Among the most useful tools at an estate planner’s disposal is a power of appointment (POA). A POA is a power conferred on a trust beneficiary to direct, in a manner different from that specified as a default dispositive mechanism in the instrument creating the trust, to or for whom trust property will pass. The holder of the power, in exercising it, essentially acts as the agent of the person who established the trust. It’s significant that a POA is, unlike powers and discretions held by trustees, a nonfiduciary power. That is, the powerholder may exercise the power in any manner he chooses within its scope without any concern about owing or violating any duty to any other person.
There’s an almost infinite variety of POAs. A POA may be general or non-general, broad or restrictive, presently exercisable or exercisable on the passage of time or the occurrence of a future event or exercisable during life (an inter vivos power) or on death (usually, but not always, a testamentary power).
In designing and drafting a provision to be included in a will or trust instrument to confer a POA, it’s very important to use clear, unambiguous and comprehensive language. Such language must specify when the power is exercisable, to or for whom it’s exercisable, what property or property interest may be disposed of using the power and what procedure the powerholder must follow effectively to exercise the power.1 It’s desirable that such language have the effect of requiring the powerholder conspicuously to manifest his intent to exercise but at the same time not be a slave to nitpicking, inconsequential details.
In preparing language by which a POA is to be exercised, it’s critical to review carefully the provision by which the power was conferred and then carefully follow the rules set out in that provision to minimize any possible doubt as to whether the powerholder intended to exercise the power. If, however, only a minor or immaterial procedural rule is violated in the attempted exercise, it’s possible a court would nevertheless consider the power to have been exercised validly.2
Estate and Gift Tax Consequences
The value of property subject to a general POA, as defined in Internal Revenue Code Section 2041(b)(1),3 is generally includible in the gross estate of the powerholder—whether the power is exercised or not.4 The value of property subject to a general POA created after Oct. 21, 1942 that was exercised or released by the powerholder in a manner that would give rise to inclusion in the gross estate under IRC Sections 2035 through 2038 if the powerholder were the original transferor is likewise generally includible in the gross estate of the powerholder.5 A lapse of such a power is considered a release to the extent the lapse in any calendar year relates to the greater of $5,000 or 5 percent of the value of the property out of which the exercise of the lapsed power could have been exercised.6 Not included in the definition of a general POA is any power limited by an ascertainable standard relating to the powerholder’s health, education, support or maintenance and any power exercisable only in conjunction with the creator of the power or a person having a substantial interest in the appointive property that’s adverse to exercise of the power in favor of the powerholder.7 In the case of a general POA created on or before Oct. 21, 1942, the value of property subject to the power is includible in the gross estate of the powerholder only to the extent it’s exercised.8
The exercise or release (but not a lapse) of a general POA created after Oct. 21, 1942 is deemed a transfer of property by the powerholder9 and so is potentially subject to gift tax10 as well as to being treated as an adjusted taxable gift.11 The lapse of a general POA created after Oct. 21, 1942 is treated for gift tax purposes in a manner analogous to that in which it’s treated for estate tax purposes.12 A general POA is defined for gift tax purposes in exactly the same manner as for estate tax purposes,13 and the same exclusions from the definition of a general POA held by a decedent, as described above, apply also for gift tax purposes to powers possessed by living powerholders.14
The possession, exercise or release of a nongeneral POA ordinarily doesn’t give rise to estate or gift tax consequences, but there are a couple of notable exceptions of which to take note. First, if the exercise or release of a nongeneral power has dispositive effect on any other interests in the trust the powerholder may have, a transfer tax consequence may ensue. For example, a powerholder may be entitled to receive the entire net income of a trust during the powerholder’s life and have a presently exercisable power to appoint the trust property to the powerholder’s children. If appointment of the trust property eliminates the powerholder’s income interest and vests the property, and the post-appointment income, in the powerholder’s children, the powerholder has made a gift of the then-present value of his income interest.15
Second, for purposes of IRC Section 2042, a POA will be considered an incident of ownership with respect to a life insurance policy.16
Goals of POAs
POAs can be used to achieve a multitude of meaningful estate-planning goals for clients. Short of giving or bequeathing property outright (which has several distinct estate-planning disadvantages), a POA is the most direct and efficient means by which a property owner may confer on another the ability to determine the ultimate destination of the property. This may be an extremely important element of an estate plan. Those clients who recognize the impossibility of predicting changes in circumstances and in law may be amenable to giving POAs as a means of preserving flexibility. Depending on the facts and the breadth of a given POA, a power can be exercised in a manner that restores sense and vitality to an otherwise obsolete, and perhaps even destructive, estate plan. With a POA, it may be possible to change beneficiaries, create trusts, eliminate trusts, change the terms of a trust and shorten or extend the duration of a trust. Even a POA that isn’t exercised may help maintain an appropriate balance in the relationship between the powerholder (a trust beneficiary who has an interest for life) and the trust’s remainder beneficiaries.
Without question, the most important tax-related purpose a general POA may be used to accomplish today is inclusion of the value of the appointive assets in the powerholder’s gross estate, which, in turn, enables a step-up in the basis of the assets to their fair market value as of the powerholder’s death,17 thereby minimizing what could otherwise have been a sizable capital gains tax on a subsequent sale or exchange of low basis, high value assets. At the same time, so long as the value of the powerholder’s gross estate is equal to or less than his unused applicable exclusion amount,18 no federal estate tax will result.
Using a POA for Basis Step-Up
A client can confer a testamentary general POA by using a formula stating that the power will be exercisable only to the extent holding such power wouldn’t, by itself, cause imposition of any estate tax. The formula could be further refined so as to have effect only with respect to certain assets in a trust or to subject to such power, first, those trust assets having the lowest basis and then cascading to each next lowest basis asset until holding the power wouldn’t fail to cause imposition of estate tax.
Alternatively, a will or trust instrument could be drafted to allow an independent trustee or a trust protector to grant a general POA (perhaps, a formula general power, as described above) to a beneficiary after having examined the tax consequences of so doing. Conditioning the grant of a general POA on the determination of an independent trustee or a trust protector may provide more flexibility than having the trust instrument itself confer the general power. An estate planner should consider, though, whether a given independent trustee will have the willingness and sophistication to grant a general POA to a beneficiary and whether such independent trustee will even be available when needed for such purpose.
Finally, even in a case in which an existing irrevocable trust instrument lacks a general POA, it may be possible, by decanting, to engraft one. Decanting is the process by which the trustee of an irrevocable trust with discretionary distribution authority may, without court approval, transfer the trust property into a new, separate trust whose governing instrument has administrative and/or dispositive terms different from those contained in the original trust instrument. Under many decanting
statutes,19 it would be possible for a trustee to decant to a new trust whose terms would confer a general POA on a beneficiary. A similar result may be obtainable by means of judicial or non-judicial modification or non-judicial settlement.20
1. Bear in mind that a power exercisable only “by will” may put the powerholder in a position in which he can never be sure the power has been effectively exercised because the powerholder has no control over whether a document he thinks of as his “will” will be admitted to probate, and so will actually become his will as a matter of law, as opposed to being merely his purported will.
2. But see Cessac v. Stevens, 127 So.3d 675 (Fla. 1st DCA, Nov. 20, 2013) and Midwest Trust Company et al. v. Reed Brinton, 2014 Kan.App. Unpub. LEXIS 680 (Aug. 15, 2014).
3. A power exercisable in favor of the decedent, his estate, his creditors or the creditors of his estate. Internal Revenue Code Section 2041(b)(1).
4. IRC Section 2041(a).
6. Section 2041(b)(2).
7. Section 2041(b).
8. See supra note 4. A very narrow exception to this rule applies in the case of a partial release of the power.
9. IRC Section 2514(b).
10. IRC Section 2501(a)(1).
11. IRC Section 2001(b).
12. See supra note 5. Section 2514(e).
13. See supra note 2. Section 2514(c).
14. Section 2514(c); Section 2514(a).
15. See Regester v. Commissioner, 83 T.C. 1 (1984).
16. See Private Letter Ruling 201327010 (March 27, 2013).
17. IRC Section 1014(a).
18. The basic exclusion amount (IRC Section 2010(c)) is at the historically high level of $5.45 million for 2016 and climbing annually.
19. Decanting statutes have been enacted in 24 states to date. Those states are: Alaska, Arizona, Delaware, Florida, Illinois, Indiana, Kentucky, Michigan, Minnesota, Missouri, Nevada, New Hampshire, New Mexico (effective Jan. 1, 2017), New York, North Carolina, Ohio, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Virginia, Wisconsin and Wyoming.
20. See, e.g., Sections 111, 411, 412 and 416 of the Uniform Trust Code (enacted in 31 states and Washington, D.C. to date). Those states are: Alabama, Arizona, Arkansas, Florida, Kansas, Kentucky, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Hampshire, New Jersey, New Mexico, North Carolina, North Dakota, Ohio, Oregon, Pennsylvania, South Carolina, Tennessee, Utah, Vermont, Virginia, West Virginia, Wisconsin and Wyoming.