On February 24, the Internal Revenue Service issued proposed regulations which, if finalized, will offer individuals a favorable income tax strategy most estate planning advisors doubted would ever exist.
A common estate planning strategy, which can save federal and estate death taxes, protect assets from the rights of a divorced spouse and insulate assets from lawsuits, is to pay IRA and/or 401k accounts to a trust for the lifetime benefit of the account owner’s spouse and/or children. With special drafting, it is also possible to have the income of the trust taxed at the spouse’s or children’s usually lower federal income tax rates, rather than at the typically much higher federal income tax rates imposed on trusts. Up until the Internal Revenue Service issued its proposed regulations in late February, however, it was uncertain whether it was possible to draft the trust instrument so that, in addition, income taxes are saved at the death of the spouse or children, when the trust assets pass to the next generation of beneficiaries.
Prior to the issuance of the proposed regulations, sometimes referred to as the “SECURE Act proposed regulations,” earlier this year, it was commonly thought that, in order to achieve maximum income tax deferral when IRAs or 401k accounts are made payable to an “accumulation trust,” which trust authorizes accumulation of the IRA and/or 401k plan receipts for the above-mentioned estate tax savings, divorce protection, and lawsuit protection reasons, there had to be a trade-off. The persons or trusts that took the balance of the trust assets when the spouse or child died would be required to receive a “carryover” federal income tax basis in the IRA or 401k proceeds which were reinvested in other assets, equal to the historical cost basis of the assets, rather than a “stepped-up” income tax basis equal to the fair market value of the trust assets at the time of the spouse’s or child’s death. As a consequence, when the trust assets were later sold after the death of the spouse or child, there could be significant income taxes to pay.
Assuming this aspect of the proposed regulations is finalized in its current form, the IRS will now allow maximum income tax deferral for the IRA or 401k accounts which are made payable to the accumulation trust (which maximum deferral period could be either for the lifetime of the trust beneficiary or for up to 10 years, depending on the purpose and structure of the trust), and will simultaneously permit the income tax basis of all or part of the trust assets which were purchased with the IRA or 401k proceeds to be adjusted to the fair market value of the assets at the spouse's or child’s death. The technical reason for this is that the IRS has announced in its proposed regulations that a technique estate planning attorneys utilize to create this result (sometimes referred to as a conditional testamentary general power of appointment) will not affect the maximum income tax deferral period on IRA and 401k accounts made payable to an accumulation trust.
In higher net worth situations, the income tax basis adjustment at the spouse’s or child’s death may be limited, but, if the trust instrument is properly structured, in most situations the income tax basis adjustment will be significant, if not full. Also significant is the fact that, in so-called “dynasty trust” situations, i.e., where the estate tax, divorce and lawsuit protections of accumulation trusts are intended to continue for future generations, this same federal income tax basis adjustment at each generation can continue for hundreds of years, if not forever.
James G. Blase, CPA, JD, LLM, is a principal at Blase & Associates LLC. For more on the estate planning techniques described in this article, see Mr. Blase’s book entitled Estate Planning For The SECURE Act: Strategies For Minimizing Taxes on IRAs and 401ks, available on Amazon.