By definition, estate planning is designed to address events that may not occur for years or even decades. This requires you to make decisions regarding your estate today against the backdrop of an uncertain future. Fortunately, there are tools available to build flexibility into your plan, including powers of appointment.
Defining powers of appointment
Powers of appointment are a legal right — typically conferred by a donor in his or her will or trust — that authorizes the holder of the power (a family member or trusted advisor) to designate who’ll receive certain assets. Depending on how they’re drafted, powers of appointment may allow the holder to distribute the assets during his or her lifetime (an “inter vivos” power) or at death through a will or trust (a “testamentary” power).
Powers of appointment can be general or limited. General powers of appointment allow holders to distribute assets to anyone, even to themselves, their estates or their creditors. In contrast, limited powers of attorney limit distributions to specified beneficiaries or classes of beneficiaries (such as the donor’s children or grandchildren). Limited powers of attorney can’t be exercised in favor of the holder or his or her estate or creditors. However, it can be used to benefit the holder if distributions are limited to “ascertainable standards” related to the holder’s health, education or support.
The distinction between general and limited powers of appointment has significant tax implications. Because holders of general powers of appointment effectively exercise ownership control over the assets, those assets are included in their estates for gift and estate tax purposes. This means holders may be subject to gift tax (in the case of inter vivos powers) or estate tax (in the case of testamentary powers), regardless of whether they exercise the power. Holders of limited powers of appointment generally aren’t exposed to gift or estate tax liability.
Building flexibility
There are many ways to use powers of appointment to build flexibility into your estate plan. Examples include:
Informed decision making. Powers of appointment allow for decisions on the distribution of wealth to be made later, when all the facts are available. Suppose you have three young children, and your plan calls for your assets to be held in trust, providing your spouse with income for life and dividing the remaining assets equally among your children. By granting a limited testamentary power of appointment, you can give your spouse the ability to adjust the division of assets among the children based on their circumstances. Perhaps your daughter has become financially independent and needs less financial assistance than the others. Or maybe your son is incapable of managing the assets on his own. In that case, your spouse might direct his share into a trust that restricts his access to the funds.
Asset protection. One advantage of transferring assets to an irrevocable trust is that they’re removed from your estate and generally beyond the reach of your creditors. But what if you’re concerned about having enough money during retirement? One option is to use a “self-settled” trust and name yourself as a discretionary beneficiary. That way, the trustee can distribute funds to you if needed. But these trusts typically offer little or no asset protection (unless they’re set up in a state that authorizes domestic asset protection trusts, but there’s some uncertainty about the effectiveness of those trusts).
An alternative is to use an irrevocable trust coupled with a limited power of appointment, allowing a trusted third party to distribute assets to you. Because you’re not a beneficiary of the trust, and distributions to you are purely discretionary, this arrangement should offer strong protection against creditors.
Tax planning. Powers of appointment offer several potential tax benefits, including avoidance of estate and generation-skipping transfer taxes under certain circumstances. In addition, they can be used to ensure that assets receive a stepped-up basis, enabling beneficiaries to sell them without triggering significant capital gains taxes. (See “Using powers of appointment to avoid capital gains taxes” at X.)
Handle with care
Powers of appointment can help your family adapt your estate plan to changing circumstances and achieve significant tax savings. To be effective, these powers require precise drafting and compliance with federal and state laws, so be sure to work with your estate planning advisor to ensure that they achieve your objectives.
Sidebar: Using powers of appointment to avoid capital gains taxes
When you transfer highly appreciating assets to an irrevocable trust, their value (including all future appreciation) is removed from your estate for estate tax purposes. But unlike assets transferred at death — whose basis is “stepped up” to their fair market value — assets placed in an irrevocable trust retain your tax basis. This can result in a substantial capital gains tax bill when your beneficiaries eventually sell the assets.
With careful planning, powers of appointment can help avoid this result. Here’s an example: Joe transfers $10 million in appreciated stock (with a basis of $2 million) to an irrevocable trust for the benefit of his children. The trust also names Joe’s elderly father, Lou (whose $15 million estate tax exemption is mostly unused), as a discretionary beneficiary and grants Lou a testamentary general power of appointment over the trust assets.
When Lou dies, the general power of appointment causes the assets to be included in his estate (even if he never exercised it) and shielded from estate taxes by Lou’s exemption. As a result, the stock’s basis is stepped up to its fair market value (say, $11 million) even though it remains in the trust. This strategy allows Joe’s family to avoid as much as $1.8 million in capital gains taxes.