), over which a senior family member is granted a testamentary GPOA,[8] which would most often be a grantor trust for income tax purposes.
At the death of the senior family member holding a GPOA, the assets held in trust receive a basis adjustment to fair market value, eliminating any current gain attributable to those assets.[9] This elimination of gain occurs with respect not just to capital gains assets.[10] For example, assets which previously had been subject to depreciation deductions which would cause ordinary income recapture on sale also get the benefit of the basis adjustment. An important consideration here, which will be referenced again to a limited extent below, is that this addition to the senior family member’s taxable estate can cause estate tax liability.
When formed as a grantor trust, UpSPAT generally should remain a grantor trust as to the settlor after the death of the senior family member, although that would likely be different upon an exercise of the power as opposed to a lapse.[11]
Based on this structure and the law supporting the UpSPAT plan, the law and planning structure is fairly straightforward. An UpSPAT does not rely on any strained reading of a complex web of legal authorities, nor does it require multiple steps in a complex planning structure. However, as with many planning techniques that appear simple, the devil is often in the details. That can be true for an UpSPAT.
Funding the UpSPAT
There are two principal ways to fund an UpSPAT: (1) through a gift of assets to the trust,[12] or (2) by a sale to the trust in exchange for a promissory note. The choice between these two funding modalities has significant consequences.
A sale to a grantor trust is disregarded for income tax purposes: because the settlor and the trust are treated as the same taxpayer, there is no change in tax ownership and no gain recognition, with the trust taking a carryover basis in the purchased asset.[13] From a transfer tax standpoint, a bona fide sale for fair market value is not a “gift,” and this characterization may be central to the IRC § 1014(e) analysis. In addition, this allows the settlor to be paid the current fair market value for the relevant property, along with adequate interest, which may be important for settlors who need or desire to keep the value of the underlying property and may not use an UpSPAT if that required loss of access to that value. Yet another potential benefit of the UpSPAT sale is the ability to structure the seller-financing to allow the senior generation to obtain a deduction against their gross estate under IRC § 2053 for the value of the indebtedness, thereby allowing a larger underlying value of assets to obtain a basis adjustment without adding to the senior generation’s estate tax liability.
A gift to the trust completes the transfer more cleanly from an estate planning standpoint and avoids the ongoing note obligations and estate tax considerations associated with installment sales. However, as discussed below, a gift-funded UPSPAT raises IRC § 1014(e) risks. While there are other ways these risks may be mitigated, careful planners often prefer to rely on multiple avenues to avoid unintended tax consequences.
Section 1014(e): The One-Year Rule and Its Limits
IRC § 1014(e) provides that if a decedent acquires appreciated property by gift within the one-year period ending on the date of the decedent’s death, and such property passes from the decedent to the donor or the donor’s spouse, the basis of the property in the hands of the donor or the donor’s spouse is the adjusted basis of the property in the decedent’s hands immediately before death. In short, there is no adjustment to fair market value. The provision is aimed at “death-bed transfers” in which a donor gifts appreciated property to a terminally ill person, who then “re-returns” the property to the donor with a fresh basis. Both prongs must be met: (1) the decedent acquired appreciated property by gift within one year of death, and (2) the property passes to the donor or the donor’s spouse.
Where the UpSPAT is funded by a fair market value sale, IRC § 1014(e) is generally not implicated because a bona fide arm’s-length sale is not an acquisition “by gift” within the meaning of the statute. Accordingly, those concerned about IRC § 1014(e), particularly where the senior family member is elderly or in poor health, often prefer to fund the UpSPAT by sale. This is particularly important when the junior family member or their spouse will have an interest in the trust after the death of the senior family member.
Where the UpSPAT is funded by gift, the first prong of the statute above will be met if the senior family member dies within one year of the gift. The property was acquired by gift. Therefore, avoiding the second prong is important, that the property not return to the donor or the donor’s spouse. The IRS has interpreted “passes to” the donor broadly, including not just outright distributions but distributions through trusts in which the donor retains certain beneficial interests. This can be seen in private letter rulings citing both direct and indirect reversion to the donor.[14]
Based on this, the safest route is to sell assets to the UpSPAT and have the assets held in a trust for the descendants of the settlor after lapse of the GPOA, which may be a contingent trust that is funded only if the powerholder dies during the relevant one-year period. That provides the ability to negate application of both prongs of IRC § 1014(e) referenced above. Therefore, a gift to the UpSPAT should be safe as long as the continuing trust is not deemed to pass the assets back to the donor or the donor’s spouse.
Drafting Considerations and Risks
Estate Tax Inclusion in Senior Generation’s Taxable Estate
It is important to consider whether the senior family member can absorb inclusion of these trust assets without causing unnecessary estate tax since the UpSPAT assets will be included in their taxable estate. One way to mitigate this can be the use of a formula GPOA where the powerholder only has a GPOA over the amount of assets under the powerholder’s estate tax exemption.[15] That can reduce the basis adjustment but at the cost of estate tax which often would cause a larger tax liability and be triggered sooner, neither which are desirable. As discussed above, funding the UpSPAT via sale structured to give the senior generation an IRC § 2053 deduction should also help minimize the overall value added to the senior generation’s taxable estate.
Unwanted Exercise
What if the senior family member exercises the GPOA in a way not anticipated by the settlor? What can be done to avoid that outcome? A GPOA need not be unlimited in how it can be exercised. The power can be drafted to require the consent of a non-adverse third party, such as an independent trustee or trust protector. This is permitted without loss of GPOA treatment.[16] The result is that it would require both the senior family member and an independent third party selected by the settlor in order for any exercise. Alternatively, the power can be limited solely to appointment in favor of the creditors of the senior family member’s estate, which should substantially reduce the risk of a materially adverse exercise.
Creditor Exposure
Under the laws of most states, creditors of the holder of a GPOA created by another can reach the appointive assets to the extent the powerholder’s estate is insufficient to pay its obligations.[17] As such, practitioners should evaluate the senior member’s creditor exposure before implementing the strategy or structure the UpSPAT in a jurisdiction where this result may be avoided.[18]
Incomplete Gift Trusts or Domestic Asset Protection Trusts
While there may be methods which are safe in funding an UpSPAT, such as selling an asset to the trust for fair market value and having the settlor’s descendants be the only beneficiaries, not all planning situations allow for those options. Many settlors may want to retain certain powers of trust assets, such as a power of appointment to change the ultimate disposition among their descendants. They also may desire to keep the possibility of a cost basis adjustment should they predecease the senior family member.[19] Likewise, some settlors may desire to use a domestic asset protection trust (“DAPT”) as the UpSPAT vehicle. When funding an UpSPAT through an incomplete gift, the gift would be complete upon the death of the senior family member.[20] This can result in increased use of gift tax exemption if the asset continues to appreciate after being transferred into trust, but that may be irrelevant for settlors without any potential taxable estate given increased estate tax exemption amounts. However, for gift tax purposes, the settlor’s gift will occur simultaneously with the senior family member’s GPOA, putting the transfer squarely within IRC § 1014(e)’s one-year period if completion of the gift, for gift tax purposes, is the relevant trigger under § 1014(e). The law is not clear as to whether that is the test, although the IRS appears to have possibly conflated those items in private letter rulings.[21]
Many states allow settlors to establish trusts in which they are a beneficiary without subjecting trust assets to the creditors of the settlor (at least after a certain time period), i.e. a self-settled spendthrift trust. These DAPTs are irrevocable trusts in which the settlor typically would be a mere discretionary beneficiary.[22] For reasons indicated above,[23] it is quite possible that both IRC § 1014(e) prongs referenced above would not be met. The settlor had no revocation power or other right to demand a distribution of trust assets, therefore not causing the settlor’s gift to occur simultaneously with the death of the powerholder and the settlor’s retained interest is that of a mere discretionary right to distributions which is not enforceable possibly negating the requirement that the assets return to the settlor. These may be more risky propositions, but potentially the best alternative for certain clients.
Conclusion
Upstream basis planning, and the UPSPAT in particular, represents one of the most direct and flexible vehicles for obtaining a basis adjustment to fair market value on appreciated assets held in irrevocable trusts. By granting a testamentary GPOA to a senior family member with sufficient available estate tax exemption, assets can be included in the senior member’s taxable estate, thereby achieving elimination of embedded gain at no estate tax cost. The strategy rests on well-established law IRS guidance. The change is in the current planning environment. Historically high estate tax exemptions and elevated capital gains rates makes the step-up (recalling that there can be a step-down) a more valuable tax planning tool available to many families who expect no, or very little, estate tax liability.
There are, however, a number of critical planning variables as addressed above. Practitioners who address these variables with precision, considering both the client’s individual circumstances and the relevant legal authorities, can assist in structuring a workable UpSPAT. In my experience, these options, valuable to a large number of individuals including those without taxable estates, are underutilized.
[1] Allen, Charles J., “All About That Basis, About That Basis, No Gains,” Nov. 8, 2019, https://esapllc.com/cja-stepupplanning-2019/, and Joshua W. Sage, “Estate Inclusion: The New Estate Plan, Step-Up,” Aug. 8, 2018, https://esapllc.com/inclusion-planning/.
[2] IRC § 1014(b)(9).
[3] IRC § 1014(a).
[4] IRC §§ 1014(b)(4) and (9).
[5] IRC § 2041(a)(2), Treas. Reg. §20.2041-1(a). Mere possession at death is sufficient for inclusion; the power need not be exercised. Estate of Freeman v. Commissioner, 67 T.C. 202 (1976).
[6] IRC §2041(b)(1); Treas. Reg. §20.2041-1(c)(1).
[7] IRC §2041(b)(1)(A)–(C); Treas. Reg. §20.2041-1(c)(2); Rev. Rul. 79-63 (defining “adverse party” for purposes of §2041(b)(1)(C)).
[8] Although there appears to be no requirement that the senior family generation, it is likely advisable for the senior family member to hold some beneficial interest to avoid arguments similar to those raised in Cristofani v. Commissioner, 97 T.C. 74 (1991). Also, it appears the outcome can still be obtained even if the senior family member is unaware of, or does not understand the GPOA. See Estate of Freeman v. Commissioner, 67 T.C. 202 (1976). However, there may be state law obligations, such as under Uniform Trust Code § 813, to inform the power holder.
[9] While beyond the scope of this writing, this can also allow the senior family member’s generation skipping transfer tax exemption to be allocated to increase the amount of assets avoiding estate tax at multiple generations. IRC §§ 2631, 2632; Treas. Reg. §26.2632-1. See also Edwin P. Morrow III, “Optimizing Basis and Maintaining GST Exempt Status Through Formula General Powers of Appointment,” LISI Estate Planning Newsletter #2945 (March 16, 2022).
[10] It is important to understand in this context that the IRC § 1014 basis adjustment does not apply with respect to income in respect of decedents as defined in IRC § 691 which generally represents realized income that has yet to be recognized by the decedent, such as deferred gains under an installment note.
[11] Treas. Reg. §§ 1.671-2(e)(5) and (e)(6) Ex. 9.
[12] This may be a complete or incomplete gift for gift tax purposes. See discussion below for considerations particular to incomplete gift trusts.f
[13] Rev. Rul. 85-13.
[14] PLRs 200101021 and 200210051 (IRS citing “directly or indirectly” language in connection with §1014(e)); PLR 9026036 (property passing to trust in which donor retains income interest may constitute passing “to” the donor). Note, however, that each of these PLRs involve situations where the continuing trust for the donor contained mandatory rights to distributions for income and/or support. Where the trust is completely discretionary such that the donor has no enforceable right to distributions, there is a strong argument that the donor has not retained a problematic IRC § 1014(e) interest. See Mark R. Siegel, “IRC Section 1014(e) and Gifted Property Reconveyed in Trust,” Akron Tax Journal, Vol. 27, Article 2, 2012; Edwin Morrow, “The Upstream Optimal Basis Increase Trust,” LSIS Estate Planning Newsletter #9071 (April 17, 2018).
[15] For some additional discussion on formula GPOA’s, see Joshua W. Sage, “Estate Tax Inclusion: The New Estate Plan, Step Up,” Aug. 8, 2018, https://esapllc.com/inclusion-planning/. See also PLR 202206008 approving the use of a formula general power of appointment.
[16] I.R.C. §2041(b)(1)(C); Rev. Rul. 79-63. The third party whose consent is required must lack a “substantial beneficial interest” that would be adversely affected by exercise of the power in favor of the powerholder (i.e., the party must be non-adverse to preserve GPOA treatment).
[17] Restatement (Third) of Property: Wills and Other Donative Transfers §22.3 (Am. Law Inst. 2011); Uniform Powers of Appointment Act §502 (Unif. Law Comm’n 2013).
[18] See, e.g., Miss. Code Ann. § 91-8-504(e)(2).
[19] The IRS has confirmed its view that assets in a completed gift irrevocable trust do not obtain a basis adjustment at the settlor’s death in Rev. Rul. 2023-2.
[20] Treas. Reg. § 25.2511-2.
[21] See PLRs 200101021 and 200210051. However, note that each of these trusts were revocable by the settlor, meaning the settlor had the power to take demand return of the trust assets until the death of the powerholder, a fact cited to in these PLRs to support the IRS conclusions. Question whether the same result would be found if the trust was an incomplete gift irrevocable trust that was a completed gift under state law=.
[22] A DAPT may be an incomplete gift or completed gift trust. For discussion of how a DAPT may be a completed gift trust, outside the taxable estate of the settlor, see PLR 200944002.
[23] See Footnotes 11 and 17.
