One often misunderstood yet valuable estate planning tool found in legal documents is the power of appointment. It should not be confused with a power of attorney, which delegates certain powers to an agent while the individual is alive. The power of appointment, when used wisely, can provide significant flexibility in an otherwise irrevocable estate plan.
In essence, a power of appointment grants a person (the donee or power holder) the right, as stipulated in a will or trust, to name someone else (the appointee) to receive all or part of the donor’s money and property in the future. The donee is not obligated to exercise this power; rather, they have the option to do so. If left unused, the assets will pass to the original beneficiaries as specified in the estate plan.
There are two types of powers of appointment: general and limited. A general power allows the donee to distribute assets to themselves, their estate, creditors, or their estate’s creditors. On the other hand, a limited power is more specific and can be restricted to particular purposes, like providing for a beneficiary’s education or healthcare.
These powers can either be lifetime or testamentary. A lifetime power of appointment can be exercised during the donee’s lifetime, while a testamentary power is activated after the donee’sdeath, often through a provision in their will or trust.
There are several reasons to include powers of appointment in an estate plan, such as tax advantages, asset protection, and the desire for flexibility. For instance, granting a testamentary limited power of appointment can allow a beneficiary to decide how to distribute assets among their children, based on their circumstances and needs at that time.
However, it’s crucial to recognize that powers of appointment can carry risks, as they might be exercised in ways that contradict the donor’s intentions. For instance, if the donee acts irresponsibly, it could lead to unintended consequences, like favoring a problematic beneficiary who mismanages their inheritance. The following scenarios will better illustrate the use of powers of appointment:
Robert creates a trust that is designed to hold his property for the benefit of Jill, his daughter, for her lifetime, and which will then pass to her children upon her death. However, three of his grandchildren have a history of drug use, terrible spending habits, and have even attempted to financially exploit him in the past. Although Robert wants only his grandchildren to benefit from the trust after his daughter dies, he wants to allow Jill to determine how much (if anything) should go to each of his grandchildren, depending on how they conduct their lives in the future and what their needs are. Robert’s estate planning attorney suggests that he grant Jill a testamentary limited power of appointment in his trust that allows Jill to distribute the remainder of the trust property according to how she sees fit among her children, in equal or unequal shares at her death. This will require Jill to draft a will or trust that includes a provision that specifies how the remainder of Robert’s trust will be divided among her children at her death. Including such a power allows Robert to maintain some control over who will receive his property but also grants some important flexibility in his estate plan to his daughter, so that she can take a second look at the family circumstances years after Robert has passed away.
Theresa died, leaving a trust that owns a significant amount of quickly-appreciating corporate stock shares. Her only son David is the income beneficiary of the trust and enjoys the stock dividends that are paid out to him every year. David’s children are the remainder beneficiaries of the trust. David is in his late seventies and is experiencing failing health. Before Theresa died, she amended her trust to ensure that it contained a provision that granted David a testamentary general power of appointment over the trust. As a result, upon David’s death, the stock in the trust receives a full step up in tax basis under current federal tax law, thus eliminating the capital gains taxes that would have otherwise been due on the sale of the stock in the hands of David’s children after his death. Significant tax savings are achieved by including this type of a power of appointment.
Benjamin is Emma’s second husband. Emma has children from a previous marriage. Benjamin has never been married prior to his marriage to Emma and has no children of his own. Some of Emma’s children have been very nice to Benjamin, while others have been quite nasty to him. Emma has significant wealth and intends to ultimately leave it to her children. However, she wants to provide for Benjamin throughout the remainder of his life, if he outlives her. To accomplish this, Emma’s estate plan establishes a trust for Benjamin that is protected from estate taxes at her death. The income generated on the trust property is paid out to Benjamin for his life, with the principal of the property payable to Emma’s children at Benjamin’s death. However, Emma grants Benjamin a testamentary limited power of appointment over certain company stock held in the trust, so that upon his death, Benjamin can determine who among Emma’s children will receive that stock and in what shares. Emma explains this to her children, so that they get the message that, if they mistreat Benjamin after she is gone, he has the authority to reduce the value of their share of her trust by at least some degree. Emma’s hope is that this will incentivize her children to treat Benjamin with a certain level of respect that they sometimes neglected during Emma’s life.
These examples illustrate just a few of the more common reasons why and how powers of appointment can be creatively used to build flexibility into an estate plan. There are many other ways to use these incredibly useful tools. It is important to note, however, that they can also create significant risk and lead to unintended consequences.
For example, what if Benjamin, in the example above, turned out to be vindictive and, out of spite, exercised his testamentary limited power of appointment to grant everything to one of Emma’s children, who had a terrible gambling problem and who then lost everything in one weekend in Las Vegas? Certainly, this would not have been what Emma had intended. Nevertheless, a power of appointment can lead to this type of result, if the power holder chooses to exercise their power irresponsibly.
By understanding the benefits and limitations of powers of appointment, individuals can identify situations where they are beneficial and evaluate their presence in their estate planning documents or those of their loved ones.
If you need assistance with estate planning decisions, we can help. Please don’t hesitate to contact us for a consultation at [email protected].