Leveraging a General Power of Appointment for Basis Step-Up in Irrevocable Trusts

Estate planning often requires striking a delicate balance between reducing estate tax exposure and ensuring the most favorable cost basis for beneficiaries. Various types of irrevocable trusts—such as Intentionally Defective Grantor Trusts (IDGTs), Spousal Lifetime Access Trusts (SLATs), and Qualified Personal Residence Trusts (QPRTs)—commonly help remove appreciating assets from a grantor’s estate. However, a downside of these structures is that assets held in the trust may not qualify for a basis step-up at the grantor’s death. A strategy to counter this issue involves granting a general power of appointment (GPOA) to an older relative who is unlikely to face estate tax liability, thus allowing the assets to be included in the power holder’s estate and receive a step-up in basis for the ultimate beneficiaries.

Overview of Common Irrevocable Trusts

Intentionally Defective Grantor Trust (IDGT)

An IDGT is designed to “freeze” the value of assets for estate tax purposes while shifting future appreciation out of the grantor’s estate. Although classified as irrevocable for gift and estate tax purposes, the trust is treated as a grantor trust for income tax purposes. This arrangement means the grantor is personally responsible for any income tax liability the trust generates, which effectively allows the trust assets to grow unencumbered by taxes. From an estate planning perspective, this is advantageous because the grantor’s payment of income taxes on behalf of the trust is not considered an additional taxable gift.

Spousal Lifetime Access Trust (SLAT)

A SLAT is an irrevocable trust created by one spouse for the benefit of the other. By funding the trust, the grantor-spouse makes a completed gift of the trust assets, removing them from both spouses’ estates for estate tax purposes. Yet, the beneficiary-spouse can still access the assets (usually for limited purposes, such as health, education, maintenance, or support). SLATs preserve some level of indirect access to assets while capitalizing on estate tax savings, but they typically do not allow for a step-up in basis at the grantor’s death.

Qualified Personal Residence Trust (QPRT)

A QPRT is used when a grantor wishes to transfer a residence at a potentially discounted value for estate and gift tax purposes. The grantor retains the right to live in the home for a set term of years, after which ownership passes to the trust beneficiaries. If the grantor survives the trust term, the residence is excluded from the grantor’s estate, providing potentially significant tax savings. As with other irrevocable trusts, the assets in a QPRT (the residence) do not receive a step-up in basis at the grantor’s death unless they are somehow included in a taxable estate at a future point in time.

The Problem: Loss of Step-Up in Basis

When a person dies owning appreciated property, the property’s tax basis “steps up” to its fair market value. This benefit can substantially reduce capital gains taxes for heirs who eventually sell the asset. However, assets placed in many irrevocable trusts do not receive a step-up in basis if they are excluded from the grantor’s taxable estate. For example, if a grantor funds an IDGT with assets purchased for $1 million that grow to $3 million, and the trust remains outside the grantor’s estate at death, the original $1 million basis continues to apply, creating a large potential capital gains tax upon sale. Families that utilize these trusts risk shouldering higher capital gains taxes if they cannot find a way to reintroduce the assets into an estate for a step-up in basis—without subjecting them to estate tax.

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The Strategy: Granting a General Power of Appointment

A general power of appointment (GPOA) enables the power holder to direct where the property will go, including the possibility of directing it to themselves or their own estate. If a person dies while holding a GPOA, the assets subject to that power are included in their estate, which triggers a basis step-up (or step-down) to the date-of-death value. The key is to give this power to an individual whose estate is unlikely to trigger federal estate tax, thus preserving the new, higher basis without incurring an estate tax cost.

Why Grant a GPOA to an “Old but Poor” Relative?

Minimal estate tax risk arises when the power holder has relatively few assets and is not near the federal estate tax threshold. Their estate is unlikely to face federal estate tax, so adding trust assets to their estate will not create a new tax liability. Despite minimal risk of estate tax, having those assets included in the older relative’s estate means a step-up in basis can be achieved when the relative dies. Once their estate is settled, the trust assets pass to the intended beneficiaries with an increased cost basis, thereby reducing or even eliminating capital gains taxes if the property is eventually sold. An “old” relative is a typical choice because the expectation that they will pass away first means that this basis step-up can occur relatively soon.

Practical considerations include ensuring the trust or a designated “trust protector” has the power to grant a GPOA, selecting a power holder who is comfortable with the responsibility, and confirming that there are no creditor or Medicaid planning complications. Some trust documents rely on a formula GPOA to ensure that only the portion of the trust assets that can be included without generating estate tax liability is subject to the power. Families should also consider the holder’s health and any interpersonal or fiduciary implications that might arise.

Example Scenario

Suppose a grantor funds an IDGT with $1 million, and the assets grow to $3 million over time. To facilitate a step-up in basis, the trust instrument allows a trust protector to grant a general power of appointment to the grantor’s elderly uncle, whose personal assets are well below the federal exemption amount. When the uncle eventually passes away, the $3 million of trust assets are included in his estate. Since his total estate, even including the trust assets, remains under the taxable threshold, no federal estate tax is owed. At the same time, the basis of the trust assets is adjusted (stepped up) to $3 million as of his date of death, which can dramatically reduce capital gains exposure for the ultimate beneficiaries.

Conclusion

Irrevocable trusts like IDGTs, SLATs, and QPRTs offer significant estate tax advantages by removing appreciating assets from the grantor’s estate. Unfortunately, they can also prevent the beneficiaries from receiving a step-up in basis at the grantor’s death. By incorporating a well-structured general power of appointment, families can “borrow” another person’s estate to achieve the desired basis adjustment. This advanced technique can save beneficiaries substantial capital gains taxes while retaining the primary estate planning goals. It is critical, however, to carefully draft and implement such arrangements under the guidance of qualified attorneys, tax advisors, and financial professionals to ensure compliance with legal and tax regulations.

Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Estate planning is complex, and each situation is unique. Always consult with qualified legal and financial professionals to determine which strategies may be appropriate for your specific circumstances.