The Formula General Power of Appointment, Part 1: Fixing Old Trusts
This week kicks off a two-part series on the formula general power of appointment (GPOA)—one of the most underutilized basis planning tools available. Part 1 focuses on adding a formula GPOA to an existing irrevocable trust document. Part 2 will cover how a formula GPOA can be included in newly-drafted instruments to effectively balance income and estate tax planning for middle wealth families.
Let’s start with the trusts already on the books.
The Problem: Low Basis Assets Trapped in Old Credit Shelter Trusts
Credit shelter and bypass trusts drafted before the current planning era were built to avoid estate tax—not to optimize basis. Assets inside those trusts don’t receive a basis step-up at the surviving spouse’s or beneficiary’s death since they aren’t included in that beneficiary’s taxable estate. In a high-exemption environment, that trade-off may no longer makes sense depending on a families circumstances. The estate tax savings may be minimal or non-existent, while the embedded capital gains cost may be significant.
The Solution: Adding a Formula GPOA to the Old Credit Shelter Trust
A formula GPOA is a testamentary power granted to a trust beneficiary that causes a portion of the trust assets to be included in the beneficiary’s gross estate under IRC § 2041. The power is sized by formula to the beneficiary’s remaining applicable exclusion amount, so that no federal estate tax is expected to result. That inclusion triggers a basis adjustment under IRC § 1014 at the beneficiary’s death, removing the capital gains tax exposure, with no estate tax cost. Note that the basis will adjust both up and down unless the formula is limited to apply only to appreciated assets.
Interestingly, the power doesn’t even need to be exercised to work. The mere existence of the power at the power-holder’s death is enough to cause inclusion—and the basis adjustment follows.
There are three primary vehicles for adding a formula GPOA to a trust that doesn’t already contain one:
- Trust decanting
- Judicial or non-judicial trust modification
- Exercise of a Trust Protector’s power
The right path depends on what the original instrument allows, governing state law, and whether beneficiaries are aligned.
GST Caveat
Please be aware that if the original trust holds a GST exemption allocation, granting a formula GPOA may contaminate that exemption. This is due to the fact that the power holder becomes the new GST transferor for the included portion of assets—regardless of whether the power is exercised. In such a case, the power holder may need to allocate his or her own GST exemption in order for the affected trust assets to remain GST exempt. This requires careful analysis before proceeding.
Gift Tax Caveat
Granting the surviving spouse or another beneficiary a general power of appointment lets that person appoint property away from the remainder beneficiaries. Accordingly, if the remainder beneficiary consents or fails to object to the addition of the formula GPOA, the IRS may treat that as a taxable gift by the remainder beneficiary. Whether a gift occurs depends on the trust terms, state law, and the mechanics of the modification process.
Who Should Consider This?
Candidates who may wish to evaluate a formula GPOA “fix” are often individuals with irrevocable trusts holding highly appreciated, low-basis assets—think a family business interest, concentrated stock position, or real estate — where the surviving spouse’s or beneficiary’s estate is well under the remaining applicable exclusion amount.
Stay tuned for Part 2: how to draft the formula GPOA into new trust instruments from the start and the circumstances in which this technique may be appropriate.
Tamara M. Paulun, JD, CTFA
Director of Advanced Planning & Trusts
SAX Wealth Advisors
Important Disclosures
SAX Wealth Advisors, LLC (“SAXWA”) is an SEC registered investment adviser. Registration with the SEC or any state securities authority does not imply a certain level of skill or training. This material has been prepared for general informational and educational purposes only. It is not intended to provide, and should not be solely relied on for, legal, tax, accounting, estate planning, or individualized investment advice, and it does not create an advisory, attorney-client, or accountant-client relationship. The strategies discussed involve complex federal and state tax rules, depend on the terms of the governing instrument and applicable state law, and may not be appropriate for every individual. Information is believed to be accurate as of the date of publication. Before implementing any strategy described here, consult your own qualified estate planning attorney and CPA or tax professional regarding your specific situation.