Synopsis

The continuation of historically elevated applicable exclusion amounts under the One Big Beautiful Bill Act has sparked increased interest in planning techniques that capitalize on the larger federal exemption amounts. This article seeks to examine one such technique, the use of reciprocal spousal powers of appointment, to determine its value in invoking estate tax inclusion in first to die scenarios for complete basis adjustment in common law jurisdictions. Additionally, it outlines potential drafting techniques for implementation and addresses key considerations surrounding statutory and doctrinal limitations.

Introduction

Planners advising married couples frequently address a balance sheet of highly appreciated assets. When one spouse dies, I.R.C. § 1014(a) offers a valuable opportunity to step up basis to fair market value, but that adjustment applies only to the assets that are includible in the decedent’s estate. Married couples residing in community property states are entitled to an additional benefit, as the ownership portion of the community property attributable to the surviving spouse under I.R.C. § 1014(b)(6) will receive a new basis upon the death of the deceased spouse if at least one-half of the community property is includible in the decedent’s estate for federal estate tax purposes. Conversely, in common law jurisdictions, the surviving spouse’s assets typically remain on a carryover basis. This often leaves the surviving spouse with a substantial capital gains burden, limiting the availability of tax-efficient diversification, reallocation, or liquidation.

The challenges presented by this significant capital gains exposure have prompted continued interest in planning techniques that intentionally cause both spouses’ assets to receive a basis adjustment at the first death. One such technique involves providing each spouse with a general power of appointment over the other spouse’s revocable trust. If properly drafted, the result is inclusion under I.R.C. § 2041, allowing the assets in both trusts to receive a I.R.C. § 1014(a) basis adjustment at the time of the first spouse’s death.

Under a reciprocal general power of appointment structure, upon the death of the first spouse, the decedent’s property would be includible in the decedent’s estate under I.R.C. § 2038 if owned in a revocable trust, and the surviving spouse’s property would be includible in the decedent’s estate under I.R.C. §2041. This estate tax inclusion would not only achieve a desired basis adjustment with respect to the decedent’s own property, but, if properly implemented, for the surviving spouse’s property as well.

Where achievable, the intended basis adjustment is certainly attractive, especially when managing portfolios containing highly appreciated assets. Importantly, planning with reciprocal spousal powers of appointment can present unique statutory and doctrinal limitations that should be addressed through careful drafting. Without proper consideration, its implementation could result in failure to achieve the intended basis adjustment.

Basis Adjustment Through General Powers of Appointment

The basis adjustment under I.R.C. § 1014(a) allows for property included in a decedent’s gross estate to receive a new tax basis equal to its fair market value at the time of the decedent’s death. For planners, the elimination of the built-in gain can increase opportunities for liquidity and allow for easier means of diversification or restructuring of a client’s portfolio without triggering substantial capital gains tax.

As this adjustment only applies to assets included in the decedent’s estate, planners in common law jurisdictions face the challenge that only the decedent’s assets receive this crucial benefit, while assets of the surviving spouse remain at their present basis. The use of general powers of appointment provides the opportunity to increase inclusion in an intentional manner without producing unintended estate tax liability.

Inclusion Through I.R.C. § 2041 General Powers of Appointment

A general power of appointment exists when the powerholder may appoint the property to themselves, their estate, their creditors, or the creditors of their estate. I.R.C. § 2041 provides that property subject to this power held by a decedent is includible in the decedent’s gross estate.

When properly structured, the grant of a general power of appointment over assets held in the surviving spouse’s trust can cause those assets to become includible in the decedent’s estate. Critically, this is the core operation that allows for a basis adjustment of both spouses’ trusts at the time of the first to die.

I.R.C. § 1014(e) and the One-Year Transfer Concern

I.R.C. § 1014(e) prevents a basis adjustment where appreciated property is transferred to a decedent within one year of death and the property (or its value) returns to the original transferor. In the spousal GPOA context, I.R.C. § 1014(e) becomes relevant if:

1. The surviving spouse’s property is treated as having been “transferred” to the first spouse by reason of the general power of appointment.
2. The property effectively returns to the surviving spouse following the first spouse’s death.

Whether I.R.C. § 1014(e) applies depends heavily on how the power is structured, whether the spouse-powerholder had meaningful dominion, and whether potential “return” of property occurs outright or via ongoing trust interests. Addressing this concern is where the careful framing of the power of appointment becomes outcome-determinative.

Planning Through Reciprocal Spousal Powers of Appointment

Reciprocal powers of appointment have most commonly been implemented in the context of joint trust structures, in which both spouses contributed their assets and the assets are held as a common pool for their mutual benefit. With the extension of the favorable applicable exclusion amounts, many married couples normally need to pay little attention to the transfer tax consequences of the joint trust arrangement.

However, in instances where spouses’ combined assets risk exceeding the applicable exclusion amount, the joint trust structure can present adverse consequences. Primarily, absent careful drafting, a completed gift could occur at or after the formation and funding of a joint trust. Additionally, added care is required to create the bypass and marital trust relationship within the joint trust so that assets in the bypass trust do not become includible in the surviving spouse’s estate.[1] For these reasons, planners most commonly prefer to implement separate revocable trusts to mitigate these concerns.

Planning with the reciprocal general power of appointment technique involves each spouse’s revocable trust granting the other spouse a conditional general power of appointment over the trust property, resulting in a basis adjustment in all eligible property with respect to the decedent’s own property and in the surviving spouse’s property as well. This multi-phased step-up provides for greater access to basis management for couples. With many client portfolios expected to hold highly appreciated assets later in life, the primary objective of the reciprocal spousal power of appointment is to maximize the application of basis adjustment under I.R.C. § 1014(a). In common law jurisdictions, where the basis adjustment would otherwise apply only to the decedent spouse’s assets, this planning approach can significantly reduce the aggregate unrealized gain carried forward by the surviving spouse. When carefully implemented to address statutory limitations governing basis adjustment, the result is not only a reduction in potential future tax liability, but a meaningful expansion of planning flexibility.

While these benefits are attractive, as the reciprocal power of appointment technique deliberately seeks to force estate inclusion to obtain a basis adjustment under I.R.C. § 1014(a), its application can be constrained by statutory limitations if overlooked. As discussed, I.R.C. § 1014(e) presents a salient challenge to the implementation of the technique. To the extent that the appointed property can be deemed to “return” to the surviving spouse, a basis adjustment can be prevented, thereby eliminating the intended outcome of the drafting.

Practitioners in support of the use of this technique have identified the Service’s position that a general power of appointment held by a deceased spouse over the surviving spouse’s interest in trust property can prevent basis adjustment under I.R.C. § 1014(e).[2] In TAM 9308002, the Service considered a joint trust under which each spouse retained the right to revoke the trust as to an undivided one-half interest in the trust assets. Upon the death of the first spouse, the trust assets, including the surviving spouse’s contributed property, were subject to the debts and taxes of the decedent, resulting in estate inclusion under I.R.C. § 2041.[3] Despite that inclusion, the Service ultimately denied a basis adjustment under I.R.C. § 1014(e), on the grounds that Congress intended to prevent basis step-up where the transferor had not relinquished actual dominion and control over the property more than one year prior to death. Because the surviving spouse’s retained revocation power did not terminate prior to the decedent’s death, the Service concluded that I.R.C. § 1014(e) applied.[4]

Notably, the core interpretation behind the Service’s application of I.R.C. § 1014(e) was not driven solely by the presence of a general power of appointment over the property, but more so by the surviving spouse’s continued unilateral dominion over the transferred property.[5] One structural approach is to eliminate unilateral revocation rights and instead require joint action by both spouses to revoke the trust. Assuming such limitations are imposed more than one year prior to the first spouse’s death, the structure may avoid the Service’s conclusion that the surviving spouse’s transfer was incomplete until death.[6]

Together with drafting considerations that address the Service’s positions, implementation of the technique commonly incorporates savings clauses designed to limit or suspend the operation of a general power of appointment where its exercise or lapse would fail to produce the intended basis adjustment or would otherwise create adverse transfer tax consequences. These provisions typically operate to ensure that the powers exist only to the extent they produce estate inclusion without triggering I.R.C. § 1014(e), an unintended completed gift, or unintended estate inclusion in the surviving spouse’s estate. While savings clauses cannot eliminate all uncertainty, they serve as an important risk-management tool, ensuring that the structure of the power is aligned with the planner’s underlying tax objectives.

Is There a Risk of Reciprocal Trust Doctrine?

Given the reciprocal nature inherent in this technique, practitioners may field concerns related to the application of Reciprocal Trust Doctrine. The implications of reciprocal trust doctrine hold that if spouse A creates a trust for the benefit of Spouse B, and Spouse B creates a functionally identical trust for the benefit of Spouse A, a court can be urged to uncross the trusts.[7] Effectively, Spouse A and Spouse B will each be treated as the donor of their respective trust for his or her own benefit. Where it can be deemed that two trusts have sufficient interrelatedness and create an arrangement of mutual value that leaves the settlors in approximately the same position, a court may conclude through the application of the reciprocal trust doctrine that the donor possesses beneficial interests or powers over the trust property resulting in estate tax consequences that differ from those intended.[8]

Most commonly, spousal lifetime access trusts present instances where the reciprocal trust doctrine might be invoked. In SLAT planning, Spouse A makes a gift of assets using some of Spouse A’s remaining exemption amount to a trust benefiting Spouse B, and Spouse B makes a gift of assets using some of Spouse B’s remaining exemption amount to a trust for the benefit of Spouse A. With proper planning, each spouse effectively utilizes their exemption amounts with none of the transferred trust property included in either spouse’s taxable estate.

Where SLATs present the risk of reciprocity based on mirrored beneficial interests, the use of reciprocal spousal powers of appointment may raise concerns surrounding the power-based reciprocity being invoked. Unlike the traditional reciprocal trust cases focusing on mirrored beneficial interests, reciprocity in this context would arise from similarities in the control mechanisms embedded in the trusts. The concern is not that each spouse receives an identical beneficial interest, but whether each spouse has exchanged a power that is substantially equivalent in scope and effect.

Consequently, the concern surrounding application of the doctrine in this context would not be unintended estate inclusion, but that, if applied, it might alter the characterization of that inclusion. In a reciprocal general power of appointment structure, each spouse establishes a revocable trust for his or her own benefit and grants the other spouse a functionally identical general power of appointment with the objective of intentionally including the other spouse’s trust in the decedent’s estate under I.R.C. § 2041. If the nature of the powers were to be collapsed, however, the resulting inclusion could be reframed as settlor-based rather than power-based. This would undermine the “acquired from a decedent” requirement of I.R.C. § 1014(a) and, depending on the timing and disposition of the property, could potentially implicate I.R.C. § 1014(e). In that event, the risk lies not in the inclusion itself, but in the way the arrangement is characterized.

Importantly, several distinctions weaken the case for applying reciprocal trust doctrine to reciprocal spousal powers of appointment in revocable trust planning. Unlike typical reciprocal trust arrangements, the grantor of a revocable trust already retains full dominion over the trust property, and estate inclusion is not being avoided, but intentionally invoked. Additionally, the reciprocal powers do not restore access, enjoyment, or control that would otherwise be unavailable. These features undermine the rationale that has supported application of the doctrine to reciprocal trust arrangements. And while a planning structure employing reciprocal spousal general powers of appointment could be scrutinized under a reciprocal trust doctrine framework, there is no precedent for the doctrine being applied in this context.

Whether such an extension of the reciprocal trust doctrine would be pursued is uncertain, but the doctrine has not historically been applied to reciprocal spousal powers of appointment in revocable trust planning. While the reciprocal trust doctrine is conceptually misaligned with this planning, basis planning that relies on mirrored spousal powers should be approached with care. In practice, the successful use of reciprocal spousal general powers of appointment depends less on the mere presence of a power and more on how that power is drafted, conditioned, and framed.

Structuring the Powers of Appointment

As discussed, overcoming limiting rules depends heavily on how the reciprocal powers are drafted and framed. Techniques that vary the structure and conditions of the powers of appointment assist in attenuating the risks inherent to this planning. Savings clauses can help mitigate risks associated with misapplication of the power by framing the use of the powers to be exercisable only to the extent they will achieve their intended outcome.

Conditional Savings Clauses

While heeding the aforesaid risks may minimize transfer risks associated with the use of reciprocal spousal general powers of appointment, savings clauses dictate that the power of appointment is not exercisable to the extent it would not result in a basis adjustment or would otherwise create adverse transfer tax consequences. In effect, the power is structured to be inapplicable if it would not achieve its desired objective. Trust instruments may include clauses that functionally restrict the exercise of power in the event:[9]

1. It would not result in a basis increase under I.R.C. § 1014(e).
2. Its presence would result in a completed gift that is not eligible for the marital deduction.
3. Its lapse would result in a completed gift ineligible for the marital deduction; or
4. Its lapse would result in the inclusion in the surviving spouse’s estate for Federal estate tax purposes of property that was subject to the power prior to the lapse.

Properly drafted savings clauses do not eliminate all uncertainty inherent in the reciprocal powers and are not intended to do so. Rather, their implementation serves as an important risk-management mechanism, ensuring that the power of appointment operates only where it advances the intended tax result and is defunct where it would create unintended consequences. Savings clauses assist in supporting the conclusion that the arrangement reflects the intended basis planning.

Conclusion

Where fact patterns support the approach, the use of reciprocal spousal powers of appointment as an emerging planning consideration provides an attractive opportunity for planners to take full advantage of basis adjustment under I.R.C. § 1014(a). For advisors operating in common law jurisdictions, the increased utility of additional step-up opportunities provides for additional basis management in client portfolios holding highly appreciated assets. Where carefully implemented to account for inherent limitations, the inclusion of these powers in a married couple’s revocable trust planning can result in a reduction in potential future tax liability, improved flexibility, and a reduction in the aggregate unrealized gain carried forward by the surviving spouse.

Author Biography:

Matthew Donato, CTFA, AEP®, is a Trust Advisor at Loring Wolcott & Coolidge Trust, LLC in Boston, Massachusetts, where he works with high-net-worth individuals and families on trust administration, fiduciary services, and estate planning matters.

[1] Timothy P. O’Sullivan & Stewart T. Weaver, Drafting Reciprocal Spousal General Powers of Appointment, 29 Est. Plan. 74 (2002).

[2] Id.

[3] Tech. Adv. Mem. 9308002 (Nov. 20, 1992)

[4] Id.

[5] Id.

[6] Timothy P. O’Sullivan & Stewart T. Weaver, Drafting Reciprocal Spousal General Powers of Appointment, 29 Est. Plan. 74 (2002).

[7] J. Zachary Haupt, Understanding and Avoiding the Reciprocal Trust Doctrine, Del. Banker Mag., Spring 2021.

[8] Id.

[9] Timothy P. O’Sullivan & Stewart T. Weaver, Drafting Reciprocal Spousal General Powers of Appointment, 29 Est. Plan. 74 (2002).