Use Powers of Appointment To Create Flexibility

Estate Planner May-Jun 2001

A power of appointment can be an effective estate planning technique, facilitating how your property may ultimately pass to your heirs. There are two types: a general power of appointment and a limited or special power of appointment. You — the testator or grantor — may convey each power to a donee or holder — usually your spouse, child or an unrelated party — through your will or living trust.

General Powers of Appointment

A general power of appointment is any power over the disposition of property exercisable in favor of your holder’s estate or creditors, or the creditors of his or her estate. This includes all powers regardless of the nomenclature used in creating the powers and regardless of local property law connotation. For example, a power of appointment exercisable to meet the estate tax or other taxes, debts, or charges enforceable against your estate is included within the meaning of a general power of appointment.

A power of appointment exercisable for discharging your holder’s legal obligation or for his or her pecuniary benefit also is a general power of appointment exercisable in favor of your holder or his or her creditors. The existence of a general power of appointment will cause assets subject to such powers to be included in your holder’s estate for estate tax purposes. The exercise or release — other than by disclaimer — of a general power of appointment is a transfer subject to gift tax.

Typically, you want your beneficiary to receive your property with outright ownership and without exposure to creditors. For instance, you may create a trust granting your spouse a general power of appointment over your trust assets. If the power is exercisable in favor of your spouse and your minor children, it’s a general power of appointment. Your spouse can then appoint the property equally or unequally among your minor children. In addition, he or she can continually adapt the trust to fit your family’s needs or may appoint some assets to him- or herself. You can broadly structure a general power of appointment to favor your child’s descendants, his or her spouse, other beneficiaries, or charities.

Special or Limited Powers Of Appointment

A power of appointment that is not a general power of appointment is a special, limited or nongeneral power. A special power of appointment doesn’t cause your property to be included in your holder’s estate for federal estate tax purposes. To qualify as a special or limited power of appointment, the power to appropriate property for the benefit of your holder must be limited by an ascertainable standard relating to his or her health, education, support or maintenance. The safe-harbor phrases specifically denoted as qualifying as an ascertainable standard include:

  • Support,
  • Support in reasonable comfort,
  • Maintenance in health and reasonable comfort,
  • Support in the accustomed manner of living,
  • College and professional education,
  • Medical, dental and hospital expenses, and
  • Invalidism expenses.

The applicable Treasury regulations specifically exclude any provision or appropriations for the “comfort, welfare or happiness of the holder.” Thus, carefully word your special or limited power of appointment. Otherwise, any misused word or phrase may create disastrous estate or gift tax consequences to you or your holder.

Reasons To Choose a General Power of Appointment

To qualify for the federal estate tax marital deduction, a marital trust requires a general power of appointment. This trust may be preferable if you want your spouse to have a lifetime power of appointment over the trust property. Alternatively, you may grant your spouse a right of withdrawal over trust assets. You may also wish to grant your children the right of withdrawal over their trusts at specified ages or at staggered intervals.

You can sometimes use a general power of appointment to lower overall transfer taxes if the federal generation-skipping transfer tax applies. This typically occurs when your child’s estate tax marginal bracket is less than the maximum rate. Accordingly, giving your child a general power of appointment would cause trust assets to be in the child’s estate for estate tax purposes and not subject to generation-skipping transfer taxes.

Reason To Choose a Special or Limited Power of Appointment

If you decide to leave everything to your children after you and your spouse die, they should receive the assets in trust. When should your children receive distributions? Distribution of principal can be more restrictive than distribution of income. Thus a limited power of appointment may be useful. If your children can use principal only for support, you may guard against them spending the inheritance unwisely.

Create Flexibility In Your Estate Plan

Depending on your situation, the right power of appointment may provide you with flexibility, reduce your tax liability or create other benefits. But choosing the correct power of appointment — general or special or limited — can be complicated. Please call us if you wish to know how a power of appointment can benefit your estate plan.

When To Avoid Powers of Appointment

You should avoid some types of powers of appointment in certain circumstances. For example, a power of appointment in a trust that your holder can exercise during his or her lifetime will disqualify that trust for qualified terminal interest property (QTIP) trust or qualified subchapter S corporation trust (QSST) status. To achieve the desired tax objectives of these trusts, limit the power to a testamentary power exercisable only at death.

And an inadvertent power of appointment may be problematic. For example, if the trustee has the power to distribute property to him- or herself as a beneficiary, that power will be regarded as a general power of appointment unless it’s limited to an ascertainable standard. Thus, if you want your child to serve as trustee of his or her separate trust, limit the child’s power to convey income or principal to an ascertainable standard.