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uncle murray

By James See

Having Your Cake and Eating it Too

Obtaining a Stepped-Up Basis in Irrevocable Trusts

By: Cody J. Parks, JD, LLM

January 2023

One of the primary objectives in Estate Planning is to maximize the value that passes to your loved ones and minimize the value that goes to the Government. The IRS is well aware of this objective; and they’ve thrown many wrenches at the wealthy in the Tax Code to hinder them. This Article will explain how you can avoid BOTH an Income Tax and an Estate Tax through the use of an “Uncle Murray.” This strategy is also referred to as an UPSPAT (upstream power of appointment trust) or a Syndicated Power of Appointment. To better understand the wrench which this Article is focused on, it is important to understand the Gifting Rules.

Gifting Rules

As of the date of this Article, everyone is allowed to pass on $12,920,000 (the “Estate Tax Exemption”) of their wealth during life or at death without incurring a tax liability. Generally, any assets transferred over this amount will be taxed at a 40% rate. At death, any assets that are transferred using the ~$13M exemption or that are subject to a 40% tax will receive a stepped-up basis for income tax. As a result, whatever the current value of the asset is at the Decedents death will be their new basis in the asset. This means that when their Beneficiaries receive the assets, they could sell them the next day and owe $0 in Capital Gains. Because the assets were already subject to the Estate Tax, they will not be subject to the Income Tax.

In contrast, if assets are not subject to the Estate Tax, they will be subject to the Income Tax. Because assets are constantly appreciating in value, it is typically better for an individual to gift assets sooner than later during their life using this $13M Exemption. Once the assets are transferred to an Irrevocable Trust for the benefit of a Spouse or other loved one, all the growth and appreciation tied to these assets will escape a 40% Estate Tax. However, because these assets escaped the Estate Tax, they will be subject to the Income Tax once the beneficiaries sell the assets they received. This is because when an asset is gifted, the basis that the Donor had is transferred to the Donee (a “Carry Over Basis”). Thus, when the Donee sells the assets they were gifted, the increased value will all be subject to a Capital Gains Tax.

Powers of Appointment

So here arises the question, is there a way to transfer assets to an Irrevocable Trust to escape the 40% Estate Tax while also receiving a Stepped-Up basis on the assets to avoid Capital Gains? The answer is yes. The tax code is structured in a way that you can have your cake and eat it too through the strategic use of a Testamentary General Power of Appointment.

A Testamentary Power of Appointment is a provision which may be inserted in a trust which allows a beneficiary to direct who gets the assets at the beneficiary’s death. Typically, a Power of Appointment is used to increase the flexibility of an irrevocable trust, i.e., change the remainder beneficiaries. This Power of Appointment can either be General, which means that under IRC §2041(a)(2) the assets are subject to the 40% estate tax to the Beneficiary exercising the power, or it can be limited, which means the assets will not be subject to the estate tax of the Beneficiary exercising the power.

A Power of Appointment is labelled as being General or Limited based on who the Beneficiary is allowed to appoint the assets to. If the provisions of the Power of Appointment allow you to appoint to yourself, your estate, your creditors, or creditors of your estate then it is a General Power. In contrast, if the trust provisions do not allow you to appoint assets to yourself, your estate, your creditors, or creditors of your estate, then the power is Limited.

Herein lies the magic; if you use your estate tax exemption and make a gift to a properly drafted Irrevocable Trust, those assets will escape a 40% Estate Tax. Further, if you give someone a General Power of Appointment in a Trust, you can use their estate tax exemption to include trust assets (up to their remaining Exemption) in their Estate, which gives you a Stepped-Up Income Tax Basis at their death. This allows you to avoid the Income Tax and the Estate Tax if a highly appreciated asset is sold shortly after their death.

Identifying the Holder of the Power of Appointment

At Dana Whiting Law, we refer to the person holding the General Power of Appointment as an “Uncle Murray.” There are many key factors to identifying who should be named as the Uncle Murray and given this General Power of Appointment to. The following should all be considered:

  • The relationship of the individual– Ideally this should be a family member, someone who would naturally be named in your trust. Although this is not a requirement it would reduce any IRS scrutiny.

  • Someone you help financially– Whoever you name will also need to be named as a Beneficiary of the Trust. This means you need to feel comfortable naming someone that you don’t mind making sporadic distributions to from the trust to legitimize them as a Beneficiary. These Distributions do not need to be large; it could be as simple as paying utility bills here and there or buying them new tires for their car.

  • Age and health– The longer your Uncle Murray lives, the longer it will be until you are able to use their Exemption for a Stepped-Up basis on your assets.

  • Low net worth– The benefit is only realized to the extent that the named Beneficiary has an available Estate Tax Exemption. The less assets they have then the more Exemption will be available to you.

  • No Creditors– Because the individual would need to be named a Beneficiary of a trust, it is important to make sure they have no creditors. Although it is unlikely, a creditor could penetrate the assets of the trust.

Other Considerations

This technique as outlined has not been challenged by the IRS, so there is always a risk that the IRS will challenge this, and an unfavorable ruling could be released. There is no code section authorizing the full use of this strategy, but by connecting various code sections this strategy is firmly rooted in the Tax Code. However, there is no downside to utilizing this strategy, you are not locked into taking the position of a stepped-up basis until the Uncle Murray passes away. Once they pass away you will have a choice as to whether you want to file to use their exemption or not.

Although the Beneficiary will be given the narrow Power to Appoint to Creditors of their estate, they would only be able to exercise this power with the approval of a third party, usually a Trust Protector (which would refuse permission). If this Power is not actually exercised, any Creditors of their Estate would have no claim to the assets owned by the Trust. Further, it is unlikely that the beneficiary would even know who the Creditors of their Estate will be. Thus, the risk factor is extremely low that there would be negative consequences in utilizing this strategy.