The Power of Appointment



What is It? The power of appointment is one of the most powerful instruments in estate planning. Simply put, a power of appointment is the right to tell the trustee to pay money from the trust to someone.

Who can that "someone" be? That is the major tax question. How is the power to be exercised? That is a secondary question.

Example: assume a trust to pay income to C for life, and at C's death the principal would go to C's children. But C might be given the power to appoint (perhaps a portion of ) the trust among her descendants by will. Thus, C can vary their shares. This is a minimal power which I strongly recommend, even if parents don't want to give the beneficiary full control because it gives C a chance to see what the respective needs of her children are. It gives her a chance to adapt the trust for the needs of her family.

This is a testamentary power of appointment -- exercisable only at death. C might be given a power to appoint during life as well as at death, making gifts to the children.

This is a special power of appointment -- it may only be appointed among C's descendants. It could be made broader. Perhaps C's descendants and their spouses. Perhaps your descendants. Perhaps include charities. Perhaps as far as the power to appoint to herself (a power to withdraw). How far can we go? How far do you want to go?

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The Only Tax Limitation The most important thing to know about a power of appointment is its Federal Estate Tax consequences.

A trust created by A will be included in C's federal taxable estate if C is given a general power of appointment. That is defined as a power to appoint to yourself, your estate, your creditors, or the creditors of your estate. Furthermore, even if you can appoint to yourself, it is not a general power of appointment for tax purposes if your right to do so is limited by an ascertainable standard relating to your health, education, maintenance and support. [There's a potential trap here -- a power to distribute to yourself based on your needs is OK -- but not a power to distribute based on the needs of your dependents -- which is why we may need another trustee -- see trustee discussion]. But words like "comfort", "welfare", "best interests" are not ascertainable standards and cause a problem *if the beneficiary is trustee* -- it's the combination of beneficiary and unrestricted power that causes a problem

Aside from a QTIP deducted by one spouse and included in the survivor's estate, a trust created by A will only be included in C's federal estate if C is given a general power of appointment. No other restrictions on C's power are required for tax purposes. A may want to put on other restrictions for non-tax purposes (see Introduction to Trusts, but they are not required to avoid taxation.

That is such an important statement, let me repeat it:

Aside from a QTIP deducted by one spouse and included in the survivor's estate, a trust created by A will only be included in C's federal estate if C is given a general power of appointment. No other restrictions on C's power are required for tax purposes. A may want to put on other restrictions for non-tax purposes, but they are not required to avoid taxation.

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Can a Beneficiary be Trustee? Being trustee does not by itself create a taxable situation. The problem comes when the trustee has powers which may lead to taxation. A beneficiary may be trustee. The trustee-beneficiary may distribute to themselves based on an ascertainable standard. But what about their dependents? I have taken the approach of restricting the trustee from voting on distributions to persons dependent on them but creating a position of "designator" who can change trustees. Thus, if the beneficiary wants money for that purpose, they can appoint a co-trustee with authority to distribute and ask the trustee to do so. If the trustee does not comply, they change the trustee. At one point, the I. R. S. argued that this made the beneficiary taxable as though they had the trustee's powers directly, but they gave up after losing the issue in court.

For full discussion of the potential flexibility this provides, see Give the Advantages of Trusts.

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