Tax Traps With Limited Powers of Appointment

Take-Away: The use of limited powers of appointment is increasing these days as individuals attempt to build flexibility into their estate plans while avoiding transfer taxation of their heirs. Conferring a limited power of appointment on a dynasty trust beneficiary is an excellent way to avoid estate taxes on the beneficiary’s death, yet give the beneficiary the ability to shift the economic benefit of the trust among future trust beneficiaries. As a general rule, the exercise of a limited power of appointment does not result in any taxation of the holder of the limited power of appointment. However there are two situations where the exercise of the limited power of appointment can cause taxation to the limited power holder: (i) the ‘Delaware Tax Trap’; and (ii) when a legal enforceable right held by the donee of the power of appointment is lost or released upon the exercise of the limited power of appointment.

Background:

Power of Appointment: A power of appointment is defined as a power that is created by a person having property subject to his or her disposition that enables the donee of the power to designate, within any limits that may be prescribed by the donor, the transferees of the property, or the shares of the interests in which it shall be received. A power of appointment also includes the power of amendment or revocation. [MCL 556.112(c).]
General Power of Appointment: A general power of appointment means a power the permissible appointees of which include the donee, or holder of the power, his or her estate, his or her creditors, and the creditors of his or her estate.[MCL 556.112 (h).]The property that is subject to a general power of appointment is subject to taxation on the power’s exercise (a gift tax is imposed.) Moreover, the property that is subject to the general power of appointment is subject to inclusion in the power holder’s taxable estate upon the holder’s death. Of importance is that the property that is subject to the general power of appointment is subject to estate taxation whether or not the power holder actually exercises the power. This means that an individual’s estate will pay estate taxes on assets that the individual never owned. Sounds un-American doesn’t it?
Limited Power of Appointment: A special or limited power of appointment is defined in the Michigan Powers of Appointment Act of 1967. [If you suffer from insomnia, I suggest you pull out this statute for an attempted quick read.] A special or limited power of appointment [they are the same thing, I just use the word limited ] is defined as a power, the permissible appointees of which do not include the donee, his or her estate, his or her creditors, or the creditors of his or her estate. [MCL 556.112 (i).]
Control, not Ownership: In short, a power of appointment gives control of wealth to its holder, which is arguably the next best thing to owning that wealth. If the wealth that is subject to that power of appointment is not owned, as a generalization, it cannot be taxed by the IRS, nor is it available to satisfy the claims of the power holder’s creditors. That, in a nutshell, is why limited powers of appointment are popular in estate planning these days.
Dynasty Trusts: The consequence of a limited power of appointment can explain, in part, the recent proliferation in dynasty trusts. A dynasty trust is set up for the child’s lifetime, normally giving the trustee the power to distribute trust income or principal, or both, to or for the benefit of the child. The child-beneficiary is also given a testamentary limited power of appointment over the trust corpus, enabling the child on his or her death to appoint the trust assets to or for the benefit of the settlor’s descendants, i.e. the child’s children. If the power is not exercised by the deceased child, then the trust assets are distributed to the settlor’s descendants according to the terms of the trust instrument. None of the assets that comprise the trust corpus are includible in the child’s taxable estate for estate tax calculation purposes since the child holds only a limited power of appointment. For example, if one of the settlor’s descendants is disabled, the child can exercise the limited power of appointment over the trust to disinherit that descendant, or to create a special needs trust for that disabled descendant so as to not jeopardize that descendant’s eligibility to receive governmental benefits. Thus, the ultimate distribution of the trust corpus can be modified using the limited power of appointment to adapt to the changing needs of the settlor’s descendants, which adds tremendous flexibility to the dynasty trust.
Rhetorical Question/Planning Considerations: With the addition of another $5.6 million in an individual’s federal gift and estate tax exemption arising from the Tax Cuts and Jobs Act, even fewer estates will be exposed to federal estate taxation (at least until 2026.) Since the assets subject to a testamentary limited power of appointment will not be exposed to federal estate taxation on the power holder’s death, they will also not be subject to an income tax basis adjustment under IRC 1014. The loss of the income tax basis adjustment on the power holder’s death may no longer be an acceptable outcome when estate taxes are no longer a worry, and could cause the proliferation in dynasty trusts to considerably slow. Then again, who knows what the estate tax rules will be beginning in 2026 (or earlier if there is a change in administrations in Washington.) Maybe the best way to respond to this uncertainty is to create the conventional dynasty trust which gives to the trust beneficiary a testamentary limited power of appointment over the trust assets, but also give in the same trust instrument to a trust protector the power to convert the testamentary limited power of appointment to a testamentary general power of appointment, which would then cause the trust corpus to be included in the power holder’s taxable estate, leading to an income tax basis adjustment to the trust assets’ fair market value on the power holder’s death. Alternatively, the trust protector could be given a power to ‘cherry pick’ trust assets (with a low income tax basis) that could be made subject to a testamentary general power of appointment held by the trust beneficiary, so only certain assets would be subject to the income tax basis (‘step-up’) adjustment.

Taxation of Limited Powers of Appointment: As previously noted, generally there are no tax consequences associated with the exercise of a limited power of appointment, unlike a general power of appointment. But there are two major exceptions or ‘traps’ to this general rule.

Delaware Tax Trap: You have heard about this trap (or technique) before from me. The Tax Code contains an exception which causes the value of property that is subject to a limited power of appointment to be taxed in the power holder’s estate. But unlike the general power of appointment which causes estate inclusion merely by passively holding the general power of appointment at the time of death, this exception requires the holder to affirmatively act to trigger the estate inclusion by actually exercising the limited power of appointment. The Tax Code [IRC 2041(a)(3) and IRC 2514(d)] contains ‘wordy’ exceptions to the general rule that there is no taxation on the exercise of a limited power of appointment. If the holder of a limited power of appointment in trust exercises the power appointing the property subject to the power to a second trust [stacking a second trust on the first trust] where the beneficiary of the second trust holds a presently exercisable general power of appointment over that second trust (which in most jurisdictions commences a new rule against perpetuities) then that exercise of the limited power of appointment will cause the appointed property to be included in the donee’s taxable estate. In sum, the donee’s exercise of the limited power to create a new general power held by a permissible appointee selected by the donee will cause estate taxation for the donee. [Head spinning yet?]Historically this trap was thought to be a bad thing, that is until estate tax exemptions began to explode in size; now there is an interest in including the value of trust assets in a power holder’s taxable estate in order to expose those assets to a valuation adjustment under IRC 1014.

Example: “I hereby exercise the testamentary limited power of appointment that given to me by my father in his Trust dated December 23, 2005, found Section 3.03 over the trust share created for my lifetime benefit, and I hereby direct the transfer and I appoint the assets held in that trust share, in further trust to John Smith, Trustee, to be held in trust for the benefit of my son Jake, and I give to my son the right to receive all of the income from the trust that is created for my son, and I also give to my son a general lifetime and testamentary power of appointment over the assets held in the name of that trust that is to be established for my son’s benefit.”

Loss of An Interest in The Property: An example might help to explain this fairly innocent ‘trap.’

Facts: Husband dies in 2012. His estate initially funds a credit shelter trust for the benefit of his surviving wife. The credit shelter trust holds $5.0 million in appreciating assets. The widow is given the right to all of the credit shelter trust’s income, payable quarter-annually to her. The trustee also possesses the discretion to invade trust principal to meet the widow’s health and support needs that cannot be met with her own financial resources. The widow is also given a lifetime and a testamentary limited power of appointment over all of the trust’s assets with the ability to appoint them to or for the benefit of a class that consists of husband’s descendants, i.e. their children and grandchildren. If the widow dies holding these limited powers of appointment over the credit shelter trust, none of the trust’s assets will be included in the widow’s taxable estate. (That’s the general rule.) Child comes to his mother, the lifetime income beneficiary credit shelter trust, and asks for financial help to pay off his mortgage. Widow-mother wants to make the gift to her son. She knows that the appreciation of assets held in the credit shelter trust will not receive a step-up in income tax basis on her death, unless she intentionally triggers the ‘Delaware Tax Trap,’ but her son needs the money now, not when she dies. The widow also knows that her own assets held in her own name will receive an income tax basis adjustment on her death, so she is not inclined to liquidate her own assets and incur a capital gain to make the gift to her son, wanting to hold onto those assets in her name to gain the income tax basis ‘step-up’ on her death. Consequently, the widow-mother decides to exercise her lifetime limited power of appointment over the credit shelter trust in favor of her son, directing the trustee to transfer trust assets to her son of $100,000 to enable him to pay off his mortgage.

Normally the exercise of a lifetime limited power of appointment does not result in a taxable gift (lifetime or on death.) But when a property interest is lost upon the exercise of the limited power of appointment, then a taxable gift arises. The gift is not the value of the assets that were appointed to the recipient, in the example, the $100,000. Rather, the gift is the value of the income interest that was eliminated when the $100,000 of assets were appointed from the credit shelter trust. In the example, if $100,000 of credit shelter trust assets were transferred as a result of the widow’s exercise of her limited power of appointment to enable her son to pay off his mortgage, she is effectively giving away to him the income that the $100,000 would have generated if that amount had been retained in the credit shelter trust, income to which she had the right to receive but will no longer receive. Thus, by the exercise the lifetime limited power of appointment in favor of her son, the widow is making a gift of the present value of the foregone trust income that the $100,000 would have generated over the balance of her lifetime. This ‘gift’ needs to be reported on a Form 709 gift tax return by the widow (not the trustee of the credit shelter trust) for the year in which the lifetime limited power of appointment was exercised. This is the formal position taken by the IRS and confirmed in Tax Court cases- Dietz, Tax Court Memo, 1996-471 (1996.) If appreciated assets are transferred to the son from the credit shelter trust, he will take the lower income tax basis in those transferred assets, and when those assets are liquidated by him, he will incur capital gains. If cash had been distributed from the credit shelter trust to the son, there would be no gain to be recognized by him, but widow would still be treated as having gifted to her son the income interest that the $100,000 of cash would have generated the balance of her life expectancy.

Note that if the credit shelter trust in the example had provided that the widow, along with the settlor’s descendants, i.e. their children, were all discretionary income beneficiaries of the trust, then the widow would not have held any ‘right’ to all of the trust’s income, and thus upon the widow’s exercise of her limited power of appointment, there would have been no taxable gift by her when the distribution was made, as she was not entitled, as a matter of any legally enforceable right, to receive the income the $100,000 would have generated. In short, depending upon how the credit shelter trust is drafted, a gift tax may, or may not, be incurred if the limited power of appointment is exercised.

Conclusion: When you review trust instruments on behalf of Greenleaf Trust clients, and you note the existence of a limited power of appointment that is conferred on one or more trust beneficiaries, you should note both its existence and whether a lifetime exercise of that limited power of appointment will cause a gift tax to be incurred. If describing the terms of the trust to a trust beneficiary who is granted a testamentary limited power of appointment, while it is important to mention that normally the existence of the limited power of appointment in the trust will not cause additional estate tax liability, you should remind them to be wary to not inadvertently trigger the Delaware Tax Trap. Finally, if clients are interested in ‘free-basing’ to obtain the step-up in basis of assets held in trusts, consider expanding the power of a trust protector to convert a limited power of appointment to a general power of appointment, over some or all of the trust’s assets.