Planning Using Powers of Appointment
Through the years, the dynamics of your family will change. Your family may grow, children and grandchildren may be born, some offspring may mature into wise adults and some may not, some family members may suffer through illness (perhaps debilitating), and, at some point, every member of the family will die. Of course, changes come from outside of your family, too. Tax and property laws change from one Congress to the next. Unanticipated events occur in the economy or in the financial markets. Businesses may succeed wildly or fail spectacularly.
Given the inevitable changes over the course of a lifetime, you may ask:
- Can I create an estate plan that may be later adjusted for the inevitable changes of life?
- If I plan for today’s circumstances, is it possible to also plan for an uncertain future – even for events that occur after I have departed this life when my estate plan becomes irrevocable?
- Can I plan now to protect my family’s wealth for generations to come, while allowing the plan to take into consideration changed circumstances?
The answer to each of the foregoing questions is yes.
Indeed, it is possible to secure your wealth for future generations yet provide for an uncertain future, no matter what comes, by building flexibility into the plan documents.
While there are many ways to build flexibility into the irrevocable documents that create your plan, using a power of appointment makes your plan flexible by allowing future generations to adapt it to later circumstances.
What is a Power of Appointment?
An important part of any wealth plan is the transfer of wealth from members of senior generations to members of junior generations. Of course, your plan can give property outright to any person. However, doing so fails to protect that property from many risks. Property owned by an individual outright may be disposed of in any manner by such person. Property transferred outright is “unprotected” because it is subject to the claims of the owner’s creditors (possibly including those of a divorcing spouse), it may be invested imprudently and lost and it can be given away, including to persons outside your family. To protect your wealth from those and other circumstances, instead of giving your wealth to your beneficiaries outright, you could create trusts for their benefit. In fact, to protect your property for long periods of time, you can create trusts that last for (and benefit) many generations of your descendants. (Note that some states have laws that require trusts to end by a certain date.[1] Check with your attorney to see how the laws of your state could impact your plan.)
Irrevocable trusts for your beneficiaries are generally governed by the terms that you set when you create the trust. As trust law has developed, however, many states have adopted laws that allow irrevocable trusts to be changed. These laws include judicial modifications (when a court changes a trust), non-judicial settlements (when the beneficiaries and trustees agree to change the terms of a trust) and decanting (when the trustee exercises a power in its discretion to distribute the trust to another trust). Additionally, the terms of your trust can give your beneficiaries the ability to change the terms of the trust by conferring upon them a power of appointment.
A “power of appointment” is a right that the creator of a trust[2] (the donor) confers upon another person (the donee or power holder) to direct the disposition of specified property. The donor of the power of appointment sets the terms as to how the power can be exercised and the steps that the holder of the power must follow to exercise the power. If the power holder does not comply with the requirements of the power of appointment, its exercise could be void.
For example, a power of appointment may:
- be exercisable immediately, or at some time in the future (such as when its holder dies);
- restrict who may receive property when the power is exercised (such as limiting recipients to the donor’s descendants);
- set conditions on what the beneficiaries receive and how they receive it, such as requiring the power to be exercised to create another trust (and not transfer property outright); or
- restrict the mechanism for exercising the power (for example, by only allowing it to be exercised by the power holder’s will and by specific reference to the document creating the power of appointment).
Types of Powers of Appointment
Powers of appointment can be customized to suit your circumstances as well as those of your family.
However, for federal gift and estate tax (collectively, transfer tax) purposes, there are two types of powers of appointment:[3] a general power of appointment and a limited power of appointment.
- A general power of appointment allows the power holder to direct property to be distributed to any person or entity and subject to any condition as specified in the power of appointment, but the power holder must also have the ability to direct the property to be distributed to any of (i) the power holder, (ii) the power holder’s creditors, (iii) the power holder’s estate or (iv) the creditors of the power holder’s estate.[4]
- A limited power of appointment (also known as a special power of appointment) allows the power holder to direct the property to be distributed to any person or entity and subject to any condition as specified in the power of appointment other than (i) the power holder, (ii) the power holder’s creditors, (iii) the power holder’s estate or (iv) the creditors of the power holder’s estate. A limited power of appointment can be quite broad, as it can be drafted to allow the power holder to appoint the property subject to the power to anyone or any entity in the world other than the four above stated exceptions.
Ownership and Powers of Appointment
With limited exceptions, state law creates and governs interests in property and ownership rights.[5] The power holder must look to state law to determine what is owned and the rights conferred by such ownership. For example, a presently exercisable general power of appointment in favor of the power holder allows the power holder to “take” the property subject to the power of appointment. Such a power is the legal equivalent of ownership and subjects the property subject to the power of appointment to the claims of the power holder’s creditors. However, a general power of appointment exercisable by will may not be subject to the claims of the power holder’s creditors during life but could be subject to the power holder’s creditors at death. Conversely, a limited power of appointment (whether exercisable during life or at death) does not confer any economic benefit on the power holder and is not subject to the claims of the power holder’s creditors.[6] As the law of each state is different, you should consult with your attorney to determine ownership rights.
Tax Treatment of Powers of Appointment
Powers of appointment can have important tax consequences to the power holder. Generally, if the power holder dies holding a general power of appointment created after October 21, 1942 (whether the power of appointment is exercised or not), the value of the property subject to the power will be included in the power holder’s gross estate and potentially subject to federal estate tax.[7] The value of the property subject to a general power of appointment would also be included in the power holder’s gross estate if the power holder released or exercised the power under circumstances such that, had the power holder owned and transferred the property subject to the power of appointment, the property would be includible in the deceased power holder’s gross estate under certain other sections of the Internal Revenue Code (IRC).[8]
On the other hand, the value of property subject to a limited power of appointment will not be included in the power holder’s gross estate at death unless the power holder exercises the original power of appointment to
- create a second power of appointment, and
- the second power of appointment can be exercised to prevent the property subject to the second power from being owned outright or being transferred, and
- the period of time during which the property cannot be owned outright or transferred does not reference the date the original power was created.[9]
For gift tax purposes, the exercise or release of a general power of appointment created after October 21, 1942, will be deemed a transfer of property by the power holder and potentially subject to gift tax, unless the value of the property subject to the power that lapses or is released is less than the greater of $5,000 or 5% of the total value of the property subject to the power of appointment.[10]
For income tax purposes:
- to the extent property is included in the gross estate of the power holder, its tax cost basis will become its fair market value at death. The basis of appreciated property will “step up” to its then-fair market value, whereas the basis of depreciated property will be “stepped down.”
- in some cases a trust beneficiary who holds a presently exercisable power of appointment allowing the beneficiary to take the property in a trust (or who had such a power that has lapsed but has certain rights over the trust) can be treated as owning the property in the trust for income tax purposes (making the trust a so-called grantor trust).[11]
Using Powers of Appointment
As circumstances change, powers of appointment can provide flexibility to your plan. There are many ways to use powers of appointment to the advantage of your family. Following are some examples.
As circumstances change, powers of appointment can provide flexibility to your plan. There are many ways to use powers of appointment to the advantage of your family.
Unexpected Problems Arise After Death
Planning for Changed Circumstances
Spouse 1 dies, leaving a trust for the benefit of Spouse 2. The trust requires that its income be paid to Spouse 2 at least annually for life and gives the trustee the discretion to distribute principal to Spouse 2. Spouse 2 also is granted a limited power of appointment to direct the trust property to be distributed outright or in further trust for any of the Spouse 1’s descendants at Spouse 2’s death. If the power is not exercised, the assets remaining in the trust will be distributed outright to the descendants of Spouse 1, per stirpes. Assume that Spouse 1 has two children. Further assume that the oldest child of Spouse 1 develops a substance abuse problem after Spouse 1 died.
Upon Spouse 2’s death, if nothing is done, each of the children would receive one-half of the trust property, outright. In that case, property received by the older child could perpetuate, or even exacerbate, the substance abuse issues. Instead, Spouse 2 could exercise the power of appointment, requiring the oldest child’s share to be held in a trust, to provide for that child (even to the point of paying for treatment). The oldest child’s share would be protected from that child’s potential improvidence, shielded from that child’s creditors and available to care for that child. Moreover, the property would be unavailable to feed that child’s self-destructive behavior.
Special Needs
Using the same facts as outlined above, assume that after Spouse 1 died, the younger child has a child (grandchild) with severe disabilities who will require professional care for life. If the grandchild were to receive property from the trust, such a distribution could disqualify the grandchild from receiving public assistance. Ignoring tax consequences for the moment, assume Spouse 2 and the younger child plan together that Spouse 2 should provide some funds to care for the grandchild upon Spouse 2’s death. In that case, Spouse 2 could exercise the power of appointment in such a way as to provide a trust that could be used in part for the younger child and in part to provide the grandchild with services and items not provided by government assistance. Further, the power could be exercised so that upon the younger child’s death, whatever property remained in the child’s trust would continue in a trust to provide the grandchild with services and items not provided by government assistance for the rest of grandchild’s life. Upon the grandchild’s subsequent death, if there is property remaining in the trust, the exercise of the power would specify which of the descendants of Spouse 1 would receive the property and the conditions upon which it would be received. For example, if the younger child had no other descendants, any remaining property could be added to the trust for the older child.
Financial Windfall
Assume the same facts as outlined above, except that the younger child has children (grandchildren), none of whom have special needs. Further assume that the younger child was a business owner who sold the business for hundreds of millions of dollars. If Spouse 2 takes no action, upon the death of Spouse 2 one-half of the trust would be paid outright to the younger child. This would augment younger child’s estate, which (based on current law) would be subject to a substantial estate tax. Ignoring taxes for the moment, because the younger child already has a large estate, perhaps Spouse 2 could exercise the power of appointment to create trusts for the grandchildren.
Limitations on Exercise
In each of the foregoing examples, because the power of appointment restricted the possible appointees to the descendants of Spouse 1, Spouse 2 could not have directed the trust to be distributed to anyone or any entity other than a descendant of Spouse 1. If the power of appointment had allowed trust assets to be distributed “to any person or entity other than Spouse 2, Spouse 2’s creditors, Spouse 2’s estate or the creditors of Spouse 2’s estate,” Spouse 2 could have directed the entire trust to be distributed to any person or entity (either outright or in trust) other than the four entities prohibited from receiving property. In that case, even though that power of appointment would still have been a limited power of appointment, the group of potential appointees would have been so broad that Spouse 2 could have caused the property to be distributed to virtually anyone, including a new spouse, the new spouse’s children or a charitable organization. Thus, great care should be taken when drafting powers of appointment to balance flexibility with the desire to keep wealth within the family.
Tax Planning with Powers of Appointment
Taxpayers create extensive plans to minimize their overall tax liabilities. As one of America’s great jurists once wrote: “Any one (sic) may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”[12]
For decades, taxpayers have used trusts to minimize the amount of transfer taxes required to be paid by each generation of their families. Many of these strategies involve long-term trusts.
These trusts are designed to last for many generations, without being subject to transfer taxes. (Although beyond the scope of this article, usually the transferor has allocated exemption from the generation-skipping transfer tax to the trust so that it has an inclusion ratio of zero, or the trust was irrevocable before September 25, 1985.) This means that the terms of the trusts are crafted so that the value of the trust’s property is not included in the gross estate of any beneficiary who dies. The benefit of avoiding estate tax at each generation is illustrated by the table on page 5.
However, avoiding transfer taxes by holding property in a long-term trust may cause an income tax issue. As the assets in the trust appreciate, the unrealized capital gain in the assets grows. Because the assets of the trust are not considered to be transferred by the trust’s beneficiaries, the assets in the trust never receive a so-called basis step up as each beneficiary dies.[13]
In 2022, each citizen and resident of the United States has an exclusion from the federal estate tax of $12.06 million. This exclusion amount represents a significant increase from exclusion amounts of previous years. In fact, as late as 2002, the exclusion amount was only $1 million. As estate tax exclusion amounts have grown, fewer taxpayers have been subject to the federal estate tax.
Is it possible to both avoid transfer taxes and get a step-up in basis to reduce capital gain tax? To some extent, the answer is yes.
When creating a new estate plan, you could create trusts that optimize both transfer tax and capital gains tax savings. To do so, the terms of your trust could grant its beneficiaries a carefully crafted general power of appointment. Each beneficiary would have a general power of appointment (exercisable when the beneficiary dies) over an amount of property in the trust determined by a formula. The formula would limit the amount of property subject to the power of appointment to the beneficiary’s available (or unused) estate tax exclusion amount (so that no estate tax would be paid). Further, the formula would apply to those assets with the greatest unrealized capital gain. Thus, upon the beneficiary’s death, assuming the beneficiary has available estate tax exclusion, property of the trust equal in value to the unused exclusion amount with the greatest built-in capital gain would receive a step-up in basis, yet no estate tax would be due. Alternatively, the terms of the trust could designate a so-called trust protector who has the authority to confer a formulaic general power of appointment upon a beneficiary should the circumstances favor such a provision.
It may also be possible to modify an existing irrevocable trust to add a formulaic general power of appointment or add a trust protector who can confer general powers of appointment to take advantage of the technique described above. Depending on the state law governing the trust, it may be possible to modify the trust through judicial modification (when a court changes a trust), non-judicial settlement (when the beneficiaries and trustees agree to change the terms of a trust) and decanting (when the trustee exercises a power in its discretion to distribute the trust to another trust).
Still further, if the beneficiary already has been granted a limited power of appointment over the assets of the trust, depending on the state law governing the trust, it may be possible to exercise even a limited power of appointment to cause some or all of the trust’s assets to be subject to transfer tax when the beneficiary dies. To do this, the beneficiary would exercise the original power of appointment in a way that creates a second power of appointment so that second power of appointment can be exercised to prevent the property subject to the power from being owned by someone outright or being transferred for a period of time that does not reference the date upon which the original power of appointment was created.[14] This is colloquially known as “springing the Delaware tax trap.” Nevertheless, the laws of some states prevent the trap from being sprung. Before attempting to spring the Delaware tax trap, consult an attorney in the state whose law governs the trust.
* This hypothetical is for illustrative purposes only. Tax calculations have been simplified for illustrative purposes and do not take into account any tax attributes that may affect a taxpayer's particular situation (for example state and local taxes, marital status, or exemptions).
Table 1: Benefit of Avoiding Estate Tax by Generation*
Trust Not Exempt from Transfer Taxes
| Year | 1 (Creation) | 50 | 100 | 150 | 200 |
|---|---|---|---|---|---|
| Trust Property | $1,500,000 | $10,660,025 | $41,666,582 | $162,861,163 | $636,571,495 |
| Estate/GSTT Tax | ($4,797,011) | ($18,749,962) | ($73,287,524) | ($286,457,173) | |
| Balance in Trust | $1,500,000 | $5,863,014 | $22,916,620 | $89,573,640 | $350,114,322 |
Table 2: Benefit of Avoiding Estate Tax by Generation*
Trust Exempt from Transfer Taxes
| Year | 1 (Creation) | 50 | 100 | 150 | 200 |
|---|---|---|---|---|---|
| Trust Property | $1,500,000 | $10,660,025 | $75,757,422 | $538,384,011 | $3,826,124,687 |
| Estate/GSTT Tax | $0 | $0 | $0 | $0 | |
| Balance in Trust | $1,500,000 | $10,660,025 | $75,757,422 | $538,384,011 | $3,826,124,687 |
| Benefit to Family | $0 | $4,797,011 | $52,840,802 | $448,810,371 | $3,476,010,365 |
A federal estate and/or generation-skipping transfer tax (GSTT). Tax is imposed every 50 years. The federal estate and/or GSTT Tax Rate is 40%. Trust property grows at 4% each year (after federal income tax).
A Flexible, but Complex, Tool
Powers of appointment are powerful planning tools. They can be included in your plan documents at the outset or, depending on applicable state law, added to the terms of an existing irrevocable trust through a modification.
Powers of appointment can be customized to fit your and your family’s particular circumstances. Adding a power of appointment to your plan provides your beneficiaries with the ability to alter the plan to fit changing circumstances.
However, because powers of appointment are powerful, customizable and can have a large impact on taxation, you should consult with your legal, tax and financial advisors when considering adding powers of appointment to a new plan or modifying an old plan to include them.
Your PNC Private Bank advisor can discuss how you could use powers of appointment in your specific circumstances.
