The Joint Trust Craze: Who Says Community Property States Have All the Luck? (The IRS)

The Joint Trust Craze: Who Says Community Property States Have All the Luck? (The IRS)

By Jeffrey G. Moore

Couples that reside in Community Property states (such as our neighbors Washington, Idaho and California—plus seven other states not including Oregon) have one arguable advantage over us Oregonians: double step-up in basis. The “step-up in basis” advantage is an income tax advantage. More specifically, a capital-gain advantage. The unfortunate problem is that you must die in order to obtain the advantage. Simply put, if I buy stock for $10 per share (this is my purchase price or “basis”) and it appreciates to $100 per share over the next 20 years, I will have a capital gain of $90 per share at the time I sell the stock. But if I die still owning that stock valued at $100 per share, the law adjusts my basis to the fair market value of the stock at the time of my death—or $100 per share. As a result, if the stock is sold shortly after my death, the only gain will be the difference between the sale price and the date-of-death value. (Note that this step up in basis advantage does not apply to assets such as IRA’s, 401(k)’s, TSA accounts, installment notes or other tax-deferred assets.)

In Oregon, if my spouse and I own 200 shares jointly or as equal tenants in common, only the decedent spouse’s half (or 100 shares) receives a step up in basis. The surviving spouse’s half does not, at least not until he or she also passes away. In Community Property states, however, both halves get a stepped-up basis on the first death. This apparent disparity has lead to some creative legal thinking with respect to the use of joint living trusts in common law states such as Oregon. The question is whether such thinking is too creative.

The joint living trust (“joint trust”) is a common estate planning document that in essence combines the “his” and “her” separate living trusts into a single trust document. Generally speaking, both spouses have joint control of—and joint access to—all of the assets transferred to this single living trust. Although one document, the joint trust provides lifetime asset management for both spouses, and contains all of the instructions and distribution guidelines necessary upon both deaths. Implementation of the joint trust is usually based on the assumption that a couple’s marriage is stable, the spouses share similar or at least compatible estate-planning goals, a majority of the marital property is already owned “jointly,” the children are of the same marriage or are treated as such, and that the estate planning is for the good of the marital unit’s collective objectives and not necessarily the individual spousal interests. In short, the joint trust indeed requires a great deal of “trust.”

Never has the issue of “trust” been truer than with the “GPOA Joint Trust.” The GPOA Joint Trust (or “General Power of Appointment” Joint Trust) is the commonly-used joint trust coupled with a creative slant. This creative slant is an attempt to obtain on the first spouse’s death a double step up in basis for couples living, and dying, in non-Community Property states. There are also some possible estate tax advantages that could be gleaned from the strategy regardless of where a couple lives.

The strategy is a bit complex because it crosses over so many Internal Revenue Code sections. To simplify, consider the following tax rules:

  • If you have the unlimited power to control how an asset will pass upon your death (regardless of whether it is titled in your name or not), then such asset will be included in your estate for federal estate tax purposes. This power is called a “general power of appointment.”
  • Any gifts made to you prior to your death are also included in your estate.
  • Assets included in your estate at the time of your death—including assets over which you have the “general power of appointment” or which were received as a gift—will obtain a stepped-up basis upon your death (other than some of the “tax-deffered” exceptions noted above).
  • If the gift you received was acquired one-year prior to your death, however, it will be included in your estate but will not receive a stepped-up basis.

To apply these rules to an example, assume that a couple establishes a joint trust. Both spouses have the right to revoke the trust at any time and withdraw their “one-half” of the trust. A very typical plan. But in addition, and this is the creative slant, each spouse grants the other spouse the unlimited or “general power to appoint” all of the joint trust assets to whomever upon such spouse’s death. By application of tax rule number 1, above, all of the joint trust assets are therefore includible in the decedent spouse’s estate.

It seems then that the mission to obtain a step up over all the marital assets has been accomplished, correct? After all, tax rule number 3 states that if assets are included in the estate, they get a stepped-up basis and we seem to be on equal footing with the Community Property states. Take caution because the IRS disagrees. The IRS has twice taken the position in recent rulings that the granting of the “general power of appointment” by the surviving spouse is a gift to the decedent spouse at the time of the decedent spouse’s death. (See PLR’s 200101021 and 200210051.) And, of course, tax rule number 4 states that a gift within a year of death will not qualify for a stepped-up basis. In short, we are back to where we started.

The IRS obviously wants to prevent a creative double step up in basis, but some argue that the IRS’s “gift” argument is too creative itself for one obvious reason—how does a surviving spouse make “a gift” to a deceased spouse? Nevertheless, the IRS has apparently drawn its line and until the legislature or the courts state otherwise, clients should carefully scrutinize any plan guaranteeing such benefits.

There may be a silver lining in this cloud. Although the income tax strategy was disregarded, but there may be some estate tax advantages with respect to joint trust administration and the ability to completely fund a tax-planning, credit-shelter trust even if that means using the surviving spouse’s assets to do it. There are still some unresolved questions as to the IRS’s rulings, but there are some answers as well. Please feel free to call us at (503) 399-1070 if you have questions or would like to discuss these issues further.