Estate Planning attorneys have a difficult job. They need to understand each client’s family dynamic, identify areas of concern, provide advice regarding the best course of action, and consider potential tax ramifications while protecting beneficiaries from themselves. All that occurs before the attorney ever puts pen to paper. The attorney then needs to create documents that accomplish these competing goals while considering facts and circumstances that may impact the effectiveness of the plan in the future. Sounds impossible, right? It’s not. It just takes careful consideration of all the tools an Estate Planning attorney has at their disposal. A power of appointment is one of those tools. In simple terms, practitioners use powers of appointment to provide flexibility. Powers of appointment allow the holder to direct his or her share of property held in Trust to another individual or entity, either outright, or in continuing trust. Powers of appointment exist in two types, general or limited, sometimes called special.
An individual holding a general power of appointment (“GPOA”) may exercise that power in favor of anyone or any entity including themself, their estate, or the creditors of either. The GPOA has no restrictions. If the holder has a GPOA over assets, that causes inclusion of those assets in the holder’s taxable estate. As a result, the assets subject to the power get a step-up (or -down) in basis at the death of the holder. Sometimes, drafting attorneys include a GPOA to prevent another result. For example, many practitioners include language that permits an Independent Trustee to give a beneficiary a GPOA to avoid the application of undesirable tax consequences. If the Independent Trustee grants this power, then the powerholder’s estate will include the assets subject to the power, even if the powerholder fails to exercise the power. Holding the GPOA causes estate tax inclusion. It matters not whether the powerholder exercises the power.
A beneficiary holding a limited power of appointment (“LPOA”), by contrast, cannot appoint the assets to themself, their estate, or the creditors of either. The donor granting the LPOA may impose additional limits, but usually the beneficiary may exercise the LPOA in favor of a very broad class, including any one of the billions of people on earth. The overarching prohibition exists only as to the beneficiary, the beneficiary’s estate, or the creditors of either. An LPOA does not cause inclusion in the holder’s taxable estate and does not cause a step-up (or -down) in basis if the LPOA is not retained by the grantor of the trust. The LPOA gives the beneficiary the opportunity to use the information existing at their death to direct to whom assets will be distributed, without subjecting the assets to estate tax.
In creating an LPOA, you must employ care in drafting to make clear what constitutes the appropriate exercise of the LPOA. For example, the powerholder may exercise the power during life. Conversely, you may prefer to allow exercise only at the powerholder’s death. Perhaps the exercise should occur in a Will, Trust, or other writing. Regardless of the requirements, it’s vital for the proper exercise of the LPOA that the powerholder exercise the power in exactly the manner described in the granting document. When exercising the power, the powerholder should reference the power with as much specificity as possible. If the holder fails to follow the precise requirements for exercise, then the powerholder has not exercised the power.
Let’s review a quick example that demonstrates the power of an LPOA. Suppose a spouse establishes a trust for their surviving spouse and gives that surviving spouse an LPOA over the trust assets remaining at death to their descendants. If the spouse fails to exercise the power, then the trust assets will pass in equal shares to the couple’s children. If one of those children recently became a multi-millionaire, while another struggles to pay bills, that power allows the surviving spouse to alter the distribution pattern to account for those changes. Perhaps a third child recently had a disabling accident and now receives government benefits. The surviving spouse could use the LPOA to appoint assets for the disabled child to a newly created stand-alone trust.
Powers of appointment provide a great option to add flexibility to an Estate Plan. They give the powerholder the ability to account for changes in circumstances that were not contemplated at the time the plan was created. They allow a beneficiary to adjust a distribution pattern to ensure a more equitable distribution of assets gifted to them but left to their descendants upon their death. The trust or other instrument granting the power may provide requirements for the effective exercise of the power and it’s vital to exercise the power exactly as required.
Tereina Stidd, J.D., LL.M.
Associate 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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