Powers of appointment are useful estate planning tools that allow the grantor of the power to choose someone they trust to instruct the fiduciary in control of the assets to redirect the distribution of the assets from their estate or trust. This distribution can take place many years after the grantor’s death.
However, not all powers of appointment work the same way. They can have different durations and tax implications, and the laws governing them vary from state to state. Read on to learn the answers to the top tax questions about powers of appointment.
Types of Powers of Appointment
Powers of appointment have different tax implications depending on whether they are general or limited.
Aside from the exceptions provided by Internal Revenue Code (IRC) § 2041(b)(1), a power of appointment is general if the powerholder can appoint assets to one or more of the following: themselves, their estate, their creditors, or the creditors of their estate. The powerholder must pay estate tax if the value of the gift exceeds their remaining estate exemption amount.
In addition, when the powerholder dies, the assets receive a basis adjustment. That means the heirs may not have to pay significant capital gains tax when they eventually sell the assets.
A limited power of appointment, also known as a special power of appointment, is any power of appointment that is not a general power of appointment. For example, the HEMS standard is a limitation on a power of appointment because it allows assets to be distributed only for the health, education, maintenance, and support of a beneficiary, and I.R.C. § 2041(b)(1)(A) expressly states that a power that is limited to the HEMS standard is not deemed a general power of appointment.
A non-grantor beneficiary holding a limited power of appointment does not own the assets and does not owe estate tax on them. Also, generally, the assets do not receive a basis adjustment because the assets are not includible in the powerholder’s gross estate for estate tax purposes.
General and limited powers of appointment can fall under the category of testamentary powers of appointment, which are exercised in the powerholder’s will, trust, or other written instrument. The terms specify how the assets subject to the power must be distributed upon the powerholder’s death.
The opposite of a testamentary power of appointment is a lifetime power of appointment, with which the powerholder must exercise the power while they are still alive.
A powerholder is not obligated to exercise the power. In those cases, the assets are distributed according to the terms of the existing instrument. The holder of a power of appointment serves in a nonfiduciary role, unlike a trustee or personal representative.
Reasons to Use a Power of Appointment
One of the best reasons for a grantor to grant a power of appointment is to allow the trusted powerholder to decide in the future who will receive the grantor’s assets, rather than administer the assets under the terms and circumstances present at the grantor’s death. Instead of heirs receiving funds when they are very young, they could receive the assets decades later, with the powerholder making a more informed decision.
For example, a power of appointment could avoid an automatic distribution of a large sum to an heir who may spend the money on illegal drugs. In another instance, the powerholder could choose to not give significant assets to an heir who is already rich, and instead select another heir who needs more financial help.
Now that we understand powers of appointment and the reasons to use them, we can answer the most pressing tax questions about them.
1. When does a lifetime power of appointment trigger gift tax?
With a lifetime general power of appointment, the property subject to the appointment is assessed to the powerholder for estate and gift taxes, even if the power is not exercised. That is not the case for a lifetime limited power of appointment that is held but not exercised. Multiple Private Letter Rulings (I.R.S. P.L.R. 9451049 and I.R.S. P.L.R. 8535020) have concluded that, under certain circumstances, the exercise of a lifetime limited power of appointment constitutes a taxable gift by the powerholder.
One exception found in I.R.C. §§ 2041(a)(3) and 2514(d) is the Delaware tax trap, in which a limited power of appointment creates another power of appointment that extends the vesting period. Triggering the tax trap could mean estate inclusion under I.R.C. § 2041(a)(3) or gift tax under I.R.C. § 2514(d) for the powerholder.
Another situation to watch is when the powerholder takes a mandatory distribution and decants it out of the trust. The Internal Revenue Service considers that a taxable gift.
2. Should the powerholder worry that a lien could apply to the exercise of the power?
Fortunately, when an independent trustee or personal representative has pure discretion over the distribution of assets, creditors cannot reach the assets that are subject to a limited power of appointment. In some states, when a trustee or personal representative is told by the controlling instrument that they shall make distributions based on ascertainable standards, a court may compel distributions to certain supercreditors.
When a general power of appointment is exercised in favor of someone other than the powerholder’s creditors, the subject assets can be reached by those creditors in most states.
3. When is a power of appointment exercisable only by will?
Most states allow a power of appointment to be exercised in either a will or a trust. The power can be exercised in a trust created by a beneficiary or an amendment to such a trust.
States that allow a power of appointment to be exercised in a will usually require the will to be proven in probate court before the power can be exercised. Some attorneys prefer this because the court’s approval can ward off challenges from interested parties.
4. Which state’s laws apply to the power—the situs of the trust or the residency of the powerholder?
This is a complicated question. In addition to the trust situs and the powerholder’s residency, you must also consider the jurisdiction of the trust assets. This could include real property located in different states.
Regarding the power’s creation versus its exercise, section 103 of the Uniform Powers of Appointment Act states the following:
- The creation of the power is governed by the state law of the donor at the relevant time.
- The exercise of the power is governed by the state law of the powerholder at the relevant time.
The laws of the state where the property is located can sometimes affect whether taxes are assessed on the exercise of the power of appointment. Also, if the exercise of the power creates a new trust, the laws of the state governing the new trust would apply to the trust assets.
5. Where can I find the law on powers of appointment?
The National Conference of Commissioners of Uniform State Laws completed the Uniform Powers of Appointment Act in 2013 and recommended that every state enact it. So far, these twelve states have done so: Colorado, Kentucky, Illinois, Missouri, Montana, Nebraska, Nevada, New Mexico, North Carolina, Virginia, Utah, and Washington.
State laws will prevail elsewhere. In Florida and some other states, the laws regarding powers of appointment are grouped with those governing powers of attorney. Other states such as California have separate sections of the law about powers of appointment.
More Tax Information About Powers of Appointment
Learn more about the tax implications of powers of appointment by watching an on-demand webinar with Edwin Morrow, JD, LLM (tax), MBA, CFP, CM&AA, who discusses using powers of appointment for income and estate tax minimization and asset protection purposes.