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Taking into account the stratospheric $11.18 million federal estate tax exclusion enacted by the Tax Cuts and Jobs Act,1 most decedents are no longer subject to federal estate taxes. This means that many existing credit shelter trusts (and other irrevocable trusts) will no longer generate estate tax savings. Worse yet, these trusts have suddenly become counterproductive from an income tax point of view, because their assets generally don’t receive stepped-up basis treatment at the death of the surviving spouse.
An increasingly popular way to achieve basis step-up for credit shelter trusts involves springing the Delaware tax trap (the Trap)2 under Internal Revenue Code Section 2041(a)(3).3 But, can the Trap be sprung in jurisdictions where local law permits trusts to last in perpetuity or for a very long stated period? Depending on one’s interpretation of the law, trusts in perpetual (or near-perpetual) jurisdictions may be precluded from using this strategy.
RAP and Powers of Alienation
The Trap deals with successive powers of appointment (a “first power,” which creates a “second power”). Understanding the Trap in the context of successive powers can be difficult because the statute is intertwined with local property rules relating to restraints on property dispositions imposed by the rule against perpetuities (RAP) and the rule against the suspension of the power of alienation (alienation rule). The former rule voids property interests vesting too remotely, while the latter rule voids property interests in which the power of alienation (sale) is suspended beyond a permissible period. The distinction between general powers of appointment (GPAs)4 and special powers of appointment (SPAs)5 also becomes important in the analysis.
The common law RAP is that “no interest is good unless it must vest, if at all, not later than 21 years after some life in being at the creation of the interest.”6 Based on the facts existing at the time the interest was created, the rule voids future interests vesting later than 21 years after the death of a living person (the validating life). For successive powers, the perpetuity period for testing the exercise of the second power (for SPAs and testamentary GPAs) is generally measured from the date the first power was created. This is an application of the relation-back...