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

8-Dec-20

Special Power of Appointment Trusts- A Second Bite of the Apple

Take-Away: There continues to be uncertainty whether there will be significant changes to the tax laws with the election of Vice President Biden, and the outcome of the election of the two Georgia senators. With that uncertainty comes the need to plan estates with some degree of flexibility to respond to future tax law changes initiated by the new President, or a Democrat controlled Congress. One way to build flexibility into an estate plan, including the desire to exploit favorable lifetime gifts at present, is through the use of a special power of appointment trust, or SPAT.

Background: Wealthy individuals understand the benefits of lifetime gifts to shift assets and future appreciation out of their taxable estates. The current tax environment, i.e. large gift tax exemptions that will expire in 2026 and low interest rates, encourages the use of lifetime gifts. Add to that environment of an uncertain administration and Congress in Washington D.C. along with the need at some time to address deficit spending to address the pandemic, and there is an even greater inducement to shift wealth at this time before the end of the year. However, a large lifetime gift often creates anxiety in the donor, who worries that he or she may have given away ‘too much’ with a large lifetime gift. Consequently, much sophisticated estate planning these days includes not only lifetime gifts to shift assets out of the donor’s taxable estate, but also mechanisms that permit the donor to gain access to the assets that were gifted earlier in time if ever needed. Enter the SPAT to add this flexibility.

SPAT Basics: With a SPAT the settlor creates an irrevocable trust and makes lifetime gifts to that trust. The lifetime gift is sheltered by the settlor-donor’s federal gift tax exemption which is currently $11.58 million, but which is scheduled to drop back to $5.0+ million in 2026. Under the SPAT a person is named in a non-fiduciary capacity to direct the trustee to make distributions to the settlor. The ability to direct the trustee to make the transfer out of the trust is a power of appointment. Specifically a special power of appointment. [MCL 556.112(i).]

  • Settlor: The settlor of the irrevocable trust is not the trustee, not a trust director, nor a beneficiary of the trust when assets are transferred to it.
  • Trust: The trust is irrevocable. However, the trust can be established where a trust director can be given the power to amend the trust, i.e. actions that might later benefit the settlor.
  • Not a Self-Settled Trust: By setting the trust  up this way, with the settlor not named as a beneficiary, the trust is not self-settled, which provides creditor protection.
  • Grantor Trust Classification: If the power of appointment holder is not an adverse party as defined in the Tax Code, the trust will be classified as a grantor [IRC 676 and 677.]
  • Trust Director: An individual is given a special, or limited, power of appointment. [MCL 552,112(i).] The holder possesses the power to appoint (or gift) trust assets to anyone except himself, his creditors, or the creditors of his estate. These limitations protect the trust director from having to include the value of the SPAT assets in the trust director’s taxable estate on death. [IRC 2514.] While the special power of appointment could be used to appoint only trust income to the settlor, normally the power is exercised to transfer an asset out of the SPAT to the settlor or other potential appointees defined in the class of appointees.
  • Special or Limited Power of Appointment: Usually the class of persons who might benefit from the exercise of this special power of appointment is much more narrowly described, yet the class as described could include the trust settlor as a potential appointee.
  • LLC: Often, for creditor protection purposes, the trustee of the SPAT will transfer the SPAT’s assets to an LLC. The settlor can act as manager of the LLC and thus still have control over the SPAT’s assets. The LLC could also be established with voting and non-voting interests depending upon the settlor’s needs. Arguably, the trustee of the SPAT would not have to know what the settlor was doing with the LLC’s assets if the SPAT is just an LLC member.
  • Overview: The settlor gives up dominion and control over the transferred assets that are held in the SPAT making a lifetime gift using the settlor’s lifetime gift tax exemption. Through the trust director exercising the special power of appointment the settlor can get the transferred assets back at a future date (if needed.)

SPAT Advantages: The primary benefit of a SPAT is derived from the fact that the settlor is not a beneficiary of the trust.

  • Access: While not a trust beneficiary, the special power of appointment can be exercised, if need be, to ‘give’ the SPAT’s assets back to the settlor at a future time, while also making the SPAT non self-settled, so as to obtain spendthrift creditor protection. If the settlor ever needs to access the SPAT’s assets, the special power of appointment can be exercised to move SPAT assets back to the settlor to meet his or her financial needs, thus adding the desired flexibility to the settlor’s estate plan.
  • Not a DAPT: While a Michigan Qualified Distributions in Trust, i.e. Michigan’s version of a domestic asset protect trust, or DAPT, could also be used by the settlor, not all states respect DAPTs, and a few states, e.g. California,  are particularly hostile toward DAPTs. Accordingly, unlike a DAPT, a SPAT can provide meaningful creditor protection in all 50 states, particularly if the settlor moves to a state that does not respect DAPTs.
  • Bankruptcy: Since the settlor retained no beneficial interest in the SPAT’s assets, if the settlor ever has to file for bankruptcy, the SPAT’s assets are not listed on the settlor’s bankruptcy schedule, unless they were transferred to the SPAT within 1-2 years of filing for bankruptcy. In short, the settlor can say with a straight face that he/she neither owns nor controls the SPAT’s assets when questioned under oath in a bankruptcy proceeding. Accordingly, a SPAT will typically survive bankruptcy without losing ownership of the trust’s property. In short, an irrevocable, non-self-settled spendthrift trust like a SPAT will not be available to the settlor’s creditors in a bankruptcy proceeding. [11 U.S.C. 541(c)(2).] With a DAPT, the trust assets have to remain in the DAPT at least 10 years to be fully protected if its settlor-DAPT-beneficiary has to file for bankruptcy, which is not the case with a SPAT. [11 U.S.C 548(e).]
  • Grantor Trust: A SPAT is typically set up as a grantor This results in simplified income tax treatment. The SPAT is disregarded as a separate entity from the settlor for income tax purposes, and the SPAT’s income is treated as if it were earned directly by the settlor and thus is reported on the settlor’s 1040 income tax return. Not having to file an extra income tax return for the SPAT thus reduces administrative distractions and expense.

Disadvantages of a SPAT:

  • Voidable Transaction?: Most SPATs are funded as gifts. A state’s voidable transaction act could be triggered with a gift, which might be a reversible transfer, if the gift rendered the settlor insolvent, or it was made to defraud, delay or hinder the settlor’s creditors. Each state has its own version of either the Uniform Voidable Transaction Act (Michigan) or the Uniform Voidable Transfer Act. A gift that renders the settlor insolvent is the most easily reversible type of transfer under either Uniform Act. A
  • Settlor a De facto Beneficiary?: If frequent distributions are made from the SPAT back to the settlor, a creditor might successfully argue that the settlor is a de facto trust beneficiary, even if he/she is not named as a beneficiary in the trust instrument. This might cause a judge to treat the trust as being self-settled in turn exposing trust assets to creditor claims.
  • Power Holder Acts Unexpectedly: The special power of appointment holder could ‘go rogue’ and appoint the SPAT’s assets to anyone other than himself or herself or his or her creditors. This risk can be minimized in two separate ways.

One way is to include in the trust instrument that a trust director (formerly called a trust protector) can veto the appointer’s actions, if not replace the appointer. While is it possible that the settlor could also retain this veto power over the appointer’s actions, that retained veto power by the settlor could cause the value of the SPAT’s assets to be included in the settlor’s taxable estate.

The other approach is to narrow the scope of the appointer’s special power of appointment in the trust instrument to a group or class of appointees that consists of the settlor’s grandparent’s descendants, i.e. a restricted class that would include the settlor who while not named, remains as a potential appointee.

Conclusion: Normally a SPAT is viewed as a powerful domestic asset protection device to shelter assets from creditor claims. A SPAT can also be considered as an alternative to a DAPT, such as Michigan’s Qualified Dispositions in Trust Act, if for some reason the restrictions and limitations required to establish a self-settled trust under that Act make it unavailable. The settlor’s ability to access assets transferred to an irrevocable trust at a future date may also prove to be the needed incentive to overcome the donor’s reluctance to make large lifetime gift at this time.