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Advisors: Harness the Power of the Swap

Advisors: Harness the Power of the Swap

Advisors hoping to minimize income taxes and protect the assets of their clients’ estates should be familiar with swap powers and how they work, so they can help clients reap their full benefits.

Financial planners investing trust assets have a critical duty to monitor the swap powers contained in many of those trusts, and to assure that the intended benefits are realized. The money involved in many cases can be substantial, but too often planners don’t understand the nuances of swap powers, how to monitor them, or when and how to exercise them.

In the absence of a team approach to estate planning — the coordinated involvement of the financial planner, CPA and estate planning attorney — it falls to the advisor to ensure that these powers are properly exercised.


Clients frequently set up irrevocable trusts, which can provide protection for assets from lawsuits, divorce or claims against the client, and can grow assets outside the client’s estate to save on estate taxes. These benefits are not generally available with revocable trusts.

If the client (the trustor or settlor) includes certain powers within the trust, it will be classified for income tax purposes as a “grantor trust.” When this occurs, the client/settlor may be taxed on all the income earned by the trust. This might sound off-putting to a client initially, but it offers powerful tax and asset-protection benefits.

Paying income taxes on trust income allows the assets within the trust to grow faster without domination by those taxes. The assets effectively grow taxfree, and each time the client pays the additional income tax, it reduces the amount of assets that could potentially be taxed or obtained by creditors. For most clients this is important because, now that the estate tax exemption is so high, their chief concerns are divorce and asset-protection.

Giving the settlor who created an irrevocable trust the right to substitute personal assets (almost always cash) for trust assets (e.g., highly appreciated securities) of equivalent value is all it takes to lay the groundwork for these potential benefits. Simple, but powerful.

Here is an example of how swap powers can be used:

A physician client, the settlor of a trust, gave the trust $3 million in cash in 2012, fearing that the estate tax exemption would drop to $1 million the following year. While that never materialized, the trust was still able to cap the growth of the client’s estate and in this way ensure that it will not exceed the federal estate tax exemption. Maintaining the trust plan is a great insurance policy against a future adverse estate tax law changes.

Regardless of what happens with the estate tax, the physician client can still benefit tremendously from the protection afforded assets inside the trust from malpractice claims. One particular fund inside the trust was purchased for $200,000 and has grown in value to $2 million. If the physician/settlor gifts $2 million to the trust, the trustee can swap it for the $2 million from the highly appreciated fund. Because the fund is included in her estate, it will receive a full step-up in income tax basis to its $2 million fair market value, once the physician dies. That will eliminate $1.8 million in capital gains. The physician’s estate (the estate tax or assets that a claimant could reach) won’t be affected by the transaction.

For older or ailing clients, exercising a swap is an important planning step. But who is watching the cookie jar? Most clients do not have annual meetings with their estate planning attorney. Accountants may prepare tax returns and suggest income tax planning, but unless the accountant is actively involved in managing the client’s portfolio, it is unlikely the CPA will have the relevant information to monitor a swap power. Hence it falls to the advisor to monitor asset appreciation inside an irrevocable trust.

In this regard, the following are actions that the advisor should take:

  • Identify client situations. Does the client have an irrevocable trust that includes swap powers? Advisors should have a copy of the trust on file, a highlight or excerpt of the swap provision in a tickler file for review meetings and the contact information for the attorney who is responsible. This way, the attorney can be reached if there are any technical questions as to how any transaction should be handled.
  • Communicate with the trustee. Advisors should have the contact information for the appropriate trustee and regularly discuss exercising the swap power. In too many cases, advisors will discover that the trustee is completely unaware of the power or what it means. Having a conversation in advance can be useful, especially if the power has to be exercised urgently, such as if the client/settlor was in a major accident and sustained serious injuries.
  • Prepare documentation: Request that the attorney for the trust prepare a swap acknowledgement document. The IRS has issued Revenue Ruling 2008-22, which lists requirements for properly handling a swap. For example, the trustee might be obligated to confirm that the swapped assets have the same or equivalent value. Having the trustee sign a simple acknowledgment confirming compliance in advance of a swap, equips the advisor to move quickly in the event of a client health emergency or similarly urgent situation. The advisor should also have the attorney confirm any other requirements ahead of time. 
  • Arrange Lines: Does the client have cash available to effect a swap? In almost all cases, the answer is no. But the solution, with a modicum of advance planning, is not only simple but a great value-added service: Establish a line of credit. Even for clients averse to margin loans and debt, having a way to quickly access cash may be essential if a client has to exercise the swap power quickly.
  • Periodic Review Meetings: Every client review meeting should identify highly appreciated trust holdings and review the client’s health status. If the client is in good health and in her 70s, perhaps it’s too soonto exercise a swap. But if the client is in her 90s, it’s a different story and a swap should be made any time there is significant appreciation. If a client in her 90s dies with highly-appreciated assets in a grantor trust, and the advisor has no record of having discussed a possible asset swap, the beneficiaries might view the substantial capital gains as the advisor’s responsibility. If the advisor can show that he raised the issue during a regular review, this becomes a non-issue.
  • Advisory Agreements: Advisors should update their client contracts to clarify the scope of the advisor’s liability for monitoring and exercising swap powers. The ultimate responsibility to monitor the swap power should belong to the trustee, not the advisor. Likewise, the legal formalities should be the responsibility of the trust’s attorney, and not the advisor. 

Swap powers have become ubiquitous in estate planning. Advisors can provide crucial services, and limit their potential liability, by thoroughly educating themselves and their clients on this valuable estate planning strategy.
Martin M. Shenkman, CPA, PFS, JD, is a Financial Planning contributing writer and an estate planner in Paramus, N.J. He runs laweasy.com, a free legal website.

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