This is another in a series of blogs on the basics of estate planning.
The last blog examined the basics of powers of appointment. This blog will examine how they can impact taxation. From a gift and estate tax perspective, there are two kinds of powers of appointment, a limited power of appointment (or “LPOA”), and a general power of appointment (or “GPOA”). They can cause dramatically different gift and estate taxation results, as well as income taxation results.
A general power of appointment is one that may be exercised in favor if the powerholder or the powerholder’s estate, or the creditors of either. It doesn’t matter if the power also may be exercised in favor of other people. If it is possible for the powerholder to exercise the power in favor of one of those categories, it is a general power of appointment, even if, in fact, it is never exercised in that manner.
A general power of appointment is one that causes inclusion in the taxable estate of the holder. Unless the holder has an estate, including the assets, of more than the federal exclusion, currently $5.49 million, the inclusion will not cause a federal estate tax. However, the mere inclusion in the estate does cause a change in the income tax basis of the assets to the value as of the date of death. Generally, this is advantageous. Let’s look at a quick example. A trust is set up and it includes a farm.
The farm was purchased for $50,000, but is now worth $3 million due to development pressure. Johnny dies with a general power of appointment over the farm. The farm is included in Johnny’s taxable estate, even though Johnny did not exercise the power of appointment and the farm actually goes to others pursuant to the terms of the trust. Since it was included for estate tax purposes in Johnny’s estate, the farm’s income tax basis is changed to $3 million, i.e., the value at Johnny’s death. Johnny had a home and other assets when he died which totaled $2 million. Since the total value of his estate was “only” $5 million, i.e., less than Johnny’s exclusion of $5.49 million, there’s no federal estate tax to be paid.
Conversely, a limited power of appointment is one that may not be exercised in favor of the powerholder, the powerholder’s estate, or the creditors of either. A limited power will not cause inclusion in the estate of the powerholder, and hence will not cause a change in income tax basis in the property subject to the power. (However, if the powerholder is the grantor of the trust, there will be inclusion in the estate of the powerholder/grantor under Section 2038 because of the retained control.)
Thus, powers of appointment can be very helpful when used wisely in an estate plan. A power of appointment adds flexibility, as discussed in Part 1 of this article. A power of appointment can also help achieve the tax results desired, such as non-inclusion in the taxable estate (LPOA), or inclusion in the taxable estate and a change in basis in the assets (GPOA). Consider including powers of appointment to add flexibility and the desired tax treatment.
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
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