1-Mar-20
‘Freebasing’ With Grandma Revisited
Take-Away: Using a testamentary general power of appointment is a convenient way to add income tax basis to assets on the power holder’s death. There are risks, however, in ‘free-basing’ with a testamentary power of appointment.
Background: We have covered this estate planning strategy in the past [actually a couple of years ago if you can believe I have been at Greenleaf Trust that long!] The strategy exploits the estate taxation of assets that are subject to a general power of appointment, whether or not that power of appointment is actually exercised. Merely holding a general power of appointment is sufficient to expose the value of the assets that are subject to the general power of appointment to inclusion in the power holder’s estate, in turn leading to an income tax basis adjustment [IRC 2041; IRC 1014.]
Definition: Generally a power of appointment will be classified as a general power of appointment if the power holder may exercise the power of appointment in favor of himself/herself, or his/her creditors, or his/her estate, or the creditors of his/her estate. Note the use of the disjunctive. Thus, a taxable power of appointment exists if it can be exercised in favor of any of these four statutory objects. With free-basing, it is the last of the four that leads to this summary.
Federal and State Law: State law defines the legal rights that relate to the power of appointment; it determines the nature of the power holder’s interest in property and the scope of that interest. Federal law determines whether such rights are taxable. Morgan v. Commissioner, 309 US 78 (1940.) Thus, state laws can create different rights for the same power, which can result in varying taxation. A power that is exercisable to pay estate taxes, or any other taxes, debts or charges that are enforceable against the power holder’s estate is treated (and taxed) as a general power of appointment. [Reg. 20.2041-1(c)(1).]
Creditor Risk: At common law, and under most state power of appointment statutes, the creditors of the general power of appointment holder can access the assets that are subject to the general power of appointment. In order to protect the assets held in trust that are subject to the power of appointment, often the decision is made to give the power holder only a testamentary general power of appointment over trust assets. This way, even if the power holder experiences lifetime creditor problems, the trust’s assets are not at risk.
Rogue Power Risk: Another risk is that the power holder might actually exercise the power of appointment on his/her death in favor of someone who the trust settlor would never have wanted to benefit from the trust that the settlor created. In order to prevent the power holder from going ‘rogue’ and exercising the power of appointment contrary to the settlor’s presumed intent (or even to exercise the power of appointment) it is thought that if the power of appointment is limited to being exercised in favor of the power holder’s estate creditors, that ‘narrowing’ of the scope of the power of appointment will achieve the settlor’s goal of adjusting the income tax basis of the trust assets while at the same time minimizing the risk that the power holder will exercise the power contrary to the settlor’s wishes. Recall that merely holder a power of appointment in favor of one’s estate creditors is sufficient to expose the trust assets subject to that power to an income tax basis adjustment on the power holder’s death. Hence the strategy of naming grandma as a power of appointment holder over her grandchildren’s trust where she is given a testamentary power of appointment to appoint trust assets to the creditors of her estate.
Sonny and Mona Example: Sonny intends to create a trust for his children using highly appreciated marketable securities. Sonny creates a grantor trust to which he sells his marketable securities. Since it is a grantor trust, no gain is recognized by Sonny. The trustee gives Sonny a promissory note to complete the sale. Sonny’s children are the trust beneficiaries. Sonny also gives his mother, Mona, age 87, a testamentary power of appointment to appoint trust assets to her estate creditors on her death. “Mona Smith, my mother, shall hold a testamentary power of appointment over the assets held in this trust limited to creditors of her estate, exercisable by specific reference to this power of appointment in her Will that is admitted to probate after her death.” When Mona dies the value of all of the trust’s assets are included in Mona’s taxable estate. Mona’s federal estate tax exemption amount, e.g. $11.58 million currently, is more than enough to shelter Mona’s own assets along with the value of the stock held in the trust that Sonny created for his children. No estate tax will be paid, yet a 100% income tax basis adjustment is made to the trust’s assets. To finish the plan, the trustee then sells the assets after Mona’s death, without recognizing any capital gain, and the trustee then uses the sales proceeds to pay the note initially given to Sonny by the trustee. In short, free-basing with grandma’s death.
Sonny, Mona and Rod Example: Change the facts just a bit. Suppose that Mona spends her winters in Florida. She becomes a fast friend of Rod (who happens to wear an ascot and drivea Mercedes convertible but with no visible means of support.) Sonny is not enamoured with his mother’s choice of ‘friends’ while in Florida, and he fears that Rod may have an abnormal influence over his mother, who was always fond of men wearing ascots. Fortunately, Sonny takes comfort from the fact that Mona only holds in the trust he created a testamentary power of appointment in favor of her estate creditors, so if she decides to reward Rod for his attention and friendship, she will not be using the trust assets (which Sonny still views as his assets despite them being sold to the trust.) Sonny’s comfort may be misplaced:
What if Mona gives to Rod a $10,000 promissory note, which remains unpaid at the time of her death? Rod is a creditor of Mona’s estate. The terms of Mona’s power of appointment would be satisfied with the power exercised by Mona’s Will appointing $10,000 of trust assets to Rod to satisfy his claim against her estate.
What if Mona amends her Will to appoint from the trust $100,000 of trust assets to Rod, her BFF, who holds her $10,000 promissory note. The way the power of appointment given to Mona reads, the power of appointment to satisfy estate creditors is not limited to the amount that is owed to Rod at the time of Mona’s death. Rod is in fact a creditor who meets the definition of a ‘creditor’ but the power of appointment is not limited to just satisfying Mona’s outstanding debt to Rod.
Answers? Normally, a general power of appointment in favor of the creditors of the power holder’s estate is exercisable only in favor of those creditors. Other appointments are impermissible appointees. [Restatement (Third) of Property, Section 19.15, note 5; Uniform Power of Appointment Act, Section 305(b).]
There is no guidance on state law rules with regard to how much property may be appointed to creditors of the power holder’s estate. Mona’s appointment of $10,000 to Rod is clearly a valid exercise of her testatmentary power of appointment in the trust as she owed him money at the time of her death and he was a creditor. But is the power limited to what is owed, or does the power, as written, describe a class (anyone who is a creditor of Mona’s estate is an eligible appointee, regardless of the amount they are owed) for whom the power of appointment may be exercised?
After the first $10,000 is appointed and paid to Rod, Rod technically ceases to be a creditor of Mona’s estate. Is Rod an impermissible appointee to the remaining $90,000 Mona appointed to him under her Will? It could be argued that because Rod is a creditor when Mona exercised the power of appointment under her Will, the entire trust corpus could be appointed to Rod, as creditor status is fixed and determined at the moment of Mona’s death without regard to the amount of the indebtedness.
Assume that state law that governs Mona’s exercise of her power of appointment limits the appointive property to Rod at $10,000. Is only $10,000 of the value the trust property included under IRC 2041 in Mona’s estate? If Rod is the only permissible appointee available, the answer to this question is probably be ‘yes.’ However, the way Mona’s power of appointment is phrased, she could appoint the remaining trust property for the benefit of other creditors. If the entire trust estate could have been appointed by Mona to satisfy multiple creditor claims, then the value of the entire trust estate should be included in Mona’s taxable estate and thus receive an income tax basis adjustment. Recall that it is the breadth of the control the power holder can exercise over the trust property and not the actual exercise of that control that dictates the estate tax inclusion (and thus the income basis adjustment.)
When Sonny gave Mona under the trust a testamentary power of appointment to satisfy creditors of her estate, the reality is that Sonny never expected Mona to actually exercise that power of appointment. The sole reason to give Mona the power of appointment under the trust instrument was to expose the assets subject to that power to an income tax basis adjustment on Mona’s death. When Sonny learns that his late-mother appointed $100,000 to ascot-wearing Rod, does he have any recourse? /did Rod, he of questionable financial means, actually loan Mona $10,000? The trustee might be able attack Mona’s $100,000 appointment to Rod as a fraud on the power of appointment under state law. [Restatements (Second) and (Third) of Property, Sections 20.1 to 20.4 (Second) and Sections 19.15, 19.16 (Third); Uniform Power of Appointment Act, Section 302.]
Conclusion: Free-basing with testamentary powers of appointment is an effective way to increase the income tax basis of assets held in trust. That said, due to some of the unanswered questions associated with a testamentary power of appointment in favor of estate creditors, such a power should be narrowly drafted. Consider: (A) Rather than blindly hope that state law limits creditor appointments to the amount actually owed, the testamentary power of appointment should apply only to legally enforceable debts. (B) Require the consent of a non-adverse party to the holder’s exercise of the power of appointment. [Reg. 20.2041-3(c)(2)] (C) Insert a notice requirement to the exercise of the power of appointment to the trustee. [Reg.20.2041-3(b).] (D) If there are specific individuals that the settlor is concerned about, e.g. Rod, expressly exclude him from qualifying as a permissible creditor appointee to avoid ‘game-playing.’ Finally, if the goal is to obtain an income tax basis adjustment, the testamentary power of appointment should be limited to only those assets held in the trust that have appreciated in value, which has the effect of not exposing all of the assets in the trust to the exercise of the power by its holder, just those that will benefit from an income tax basis adjustment.