By Eva Stark, JD, LL.M.
When establishing an estate plan, it is impossible to anticipate all future changes in family dynamics, personal finances or applicable tax laws. For these reasons, it is often beneficial to incorporate flexibility in an estate plan so that an existing document may easily be adapted to changing circumstances. One widely used estate planning tool that can add significant flexibility is the power of appointment.
A power of appointment gives a person (i.e., the "powerholder") the ability to direct how the assets subject to the power of appointment will pass. A power of appointment may be made effective during the powerholder’s lifetime (i.e., a lifetime power of appointment), or more typically, at the powerholder's death (i.e., a testamentary power of appointment).
Powers of appointment generally fall into two distinct categories: "limited" (also known as "special") and "general" powers of appointment. A limited or special power of appointment permits the powerholder to appoint assets to any person or entity EXCEPT the powerholder, his estate, his creditors, or the creditors of his estate. If the powerholder may appoint assets to a person or entity that falls under these four exceptions, a general power of appointment exists. Both limited and general powers of appointment may be drafted narrowly or broadly to achieve specific estate planning objectives, provided that the four exceptions above are respected.
Whether a power of appointment is considered general or limited is critical as each type has drastically different tax and nontax consequences. Limited powers of appointment typically do not cause estate inclusion and generally do not affect the basis of property subject to the power of appointment (they can, however, have tax consequences under certain circumstances). General powers of appointment, in contrast, will cause assets subject to the power of appointment to be included in the powerholder’s taxable estate. Estate inclusion will generally occur even if the power of appointment is never exercised—its mere existence is enough. General powers of appointment also can trigger a basis adjustment to the amount equal to value which is includible in the powerholder's taxable estate.
Non-tax considerations also are important when creating powers of appointment. For example, a general power of appointment over a trust, especially if it is effective during the powerholder's lifetime, could allow the powerholder's creditors to reach trust assets, an often-unintended result. In contrast, a special power of appointment generally will not result in loss of creditor protection. Due to these major differences, special powers of appointment are often used to allow changes in distribution schemes while general powers of appointment are often used to achieve certain tax objectives.
Common Uses for Powers of Appointment
CHANGING INADVISABLE DISTRIBUTION SCHEMES THROUGH SPECIAL POWERS OF APPOINTMENT
Suppose that Bob died and his estate plan left all of Bob's assets in trust for his wife Mary for her lifetime. Bob's trust provides that at Mary's death, assets are to be divided into equal shares among Bob's three children, and each child's share is to be distributed outright once the child attains age 40. Suppose that all three of the children have attained age 40. The first child is an extraordinarily successful businessperson who does not need her inheritance and any inheritance would only exacerbate her own income tax and estate tax burden. The second child is a stay-at-home parent who is financially savvy and responsible. The third child suffers from a gambling addiction and faces substantial creditor problems.
It could be advisable for the family to channel the trust assets only to the second and third child and to prevent an outright distribution to the third child, but the trust holding Bob's assets became irrevocable at Bob's death.
If the trust grants Mary a limited power of appointment at her death, she could easily utilize that power to appoint assets only to the second and third child and direct that the third child's share be kept in trust for his lifetime for enhanced creditor protection of his inheritance.
TAX PLANNING THROUGH GENERAL POWERS OF APPOINTMENT
Suppose that George died in 2015 and left all his assets in trust for his son, Junior. At his death, George owned land valued at approximately $5 million and no other assets. George's executor allocated his generation-skipping transfer (GST) tax exemption to the trust, and all assets in the trust pass estate and GST tax free (the exemption in 2015 was $5.24 million). In 2020, Junior dies unexpectedly. The land is valued at $9 million at Junior's death. Under the terms of the trust, Junior's trust share passes to his only child, Jane. Jane faces a medical emergency and needs a substantial amount of funds immediately. The Trustee chooses to liquidate the land and distribute funds to Jane's medical providers. Assuming a 20% capital gains rate plus a 3.8% Medicare surtax (and no state income tax), the sale could produce a tax bill of $952,000. However, if Junior would have had a general power of appointment over the trust property, the value of the land ($9 million) would be includible in his taxable estate. Because this value is less than Junior's federal estate tax exemption amount ($11.58 million in 2020), no estate taxes would be triggered (assuming no applicable state-level estate taxes). For income tax purposes, the inclusion of the land into his taxable estate would also trigger a basis step-up in the value of the property to $9 million. As a result, upon liquidation, no capital gains would be produced. All income taxes on the sale would be avoided at no additional estate tax cost.
Simply granting all beneficiaries a general power of appointment at death is generally not advisable, because, as previously noted, the mere existence of the power of appointment will cause estate inclusion for the powerholder. A more precise method is to create a formula general power of appointment that may limit the power of appointment only to an amount equal to: (i) the powerholder's unused estate tax exemption (federal or state), (ii) appreciated property in the trust, and/or (iii) an amount that produces greater income tax savings than the added estate tax cost.
Alternatively, an independent third party might also be given the discretion to grant beneficiaries a general power of appointment at death to the extent that tax savings are produced.
Powers of appointment can add substantial flexibility and result in substantial tax savings if drafted properly. Clients who think they might benefit from such planning should discuss powers of appointment with their estate planning or tax attorney. Creating powers of appointment requires very precise planning and drafting as well as consideration of both tax and non-tax consequences.
Eva Stark, JD, LL.M.,joined The Nautilus Group® in 2014 to assist with the development of estate and business plans. She also performs advanced tax research. Eva graduated summa cum laude with a BS in economics and finance from The University of Texas at Dallas. She earned her JD, with honors, from Southern Methodist University, where she served as a student attorney and chief counsel at the SMU Federal Taxpayers Clinic. She received her LL.M. in taxation from Georgetown University Law Center. Prior to joining Nautilus, Eva worked in private practice in tax controversy, business law, and litigation.
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