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

20-Feb-20

Powers of Appointment – Lapses and Releases

Take-Away: Much attention is given these days to powers of appointment, either in connection with adding flexibility to dynasty-type trusts, or to intentionally expose the value of trust assets to estate inclusion in cause an adjustment to the income tax basis in a trust’s assets in the hands of the remainder beneficiaries, or to eliminate a general power of appointment due to the beneficiary’s creditor threats. Planning with powers of appointment requires a working knowledge of releases and lapses of existing powers of appointment. The key difference is that a release  of a power of appointment carries transfer tax consequences, while a lapse of that same power of appointment normally is without tax consequences. Example: A trust beneficiary who possesses a crummey withdrawal right should never release or waive that right. Rather, that beneficiary should merely permit their withdrawal right to lapse by its own terms.

Background: A power of appointment is normally given to an individual who is expected to live longer than either the testator or settlor. The thought is that the holder of the power of appointment will be in a better position to make a wiser choice of who should receive trust property, how much, and what combination of principal or income should be paid. A power of appointment is especially beneficial when there are many beneficiaries to a trust or estate. A power of appointment is always discretionary and can be given to anyone, but usually it is given to a trust beneficiary. Unlike a trustee who owes a fiduciary duty to beneficiaries of a trust, the holder of the power of appointment owes no duty to anyone and the holder may choose not to exercise the appointment, and may even choose to release the power of appointment.

Tax Code Sections: The tax consequences of a general, or limited, power of appointment are addressed in several different the Tax Code sections.

  • IRC 2041(b)(1): A general power of appointment is a power that is exercisable in favor of the decedent, the decedent’s estate, the decedent’s creditors, or the creditors of the decedent’s estate. [The assets subject to a general power of appointment are available to satisfy the claims of the general power of appointment holder.]
  • IRC 2041(b)(2): The lapse of a power of appointment will be considered a release of that power. Exception: This rules applies with respect to the lapse of powers of appointment during any calendar year but only to the extent that the property which could have been appointed by the exercise of such lapsed power, exceeded in value at the time of that lapse, the greater of the following amounts: (i) $5,000 or (ii) 5% of the aggregate value, at the time of the lapse, of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could have been satisfied. [This is the source of a beneficiary’s 5+5 power of withdrawal right found in many trusts.]
  • IRC 2041(a)(2): The value of a decedent’s gross estate includes the value of all property to the extent of any property with respect to which the decedent has at the time of his or her death a general power of appointment, or with respect to which the decedent has at any time exercised or released such power by a disposition which is of such nature that if it were a transfer of property owned by the decedent, such property would be includible in the decedent’s gross estate under IRC 2035 to 2038 inclusive, e.g. a release of a power of appointment within three years of the power holder’s death.  A power of appointment will be considered to exist on the date of the decedent’s death even though the exercise of the power is subject to a precedent giving of notice and even though the exercise of the power takes effect only on the expiration of a stated period after its exercise, whether or not on or before the date of the decedent’s death notice has been given or the power has been exercised. [This is the cause of may ‘free-basing’ strategies used to intentionally cause estate inclusion of assets that are subject to a general power of appointment, to gain the income tax basis adjustment due to estate inclusion.]
  • IRC 2501(a)(1): A tax is imposed for each calendar year on the transfer of property by gift by an individual . IRC 2511(A)(1): A gift tax is tax applied whether the transfer is in trust, whether the gift is direct or indirect, and whether the property is real, personal or intangible.
  • IRC 2514(b): The exercise or the release of a general power of appointment is deemed a transfer of property by the individual who possesses that power of appointment. [This is the trap for a crummey beneficiary who releases his/her right to withdraw assets transferred to the trust.]
  • IRC 2514(c): The lapse of a power of appointment during the life of the person who holds the power is considered a release of that power. However, this treatment applies with respect to a lapse of powers during any calendar year only to the extent that property which could have been appointed by exercise of such lapsed powers exceeds in value the greater of the following amounts: (i) $5,000 or (ii) 5% of the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapses powers could be satisfied. [Again, this is the source of a trust beneficiary’s 5+5 withdrawal right found in many trusts.]

Releases: Unless the instrument creating the power of appointment manifests a contrary intent, the power of appointment may be released, in whole or in part, by the holder of the power of appointment.  Rather than exercising the power of appointment, the holder can release the power, either completely or partially. The release can specify the appointive property, or limit the permissible appointees. Generally, a release has the same effect as if the appointment was never exercised.  In essence, the holder is effectively saying that he/she will never exercise the appointment. Consequently, a release of the power of appointment has the effect of an appointment that was never exercised, but is fixed at the time of the of the release. A general power of appointment can be released in part, which makes it a limited (or non-general) power of appointment. However, such a release may be a taxable event for gift of estate tax purposes, or it may not prevent the holder from being treated as continuing to hold a general power of appointment.  In short, a release of a general power of appointment, either during lifetime or testamentary, that involves the disposition of property that would be covered by IRC 2036-to IRC 2038 is the equivalent to the actual exercise of the power of appointment.

Grantor Trust Implications: The holder of a power of appointment is treated as the owner for federal income tax purposes of any portion of a trust for which the power holder possesses the power exercisable solely by himself to vest the trust  corpus or the income from the trust in himself. Exceptions to this general rule are: (i) if the settlor of the trust is considered the owner of the trust for income tax reporting  purposes [IRC 678(b)]; (ii) if the power of appointment holder, acting in the capacity as trustee or co-trustee, merely applies trust income to support or maintain a person whom the power holder is obligated to support or maintain [IRC 678(c)]; and (iii) the power holder disclaims the power of appointment within a reasonable time after becoming  aware of the existence of the  power of appointment. As a general rule, to the extent the individual who did not create a trust possesses the unilateral right to withdraw the income or principal of the trust, or has previously partially released  or otherwise modified the power but has retained after such release or modification such ‘control’ so the income, deductions and credits would be attributed to the individual under the grantor trust rules of IRC 671-677, then the income, deductions and credits of the trust are attributed to the individual, unless the income, deductions and credits would otherwise be attributable to the grantor. [IRC 678.] Accordingly, a unilateral exercise of a general power of appointment will trigger application of IRC 678 (the so called Beneficiary Owned Trust rule.)

Lapses: The distinction between a lapse of a power of appointment and a release of the power of appointment is that the lapse is a failure to exercise the power of appointment within a specified time, such that the power expires under its own terms, not by the power holder’s intentional act.

  • Example #1: A lapse of a crummey withdrawal right reflects this rule. Assets are transferred to a trust. The beneficiary of the trust is given the right to withdraw the transferred assets, up to $15,000 a year, but the withdrawal right must be exercised within 45 days of the notice of the  transfer of the assets to the trust. If the beneficiary fails to exercise his/her right of withdrawal within the allotted time period,  then their withdrawal right The beneficiary is not treated has having made a contribution of their own assets to the trust. Therefore, the beneficiary is not treated for transfer tax purposes has having made a taxable transfer with a retained right to the transferred asset.
  • Example #2: A trust beneficiary is given the right to withdraw 5% or $5,000 (whichever amount is larger) of a trust’s corpus each year, commonly known as the 5+5power. A credit shelter trust is created for the surviving spouse. The surviving spouse is given the right, on December 1 of each year, to withdraw either 5% of the trust’s assets or $5,000 (whichever is larger) prior to the end of that calendar year. Failure to exercise the right of withdrawal, which is technically a power of appointment, results in a lapse of the spouse’s withdrawal right. Therefore, the surviving spouse is not treated as having made a transfer of his/her own assets to the trust, and as a result the value of the credit shelter trust’s assets are not dragged back into the surviving spouse’s taxable estate under IRC 2036 (a lifetime transfer with a retained right to the transferred assets’ income.) Note that if the beneficiary’s withdrawal right exceeds the 5+5 threshold, the lapse will only be treated as to the 5+5 amount, i.e. the excess is treated as a taxable release by the trust beneficiary.

Treasury Regulations: The Regulations provide some helpful analysis of the distinction between a lapse and a release of a power of appointment, but they can also be a bit confusing since some lapses are treated as  taxable releases.  [Treas. Reg. 25.2514-3 (4).]

  • A release of a power of appointment need not be formal or express in character. For example, the failure to exercise a general power of appointment created after October 21, 1942,within a specified time so that the power lapses, constitutes a release of the power. In any cases where the possessor of a general power of appointment is incapable of validly exercising or releasing a power, by reason of minority, or otherwise, and the power may not be validly exercised or release on his behalf, the failure to exercise or release the power is not a lapse of the power. If a trustee has in his capacity as trustee a power which is considered as a general power of appointment, his resignation or removal as trustee will cause a lapse of his power. However, section 2515(e) provides that a lapse during any calendar year is considered as a release so as to be subject to the gift tax only to the extent that the property which could have been appointed by the exercise of the lapsed power of appointment exceeds the greater of (i) $5,000 or (ii) 5 percent of the aggregate value, at the time of the lapse, of the assets out of which, or the proceeds of which, the exercise of the lapse power could be satisfied. For example, if an individual has a noncumulative right to withdraw $10,000 a year from the principal of a trust fund, the failure to exercise this right of withdrawal in a particular year will not constitute a gift if the fund at the end of the year equals or exceeds $200,000. If, however, at the end of the particular year the fund should be worth only $100,000, the failure  to exercise the power will be considered a gift to the extent of $5,000, the excess of $10,000 over 5 percent of a fund of $100,000. Where the failure to exercise a power, such as a right of withdrawal, occurs in more than a single year, the value of the taxable transfer will be determined separately for each year.

Disclaimers: As a matter of common law, a power of appointment may be disclaimed. [IRC 2518; Treas. Reg. 25.2518-3(a)(1)(iii.)] If the disclaimer by the holder is made within 9 months after the power of appointment is created, it will be a qualified disclaimer, without any gift tax consequences to the disclaimant,  and it will not be considered a release of the power of appointment  for gift tax purposes. [ Treas. Reg. 2514-3(5).] Note, a disclaimer of a power of appointment is not identical to a disclaimer of an appointment by the appointee for whose benefit the power is exercised; the appointee (or taker-in-default) may disclaim the interest in the appointed property within 9 months after the power of appointment is created in order to avoid it being treated as a taxable gift by the disclaimant. As noted above for grantor trusts,  release of a power of appointment, as opposed to a qualified disclaimer of the power of appointment, must be within a reasonable time. [IRC 678.] This is in contrast to the qualified disclaimer rule which uses a fixed 9 months from the property interest’s creation.