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

20-May-19

Powers of Appointment: A Reprieve for Creditors?

Take-Away: A large part of Michigan’s recent Directed and Divided Trust Act is based upon the Uniform Directed Trust Act, which, in turn, was created with specific reference to the Uniform Power of Appointment Act. There was a subtle shift in creditor rights under the Uniform Power of Appointment Act that might work its way into a Michigan trust that contains a power of appointment. It is not clear, at this early date, if that change in creditor rights will be the case.

Question: Should creditors be able to compel a distribution of assets held in an irrevocable trust when the creditor’s debtor holds a general power of appointment over trust assets?

Background: The Uniform Directed Trust Act was written as a companion to the Uniform Power of Appointment Act. The Uniform Directed Trust Act’s provisions do not treat the holder of a power of appointment as a trust director. Under the Uniform Directed Trust Act, a power of appointment holder is presumed not to be a fiduciary of the directed trust. The same holds true with respect to the Michigan Directed and Divided Trust Act- a person who holds a general power of appointment in a non-fiduciary capacity is not treated as a trust director. This treatment that a general power of appointment holder may not be treated as a fiduciary [found in the Uniform Power of Appointment Act] might have a bearing on creditor rights against a person who merely holds a general power of appointment under a directed trust in Michigan.

Common Law: The traditional common law view is that if the individual who holds a general power of appointment over trust assets that he/she did not create, i.e. the power was not retained by him or her, that power holder’s creditors could not reach the appointive assets held in the trust unless the power was actually exercised by the power holder. In short, the mere presence of the general power of appointment in the trust instrument did not expose the trust’s assets to satisfy the power holder’s creditor claims.

  • Actual Exercise: Therefore, when an individual holds a general power of appointment over trust assets, even when the trust assets could be appointed to the power holder or to creditors of the power holder, i.e. a general power of appointment was created, the power holder’s creditors could not reach the trust assets until the power of appointment was actually exercised by the power holder. Consequently, if the general power of appointment was never exercised by the power holder, the power holder’s creditors could never reach the assets that were the subject of the power of appointment.
  • Academics Disagree: That is not to say that the traditional common law view with regard to general powers of attorney was readily accepted. Actually, there was (is?) a longstanding debate on this issue of whether assets held in trust could be accessed by the power holder’s creditors. Lawyers who represent the power holders asserted that their clients did not want creditors to be able to reach assets held in trust, and thus they took a narrow view of when creditors should be able to access trust assets that are subject to a power of appointment- only when the power was actually exercised by the power holder. In contrast, academics [who, as a broad generalization, wrote the Restatement (Third) of Trusts and greatly influence almost all of the Uniform Acts these days- they actually have time to preach to us what they think the  law ought to be!]- felt that a trust beneficiary who holds a general power of appointment should be subject to a court order that compels that power holder to exercise the power of appointment and thus make the trust assets available to satisfy the power holder’s creditors- taking the when out of the common law interpretation. In short, academics believe a creditor should be permitted to access trust assets to satisfy their claims when the beneficiary merely holds, but has not yet exercised, a general power of appointment over the trust.

Uniform Power of Appointment Act: The Uniform Power of Appointment Act changes the common law. The drafters of this Uniform Power of Appointment Act changed this rule so that now, if a general power holder could exercise the power in order to pay creditors, e.g., he/she holds a general power of appointment and thus possesses the ability to appoint trust assets to satisfy creditor claims, then a creditor should be able to reach the appointive assets held in trust to satisfy its claim against the general power holder.

Consequences of the Change: This change in the Uniform Power of Appointment Act was intended to be subtle and not earth shattering, since historically general powers of appointment were not frequently used in trusts, as more often trust instruments usually gave to a trust beneficiary only a limited power of appointment to re-direct trust assets among their descendants. General powers of appointment were not commonly added to irrevocable trusts due to the estate tax exposure caused by a general power of appointment. [IRC 2041.] However, general powers of appointment in trusts are now regularly used to expose trust assets to an income tax basis adjustment on the power holder’s death. General powers of appointment are also used to add flexibility to a trust instrument in these fast-changing times. Accordingly, it is common to find trust instruments that intentionally give a trust protector (now called a trust director) the ability to amend the trust instrument to add a general power of appointment exercisable by a trust beneficiary. General powers of appointment are also added by trust protectors to dynasty-type trusts to avoid the imposition of the generation skipping transfer tax that would otherwise be imposed on trust distributions and terminations, when a trust beneficiary dies, in light of the now-high federal estate tax exemption amount, where the inclusion of the value of the appointive assets in the power holder’s estate will not cause a federal estate tax to be paid.

However, we are now preoccupied adding general powers of appointments to trusts in order to save income taxes with a basis ‘step-up’ on the power holder’s death,  intentionally engaging in free-basing strategies that use a general power of appointment to gain a step-up in the income tax basis of the trust’s assets on the beneficiary’s death. [IRC 2041(b) (1); IRC 1014(b) (1).]  All of this added flexibility and preoccupation with free-basing strategies that use general powers of appointment makes sense, but they may now they may carry the risk of exposing trust assets to the power holder’s creditor claims.

The Uniform Directed Trust Act makes presumes that a person who holds a power of appointment holds it as a non-fiduciary power. The Uniform Directed Trust Act expressly excepts from its liability provisions individuals who hold powers of appointment in a non-fiduciary capacity. The Uniform Act presumes that the law that governs a power of appointment holder is covered ‘elsewhere’, i.e. the Uniform Power of Appointment Act.

Michigan has its own power of appointment statute and it has not (at least to my knowledge) formally adopted the Uniform Power of Appointment Act. [see MCL 556.112(c).] As such, there may be some confusion in Michigan if it has indirectly altered its common law and statute by virtue of its adoption of most of the Uniform Directed Trust Act.

Planning Strategies: If a trust beneficiary holds of a general power of appointment over the trust for income tax (i.e. free-basing) purposes, which might now expose the trust assets to creditor claims (despite the presence of a spendthrift provision in the trust instrument) then consider a couple of the following strategies to mitigate that risk:

  • give to the trust beneficiary a testamentary general  power of appointment on the beneficiary’s death, effectively imposing the when condition back into the general power of appointment- a testamentary power that is exercisable only on the trust beneficiary’s death and not before;
  • restrict the testamentary general power of appointment to pay the power holder’s creditors on death, which precludes the power holder from ‘going rogue’ and appointing trust assets to someone the settlor never intended to benefit from the trust;
  • use a formula testamentary general power of appointment which limits the amount of assets that can be appointed to pay the power holder’s estate creditors, e.g. limit the power to an amount that will be shielded from federal estate taxation by the power holder’s (trust beneficiary’s) available federal estate tax exemption amount; the dollar limit avoids an unintended federal estate tax liability to be incurred (by virtue of the mere existence of the testamentary general power of appointment) which might be important if the federal estate tax applicable exemption amount is later reduced;
  • use a formula testamentary power of appointment that is limited to only those assets that would receive a basis ‘step-up’ on the power holder (trust beneficiary’s) death, which preserves any capital loss that might otherwise be used by remainder beneficiaries to off-set future capital gains;
  • use a formula testamentary power of appointment that is prioritized to first expose to trust assets to a gain readjustment on the power holder (trust beneficiary’s) death, i.e. assets that have the highest exposure to capital gains taxes, e.g. art, jewelry and collectibles, all of which are exposed to the 28% capital gain tax rate; or
  • make the trust beneficiary’s exercise of any lifetime general power of appointment exercisable only with the consent of a third party.

Conclusion: Powers of appointment are unique planning devices that provide flexibility to trust beneficiaries to alter, to some extent, the settlor’s initial trust disposition provisions. “The power of appointment is the most efficient dispositive device that the ingenuity of Anglo-American lawyers has ever worked out. “–Barton Leach.

Powers of appointment are far more commonplace today due to the prevalence of free-basing planning strategies, as reflected in trust instruments that give a trust director the ability to amend trust instruments to add powers or appointment, or statutes that give a trustee the power to decant trust assets to a new trust instrument where a general power of appointment is prominently added, to intentionally expose trust assets to a basis adjustment on the trust beneficiary’s death. Those are legitimate reasons to engage in general power of appointment planning techniques.

However, powers of appointment may now also come with additional creditor exposure to the appointive assets held in the trust.

The bottom line is to go slowly in making the decision to add general powers of appointment to a trust, or to change the existing situs of a trust to a jurisdiction that may have adopted the Uniform Power of Appointment Act. The remainder beneficiaries of the trust will be elated with the basis step-up in trust assets on a predecessor trust beneficiary’s death caused by the existence of a general power of appointment, but they will not be happy if those same appointive assets disappear in the payment of the predecessor beneficiary’s federal estate tax liability, or the appointive assets are lost in the payment of that predecessor beneficiary’s creditor claims. On the other hand, worst of all, the remainder beneficiaries will be unhappy if the power holder actually exercises the general power of appointment and directs the appointive assets entirely away from those trust remainder beneficiaries. Free-basing is not without risks, which just increased with the Uniform Power of Appointment Act.