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George F. Bearup, J.D. Senior Legal Trust Advisor

19-Jun-19

Old General Powers of Appointment- Intentional Increasing the Tax Basis of Assets

Take-Away: Normally the existence of a general power of appointment will cause the value of the assets that are subject to the exercise of that power of appointment to be included in the power holder’s taxable estate. That resulting estate inclusion can be both bad and good. It is bad because it exposes the power holder’s estate to federal estate taxation for the value of the assets that are not available to pay the estate tax liability that the power of appointment causes. However, those same assets that are subject to the decedent’s power of appointment will be exposed to an income tax basis adjustment that arises from the value of the assets inclusion in the power holder’s taxable estate. In one very narrow situation, however the mere existence of a general power of appointment will not cause estate taxation, nor a consequent income tax basis adjustment to the assets that were subject to the general power of appointment.

Background: A general power of appointment is exercisable in favor of the power holder, the power holder’s creditors, the power holder’s estate, or the creditors of the power holder’s estate. [IRC 2041(b) (1).] If, however, the power holder’s exercise of the general power of appointment is subject to an ascertainable standard that relates to the health, support, education or maintenance of the power holder, it will not be treated as a general power of appointment. [IRC 2041(b) (1) (A).] Nor will a power of appointment will be treated as a general power of appointment if the power holder can exercise the power only with the consent of another person under certain limited circumstances. [IRC 2041(b) (1) (C).]

General Powers of Appointment: As a generalization, a person who holds a general power of appointment, whether or not the holder exercises the power, will have the assets that are subject to that power of appointment included in the power holder’s taxable estate at death. This means that the mere existence of the general power of appointment held by an individual will cause both estate taxation of the value of the assets that are subject to the power of appointment, and a corresponding income tax basis adjustment to those same assets. [IRC 1014.]

  • Exception- “Old” General Powers of Appointment: There is one big exception to the general rule just cited with regard to general powers of appointment. The Tax Code provides that the value of the power holder’s gross estate will include the value of all property to the extent of any property with respect to which a general power of appointment was created before October 22, 1942 if exercised by the decedent. [IRC 2041(a) (1).] Therefore, the failure to exercise that ‘old’ general power of appointment or the complete release of that general power of appointment will not be treated as an exercise of that power. [IRC 2041(a) (1) (B).] Admittedly, this is a limited opportunity to consider. A trust which confers a general power of appointment to a trust beneficiary that is ‘grandfathered’ under this exception will have its youngest then-living beneficiaries now approaching their 80’s.
  • The Date is Important: Due to the Tax Code’s exception with regard to some ‘old’ general powers of appointment, it is a good idea to review the date of the trust or the Will that created the general power of appointment. For a general power of appointment that was created under an irrevocable trust, the date of the irrevocable trust governs. With a general power of appointment that is created by a Will that was executed prior to October 22, 1942, i.e. a testamentary trust, it is considered a general power of appointment that is created before that date if the testator who executes the Will died before July 1, 1949 without having republished the Will by Codicil or otherwise after October 21, 1942. [IRC 2041(b) (3).]
  • Lapses and Releases: A trust beneficiary may fail to exercise a pre-October 22, 1942 general power of appointment by either letting the power lapse, releasing that power, or disclaiming that general power of appointment. Letting the power lapse is the cleanest option, because the power holder does nothing. A lapse is an unqualified failure to exercise the general power of appointment, and the value of the assets that are subject to the ‘old’ general power of appointment will not be included in the power holder’s taxable estate. A release of the ‘old’ power of appointment is treated as the deliberate relinquishment of the general power of appointment during the power holder’s lifetime. A release, too, is an unqualified failure to exercise the general power of appointment and the value of the assets that are subject to that general power of appointment will not be includible in the power holder’s taxable estate.
  • Disclaimers: A third option to deal with an ‘old’ general power of appointment is to disclaim the power. The challenge with a disclaimer is that the power holder must follow the rigid rules described in the Tax Code as well as meet state law disclaimer requirements, e.g. the timely delivery of the disclaimer document. [IRC 2518(c) (2); MCL 700.2701 et. seq.] A power of appointment with regard to property is treated as an interest in that property; therefore, the power holder can disclaim a power of appointment independently from any other interests that are separately created for the beneficiary created by the settlor in the property held in trust. [Treas. Reg. 25.2518-3(a) (1) (iii.)] Accordingly, a trust beneficiary who is given a general power of appointment can disclaim that limited property interest, i.e. the general power of appointment over an asset, in order to avoid federal estate and gift taxation. If the power holder makes a qualified disclaimer, the disclaimed interest in the property is treated as if it had never been transferred to the power holder. [Treas. Reg. 25.2518-1(b).]

PLR 201707003 (February 17, 2017): This fairly recent private revenue ruling looked at an ‘old’ general power of appointment after a breach of fiduciary claim had been brought by the lifetime beneficiary against the trustee. The trust, created prior to October 22, 1942, was created for the lifetime benefit of the settlor’s son. The son sued the trustee for abuse of its discretionary authority with regard to distributions of income from the trust. A state court approved a settlement agreement that partitioned the trust into two separate subtrusts. Under one subtrust the son was given a general power of appointment pursuant the settlement agreement. The son promptly renounced and disclaimed his general power of appointment over that subtrust, as did the son’s daughter who was a remainder beneficiary. Both disclaimers were qualified disclaimers under IRC 2518 and the applicable state disclaimer statute. After the son’s death, the trustee identified some ambiguity when the daughter’s disclaimer, and yet another disclaimer, and the settlement agreement were all considered together, which dealt with the standard used by the trustee to distribute trust income. Treasury was asked if the daughter’s qualified disclaimer created a transfer that was subject to gift tax, or whether disclaimer would cause any part of the disclaimed interests to be included in the daughter’s gross estate at the time of her death. Treasury found that the daughter’s disclaimer was qualified under IRC 2518. Consequently, the daughter’s disclaimer of the power she held under the trust instrument did not create any transfers that were subject to federal gift tax and that no part of the disclaimed property interests that had been subject to the power of appointment would be includible in the daughter’s taxable estate for federal estate taxation. Key was making sure that the disclaimer of the ‘old’ general power of appointment was not an inadvertent exercise of the ‘old’ general power of appointment

PLR 201803003 (January 19, 2018): Yet another recent private letter ruling dealt with an ‘old’ general power of appointment created in an irrevocable trust for the benefit of a daughter prior to October 22, 1942. That trust was amended and restated twice by court order. Again, the concern was whether the successor beneficiary grandchildren (after the death of the daughter, their mother) held testamentary general powers of appointment that were eliminated when they filed qualified disclaimers. Treasury found that the grandchildren’s disclaimers did not create any taxable transfers that were subject to federal gift tax and that no part of the disclaimed interests subject to their testamentary general power of appointment would be includible in a grandchild’s taxable estate for federal estate tax calculation purposes.

Conclusion: Old trusts should be reviewed to determine if they contain a general power of appointment, usually a testamentary general power of appointment granted to remainder beneficiaries. The effective date of the creation of any general power of appointment should then be determined to see if it creates a tax problem (estate tax liability) or tax benefit (estate inclusion and income tax basis ‘step up’.) If an income tax basis adjustment is desired with regard to the assets subject to the testamentary general power of appointment (or limited to a handful of assets that would benefit from a basis step-up) then an intentional exercise of that general power of appointment will be requires- its mere existence will not obtain the desired basis adjustment.  Finally, a close reading of IRC 2041(a) (1) tells us that there is no tax consequence only if the ‘old’ general power of appointment is actually exercised. Some states (not all) provide that if a decedent holds a general power of appointment, that power will be deemed to be exercised by a Will’s residuary clause. Therefore, if the desire is to not exercise the ‘old’ general power of appointment, the language used in the beneficiary’s Will residuary clause should be checked to confirm that there would not be an inadvertent exercise of the testamentary general power of appointment.