Irrevocable trusts lie at the heart of a variety of estate planning strategies, as gifts to irrevocable trusts can allow for the transfer of assets outside of an owner’s estate for estate tax purposes with more structure than an outright gift. The downside, however, is that irrevocable trusts are "irrevocable" and can't easily be undone; in moving assets to the trust, the original owner gives up their authority over the assets, with the trustee taking over the management and distribution of the assets according to the trust's instructions. Sometimes, though, the original owner may want to take a 'mulligan' when the assets inside the trust would be more advantageous back inside their estate. Including the power of substitution when establishing the irrevocable trust can provide the opportunity to redo the funding of the trust, without jeopardizing the estate tax benefits that the trust conveys.
In this guest post, Anna Pfaehler, CFP, AEP, a Partner and Wealth Advisor at Constellation Wealth Advisors, discusses how "swap powers" – the ability to exchange assets in an irrevocable trust with other assets of equivalent value – can be used to add flexibility and income tax efficiency to an irrevocable trust.
At a high level, swap powers are often included in trusts because, under the Internal Revenue Code, they turn an irrevocable trust into a Grantor Trust where any income generated by the trust assets is taxed to the grantor (i.e., the assets' original owner). This can be advantageous given the generally higher tax rates imposed on trusts compared to individuals. If the trust is drafted as an Intentionally Defective Grantor Trust (IDGT), the trust's assets are also considered outside of the grantor's estate for estate tax purposes, giving the grantor the best of both worlds when it comes to income and estate taxation.
However, while grantors often include swap powers in their trust provisions to convey Grantor Trust status, many never actually use the swap power for its nominal purpose of exchanging assets within the trust with others of equivalent value. But swap powers can create planning opportunities to take advantage of the differences between types of assets and to optimize the trust's balance sheet as circumstances shift over time.
For example, if an asset within an irrevocable trust has substantially grown in value, that asset will not receive a step-up in basis when the grantor passes away if it remains in the trust, resulting in significant capital gains tax if it is sold later. But if the grantor uses a swap power to exchange the asset for something equivalent in value but with a higher cost basis, they can maximize their benefit from the step-up in basis by keeping the lowest-basis assets on their own balance sheet and the highest-basis assets in the trust. Swap powers can also be used to meet liquidity needs by exchanging more liquid assets in the trust, or to move assets with higher expected growth into the trust to shield their future growth from estate taxation.
The key point is that life goes on even after an irrevocable trust is drafted and funded, and shifting circumstances after the fact can leave grantors wishing for a do-over. And although swap powers won't necessarily solve every potential issue with the irrevocable trust that could arise after the fact – since there needs to actually be property of equivalent value that can be swapped into the trust to use them – it does at least create the flexibility to optimize the trust for whatever the situation at hand may be. Ultimately, advisors can help clients navigate their changing circumstances by recognizing opportunities to re-optimize their financial situation and by making the adjustments (such as a well-executed asset swap) that increase the chances of a better outcome as the client's future unfolds!
