A PRACTICAL LOOK AT SPRINGING THE DELAWARE TAX TRAP TO AVERT GENERATION SKIPPING TRANSFER TAX

Editors' Synopsis: "Delaware tax trap" is the colloquial name among tax practitioners for Internal Revenue Code section 2041(a)(3) (and its gift tax counterpart, section 2514(d)), which provides that assets subject to a power of appointment are included in the power holder's gross estate if the holder exercised the power to create another power that "under the applicable local law can be validly exercised so as to postpone the vesting of [interests in the assets] for a period ascertainable without regard to the date of the creation of the first power." Under many states' laws, the possibility of exercising a special power of appointment to create a presently exercisable general power brings the Delaware tax trap within a special power holder's election. This can be desirable when termination of the special power holder's interest in assets subject to the power may be a "taxable termination" for generation-skipping transfer tax purposes. This Article discusses the practical effects of springing the "trap" to avert the generation-skipping transfer tax.

I. INTRODUCTION

A paradigmatic use of the strategy that is the subject of this Article involves a separate trust for the benefit of one of "Settlor's" children, "Child." The trust instrument provides that on Child's death, the trust's assets are distributed as Child appoints by will. Child's power of appointment ("Power") is a "special power": it can be exercised only in favor of persons other than Child, Child's creditors, Child's estate, or the creditors of Child's estate.' The instrument provides that in default of appointment, the assets are divided into separate trusts for Child's descendants or, if none, for Settlor's descendants. Settlor's entire GST exemption2 is allocated elsewhere. Because Child's Power is a special power, it will not cause Child's gross estate to include the trust's assets.3 For that reason, Child's death is likely to be a "taxable termination" for purposes of the generation skipping transfer ("GST") tax.4 Because Settlor's GST exemption was allocated elsewhere, a taxable termination will subject the entire trust to a flat tax at the highest marginal estate tax rate.5

Unless Child's estate is already large enough to trigger the highest estate tax rate, it may be desirable to include the trust in Child's gross estate to avoid the GST tax.6 The Delaware Tax Trap may provide a means of doing that through the use of Child's Power. "Delaware tax trap" ("Trap") is the colloquial name given by tax practitioners to Internal Revenue Code ("Code") section 2041(a)(3) (and its gift tax counterpart, Code section 2514(d)).7 Section 2041(a)(3) provides that the decedent's gross estate includes assets subject to the decedent's power of appointment if the decedent exercised the power by creating another power that "under the applicable local law can be validly exercised so as to postpone the vesting of [interests in the assets] for a period ascertainable without regard to the date of the creation of the first power."8 This reference to local law refers to the rule against perpetuities;9 therefore, the question is whether the second power of appointment (the one created by decedent's exercise of the special power) may have the effect of restarting the perpetuities-testing period.

Under many states' laws, in the case of any power other than a presently exercisable general power, the period during which the exercise of the power postpones vesting of a future interest begins at the time the power is created. However, in the case of a presently exercisable general power, the period begins at the time the power is exercised.10 This means that if Child exercises the Power by creating a presently exercisable general power over the trust, the Trap will include the trust in Child's gross estate because any exercise of the general power will begin a new vesting period, one reckoned from the date of exercise, not from the creation of Child's Power.

For these purposes, a "presently exercisable" power is generally one that is not required to be exercised by will or otherwise constrained to be postponed," and a "general" power is one exercisable in favor of the holder, the holder's creditors, the holder's estate, or the creditors of holder's estate.12 The instrument creating a power of appointment can limit the manner in which the holder can exercise the power,13 but unless the instrument is prohibitive, there is no impediment under many states' laws to the exercise of a power of appointment so as to create another power in a permissible appointee.14 Therefore, unless the trust instrument prohibits Child from exercising the Power by creating a presently exercisable general power,15 the Trap may be within Child's election. If, under governing local law, a presently exercisable general power over the trust is liable to restart the period during which vesting of future interests in the trust can be postponed, Child's giving someone this type of power will cause Child's gross estate to include the trust, and for that reason Child's death will not be a taxable termination. The purpose of this Article is to discuss the practical effects of using the Trap in this way to avert the GST tax.