11-Oct-21
Mistakes Exercising a Power of Appointment
Take-Away: A power of appointment can be exceptionally helpful to change the ultimate disposition of property under a Will or Trust to address changes in the law or changes in a beneficiary’s circumstances. However, there are always traps to be wary of when exercising a power of appointment.
Background: A power of appointment is not a property interest; rather it is merely a right or power. A power of appointment can add considerable flexibility to an estate plan to permit the powerholder to alter the original planned distribution of assets held in trust to adapt to subsequent changes in laws or a beneficiary’s circumstances. Tax reasons can also motivate the grant of a power of appointment: (i) it can be used to create and incomplete gift to reduce transfer taxes; (ii) it can be used to force assets into a beneficiary’s taxable estate to incur an estate tax rather than a generations skipping transfer tax; and (iii) it can force assets into the powerholder’s estate to take advantage of the step-up in basis. [IRC 1014.]
Tax Consequences: The tax consequences of holding a power of appointment are covered either in IRC 2041 (estate) or IRC 2514 (gift.) Tax consequences turn on whether the power of appointment is a general power of appointment, which is taxable to the powerholder, or a limited power of appointment (also called a special power of appointment) which is generally not taxable to the powerholder.
Estate Tax: If the power of appointment is a general power of appointment [meaning the power can be exercised in favor of the holder of the power, the powerholder’s creditors, the powerholder’s estate, or the creditor’s of the powerholder’s estate,] then the value of the asset that is subject to the general power is included in the powerholder’s estate for estate tax calculation purposes. It does not matter whether the decedent actually exercised the general power of appointment for estate tax inclusion purposes. All that is required is that the decedent held the general power of appointment at the time of his/her death. Moreover, the value of the assets subject to the general power of appointment will be included in the decedent powerholder’s estate even if the general power had lapsed prior to the decedent-powerholder’s death. [IRC 2041(a)(2); Regulation 20.2041-3(a)(2).]
Gift Tax: For federal gift tax purposes, the exercise of a general power of appointment in favor of someone other than the powerholder or the powerholder’s creditors is deemed to be a transfer of the underlying property by the powerholder for gift tax purposes and the transfer will be treated as a taxable gift. [IRC 2514(b).] The lifetime release of a general power of appointment by the powerholder is treated the same as an exercise and thus is considered a transfer by the powerholder for gift tax purposes.
Ascertainable Standard: The use of an ascertainable standard avoids giving a beneficiary a general power of appointment. For example, if a surviving spouse is named as trustee and beneficiary of a credit shelter trust, the trustee powers conferred on the surviving spouse are in effect a power of appointment. By limiting the exercise of that discretionary power by an ascertainable standard, the credit shelter trust’s assets will not be exposed to estate taxation when the surviving spouse-trustee dies. [Regulation 20.2041-1(c).] While often the ascertainable standard is causally referred to as simply HEMS, the Regulations provide a slightly more expansive definition for the standard:
Health, including medical, dental hospital and nursing expenses and expenses of invalidism. Education, including college and professional education. Support in reasonable comfort, maintenance in health and reasonable comfort, support in his or her accustomed manner of living.
Support Obligations: A power of appointment that is exercisable for the purposes of discharging a legal obligation of support of the powerholder is considered a power of appointment exercisable in favor of the powerholder or the powerholder’s creditors, and thus treated as a general power of appointment. [Regulation 20.2041-1(c).]
Delaware Tax Trap: This trap refers to IRC 2041(a)(3)and IRC 2514(d). Both of these Tax Code sections provide that property that is subject to a power of appointment is included in the powerholder’s transfer tax base if the powerholder:
Exercises a power…by creating another power of appointment which under the applicable local law can be validly exercised so as to postpone the vesting of [interests in the assets], or suspend absolute ownership or power of alienation of such [assets] for a period ascertainable without regard to the date of creation of the first power.
In effect, the Delaware tax trap provisions transform a limited power of appointment into a general power of appointment if he powerholder exercises the power by appointing the property to a new trust with a term that extends beyond the perpetuities period governing the property that is subject to the original limited power of appointment. When the Delaware tax trap is ‘sprung’ the underlying property will be included in the limited powerholder’s transfer tax base. This trap can be avoided if upon exercising the second power, the second power is restricted to the perpetuities period of the original power. [Private Letter Ruling 200535009.]
Mistakes Exercising a Power of Appointment: While avoiding the Delaware Tax Trap is most commonly mentioned when dealing with powers of appointment, several other mistakes can be made which courts have used to not recognize a powerholder’s attempted exercise of a power of appointment. The language that grants the power of appointment most likely will dictate how the power must be exercised; normally it directs the powerholder to exercise the power in the powerholder’s Will with specific reference to the power. Sometimes the power conferring provision goes to the point or requiring the powerholder’s Will be admitted to probate
Not Exercising the Power in the Proper Document: The requirement for the powerholder to exercise the power is almost always described in the document which grants the power. Therefore, in order to validly exercise the power of appointment, the directions must be closely followed. Consequently, if the document specifies that the power of appointment must be exercised in the powerholder’s Will that is formally admitted to probate, the attempted exercise in the powerholder’s revocable trust will not work. It must be in the powerholder’s Will, and that Will must be formally admitted to probate for the power to be validly exercised.
Example: Widow and personal representative sought a declaration that her deceased husband had exercised a power of appointment under a trust created by her father in law. Husbands children intervened and claimed their father did not exercise the power of appointment in the manner prescribed by the trust. Husband’s Will left his entire estate to his wife. The wife offered evidence that her husband’s intent was to exercise the power of appointment given to him by his father’s trust. The Court held that the husband’s intent to exercise the power of appointment was immaterial in light of his failure to comply with the specific reference requirement imposed by the trust. Talcott v. Talcott, 423 So. 2d 951 (Florida Appeals, 1982.)
Not Making Specific Reference to the Power to Appoint: Usually the power of appointment must be specifically referred to in the powerholder’s Will, i.e. the source document where the power of appointment was conferred on the powerholder. If the powerholder’s Will’s residuary clause merely refers to “and all property over which I hold a power of appointment,” that statement will be insufficient to exercise the power of appointment. There must be a clear intent on the part of the powerholder to exercise the power of appointment; a somewhat generic reference to ‘all powers of appointment’ in the residuary clause will not suffice.
Example: Sally died in 2011. Her Will left the ‘rest, residue and remainder’ of her estate to Joanne. The decedent’s Will also contained a provision ‘included in my estate assts are the Stanton Kettler Trust f/b/o Sally held at Morgan Stanley Trust. Sally’s Will did not contain any other reference to the Trust, nor did it mention any power of appointment in the Trust held by Sally. The court found that Sally’s Will failed to reference the Trust and was therefore invalid. The appeals court noted that while its conclusion led to a harsh result, “whether a donee has validly exercised a power of appointment depends not on the intent of the donee, but on whether the power was exercised in the manner prescribed by the donor.” Cessac v. Stevens, 127 So. 675 (Florida Appeals, 2013).
Exercising the Power for Improper Appointees: Usually a power of appointment describes a group of potential appointees of the power, e.g. to the descendants of the powerholder. For example, a powerholder may exercise the power of appointment in their Will, appointing the property subject to the power to the powerholder’s revocable trust. That exercise would be improper, when the trust provides for the payment of the powerholder-settlor’s debts, expenses and taxes. A limited power of appointment does not allow assets that are subject to the power to be appointed to creditors of the powerholder.
Example: A surviving spouse was given powers of appointment over both a marital and credit shelter trust by her late husband. The widow then remarried. On her subsequent death her Will’s residuary clause left ‘all the rest, residue and remainder of my property, both real and personal of every kind or nature and of which I may have a power of appointment to my husband. The Pennsylvania Supreme Court found that the language of the residuary clause did not comply with the trust’s language and fulfill the donor’s condition and thus was not a valid exercise of the limited testamentary power of appointment given to the widow. Estate of Schede 231 A.2d 135 (1967).
Example: The powerholder’s parents created trusts in which the powerholder was given a limited testamentary power of appointment. The powers of appointment gave the powerholder the ability to appoint the assets in further trust to his spouse, descendants, and their spouses. The powerholder attempted to exercise the powers of appointment in favor of his revocable trust of which his spouse was the beneficiary. The court held that the attempted exercise of the power of appointment in favor of the powerholder’s revocable trust was void because the appointment was in favor of an impermissible appointee: “ If the donee of a special power of appoints a beneficial interest to a non-object of the power, the appointment is ineffective.” In addition, the court noted that the appointed assets, if they were transferred to the powerholder’s trusts, those assets would be commingled and could be used to pay debts of the decedent’s estate, which is not permissible with a special power of appointment. BMO Harris Bank, v. Towers, 43 N.E. 1131 (Illinois Appeals, 2015.)
Example: Valerie was given the authority in a trust created by her husband Harry to appoint the trust assets to “any one or more of the issue of Valerie and myself, and the spouses of such issue.” Valerie exercised the power of appointment in her Will. The effect of her exercise was to benefit her grandchildren who were residuary beneficiaries. The Court found that the language of the power of appointment “the issue of Valerie and myself and the spouses of such issue” meant only Valerie’s two daughters, not her grandchildren. Her attempted exercise of the power was an invalid exercise of he power as it would have expanded the scope of permissible appointees to persons who were not authorized by Harry, the donor of the power. Kramer v. Freedman, 346 So. 2d 1216 (Florida Appeals, 1977.)
Exercising the Power Over Property Not Included in the Power: Sometimes a power of appointment is given only over income, but not the property that generates the income. The exercise of the power of appointment beyond income would be an invalid exercise of the power of appointment. The same result occurs if the power was limited to real estate, yet the powerholder attempted to exercise the power over all assets held in a trust.
Governing Law: In 2013 the Uniform Law Commission created the Uniform Power of Appointment Act. Ten states have adopted that model Act, but not Michigan. Of interest is that the model Act changed the rules with regard to the law that governs a power of appointment. The model Act reversed the common law rule that both the creation and the exercise of the power of appointment would be governed by the law of the person who created the power of appointment. The model Act follows the Restatement (Third) of Property, Wills and Other Donative Transfers (Section 19.1, comment E) to provide that the creation of the power of appointment (or its revocation or amendment) is governed by the law of the creator’s domicile, while the exercise, release, or disclaimer of the power of appointment is governed by the powerholder’s domicile. Since Michigan has not [yet] adopted the Uniform Power of Appointment Act, it is presumed to follow the common law that the creator’s domicile controls both the creation and the exercise of the power of appointment. This change could result in some confusing conflict-of-law situations if the powerholder of the power of appointment resides in a state which has adopted the Uniform Power of Appointment Act and not in Michigan.
Conclusion: Powers of appointment are a popular and useful way to make trusts more flexible to meet the needs of the trust beneficiaries. That said, great care needs to be taken to be assured that the power of appointment is properly executed to assure that it will be effective.