CSG Law Alert: Planning Using Testamentary Powers of Appointment
Testamentary powers of appointment are a useful tool that can be used to create flexibility in an estate plan for both tax purposes and non-tax purposes. A testamentary power of appointment allows the holder of the power to modify the dispositive terms of a trust, in a broad or limited manner, at his or her death to provide flexibility for circumstances that were not known when the trust was originally created. However, testamentary powers of appointment can undo careful estate planning and can result in tax consequences so including them in an estate plan must be well thought out with proper consideration made to all facts and circumstances.
What Is a Testamentary Power of Appointment?
A testamentary power of appointment is a right granted to a beneficiary of a trust to direct that principal and/or undistributed net income remaining in such trust at the beneficiary’s death be distributed as directed by the beneficiary. The beneficiary is not required to exercise the power, and, if the power is left unexercised, then the principal and/or undistributed net income remaining in such trust at the beneficiary’s death will be distributed as directed by the terms of the trust.
General Versus Limited Powers of Appointment
There are two types of testamentary powers of appointment: (1) a general power of appointment and (2) a limited power of appointment.
A general power of appointment is a power that is exercisable by the beneficiary in favor of one or more individuals and/or entities including the beneficiary, the beneficiary’s estate, the beneficiary’s creditors and the creditors of the beneficiary’s estate. If a beneficiary has a testamentary general power of appointment, any principal and undistributed net income of the trust subject to such power will be included in the beneficiary’s gross taxable estate and may be subject to federal and/or state estate taxes. Because of the estate tax inclusion, there will be an income tax basis adjustment for the property subject to the general power of appointment. Additionally, the trust assets subject to the general power of appointment will not be subject to generation-skipping transfer (“GST”) tax because the beneficiary granted the power will be considered a new transferor for GST purposes. Upon the beneficiary’s death, his or her remaining GST exemption may be allocated to the trust assets if the transfer of such assets has GST tax potential.
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 exercisable by the beneficiary in favor of one or more descendants of such beneficiary or the descendants of the creator of such trust (“Settlor”). Unlike a general power of appointment, a limited power of appointment does not cause trust assets to be includible in the beneficiary’s taxable estate.
Creating Flexibility in Your Estate Plan with Testamentary Powers of Appointment
There are many reasons why someone might want to include a power of appointment in his or her estate plan, including tax considerations, asset protection, and a desire for flexibility to plan for the unknown. The donor of the testamentary power of appointment under a trust (i.e., the Settlor of the trust, a Trust Protector and/or the Trustee) establishes the terms as to how the power can be exercised and the steps that the beneficiary of the trust must follow to exercise the power. If the beneficiary of the trust does not comply with the requirements of the power of appointment, its exercise could be void.
For example, a power of appointment may:
- Restrict who may receive property when the power is exercised such as limiting recipients to:
- The beneficiary’s descendants, the Settlor’s descendants, or the descendants of the Settlor and the Settlor’s spouse, and/or the lineal descendants of an ancestor;
- Explicitly including or excluding spouses of descendants, adopted children from the class of descendants, and/or stepchildren from the class of descendants; and/or
- Charities that support specific causes.
- Restrict or set conditions on the amount of assets that can be appointed to recipients such as:
- Restricting certain assets such as business or real estate interests from being appointed outside of the Settlor’s bloodline or requiring such assets be appointed pro-rata amongst a class of recipients;
- Setting a maximum dollar amount or percentage of assets that can be appointed to certain recipients; and
- Broadening the class of recipients if the beneficiary is the last surviving beneficiary of the trust.
- Set conditions on what the recipients receive and how they receive it by requiring the power to be exercised to create another trust with specific terms such as:
- Requiring specific trustees of the appointed trust;
- Limiting or restricting distributions of principal from the appointed trust to some or all of the recipients; and
- Including certain parameters such as only allowing assets to be appointed to a supplemental needs trust.
If you would like to learn more about how testamentary powers of appointment can be used to help you achieve your estate planning goals while maintaining significant flexibility in your estate planning documents, please do not hesitate to reach out to your estate planning attorney at CSG Law.