An often misunderstood but common estate planning tool that can appear in estate planning documents is the power of appointment. Not to be confused with a power of attorney (the document that allows you to delegate certain powers to an agent to act on your behalf while you are still living), a power of appointment can be an incredibly useful tool if used properly and knowledgeably.
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A well-considered power of appointment allows you to maintain significant flexibility in your estate plan now and in the future, even when that estate plan is otherwise considered irrevocable under the law. Though hundreds of pages of books, scholarly articles, court decisions, and tax regulations have been written on the topic of powers of appointment, this newsletter can help you identify opportunities in which powers of appointment may be useful and recognize cases in which they can create negative consequences.
What Is a Power of Appointment?
Broadly speaking, a power of appointment is a right granted in a legal document, including in a will or a trust, by an individual (the donor) to another person (the donee or the power holder). This granted power allows the donee to name someone else as a recipient (the appointee) of all or a portion of the donor's money and property in the future. The power holder is not required to exercise the power. Rather, the power holder simply has the option to exercise it. If the power is left unexercised, then the money and property will pass to those individuals or entities who were originally named in the will or trust as the beneficiaries and in the amounts originally specified. This tool essentially allows for the person making a will or trust to postpone the decision of who should receive the donor's money and property, and grants such decision-making power to someone else who may be in a better position in the future to determine who will receive it.
General Versus Limited Powers of Appointment
In trust law and tax law, there are two types of powers of appointment: (1) a general power of appointment and (2) a limited power of appointment (also known as special or nongeneral powers of appointment). A general power of appointment is, with only a few exceptions, a power that is exercisable in favor of the decedent, their estate, their creditors, or the creditors of their estate.1 If a power of appointment does not fit within the definition of a general power, then it is, by default, a limited power of appointment. A common example of a limited power of appointment is a power that is limited to distributions for health, education, maintenance, or support of a beneficiary (called the HEMS standard). Another example is a power granted to a power holder to distribute the property among a limited group of individuals, for example, among only "your descendants."
Lifetime Versus Testamentary Powers of Appointment
An additional characteristic that can be applied to a power of appointment is whether the power is to be a lifetime power of appointment or a testamentary power of appointment. The difference has to do with the particular moment that the power can be exercised by the power holder. For example, if a power of appointment gives the power holder a power to distribute property among grandchildren only while the power holder is alive, this would be a lifetime power of appointment. However, because this is also a limited power of appointment, we can refer to this power as a lifetime limited power of appointment. Similarly, if a general power of appointment is granted, but only for life, then it would be a lifetime general power of appointment.
On the other hand, if a power of appointment (either limited or general) is granted to a power holder that can only be exercised at the power holder's death, then this would be considered a testamentary power of appointment. Typically, a testamentary power of appointment must be exercised through a provision in the powerholder's will or trust that specifies how the property subject to the power is to be distributed upon the power holder's death. Thus, someone could be granted either a testamentary limited power of appointment or a lifetime limited power of appointment, or a testamentary general power of appointment or a lifetime general power of appointment.
Why Use Powers of Appointment?
There are a variety of reasons why someone might want to use a power of appointment in their estate plan, including tax considerations, asset protection, and a desire for flexibility. The following are a few examples that can help illustrate how and why a power of appointment may be used:
- Sarah creates a trust that is designed to hold her property for the benefit of Dave, her only son, for his lifetime, and which will then pass to his children upon his death. However, three of her grandchildren have a history of drug use, terrible spending habits, and have even attempted to financially exploit her in the past. Although Sarah wants only her grandchildren to benefit from the trust after her son dies, she wants to allow Dave to determine how much (if anything) should go to each of her grandchildren, depending on how they conduct their lives in the future and what their needs are. Sarah's estate planning attorney suggests that she grant Dave a testamentary limited power of appointment in her trust that allows Dave to distribute the remainder of the trust property according to how he sees fit among his children, in equal or unequal shares at his death. This will require Dave to draft a will or trust that includes a provision that specifies how the remainder of Sarah's trust will be divided among his children at his death. Including such a power allows Sarah to maintain some control over who will receive her property, but also grants some important flexibility in her estate plan to her son so that he can take a second look at the family circumstances years after Sarah has passed away.
- Marty died, leaving a trust that owns a significant amount of quickly-appreciating corporate stock shares. His only daughter Betty is the income beneficiary of the trust and enjoys the stock dividends that are paid out to her every year. Betty's children are the remainder beneficiaries of the trust. Betty is in her late eighties and is experiencing failing health. Before Marty died, he amended his trust to ensure that it contained a provision that granted Betty a testamentary general power of appointment over the trust. As a result, upon Betty's death, the stock in the trust receives a full step up in tax basis under current federal tax law, thus eliminating the capital gains taxes that would have otherwise been due on the sale of the stock in the hands of Betty's children after her death. Significant tax savings are achieved by including this type of a power of appointment.
- John is Karen's second husband. Karen has children from a previous marriage. John has never been married and has no children of his own. Some of Karen's children have been very nice to John while others have been quite mean to him. Karen has significant wealth and intends to ultimately leave it to her children; however, she wants to provide for John throughout the remainder of his life if he outlives her. To that end, Karen's estate plan establishes a trust for John that is protected from estate taxes at her death. The income generated on the trust property is paid out to John for his life, with the principal of the property payable to her children at John's death. However, she grants John a testamentary limited power of appointment over certain company stock held in the trust so that upon his death, he can determine who among Karen's children will receive that stock and in what shares. Karen explains this to her children so that they get the message that if they mistreat John after she is gone, he has the authority to reduce the value of their share of her trust by at least some degree. Her hope is that this will incentivize her children to treat John with a certain level of respect that they sometimes have struggled with during her life.
These examples illustrate just a few of the more common reasons why and how powers of appointment can be creatively used to build flexibility into an estate plan. There are many other ways to use these incredibly useful tools. It is important to note, however, that they can also create significant risk and lead to unintended consequences.
For example, what if John, in the example above, turned out to be vindictive and, out of spite, exercised his testamentary limited power of appointment to grant everything to one of Karen's children who had a terrible gambling problem, and who then lost everything in one weekend in Atlantic City? Certainly, this would not have been what Karen had intended. But, a power of appointment can lead to this type of result if the power holder chooses to exercise their power irresponsibly.
How Can This Information Help You?
Now that you have a better grasp on the uses and limitations of this powerful estate planning tool, you can better identify in your own circumstances the situations that would call for use of a power of appointment. You can also identify the existence of powers of appointment in your own estate planning documents or in the documents of your loved ones, and consider whether these are in fact appropriate for the circumstances.
If you would like to learn more about how powers of appointment can be used to help you achieve your estate planning goals while maintaining significant flexibility in your planning, please do not hesitate to reach out to us. We are eager to help you make the best planning decisions for your unique needs. Give us a call today.
1I.R.C. § 2041(b)(1).
This newsletter is for informational purposes only and is not intended to be construed as written advice about a Federal tax matter. Readers should consult with their own professional advisors to evaluate or pursue tax, accounting, financial, or legal planning strategies.