To best enjoy this post, please be sure to first read A Family History of the Smiths & Alexanders.
The saga of the Smith and Alexander families continues with a discussion of powers of appointment and the implications of Johnny’s exercise of the limited power of appointment granted to him under his parents’ Family Trust.
A power of appointment allows a beneficiary (also known as a donee or power holder) to direct where his or her interest in an estate or trust may go. There are two primary types of powers of appointment, a general power of appointment and a limited (or special) power of appointment. A general power of appointment enables a donee to direct his or her share in a will or trust to any individual or organization including to the donee, the donee’s estate, and creditors of the donee and the donee’s estate. A limited power of appointment enables a donee to direct his or her share to a specific class of beneficiaries (frequently his or her descendants) but not to the donee, the donee’s estate, the creditors of the donee nor the creditors of his or her estate.
The governing instrument will typically instruct the donee as to the manner in which to exercise the power of appointment. For example, the documents of the testator (known as the donor) may provide that the donee may exercise the power in his or her will by making specific reference to the power.
A power of appointment is beneficial because it provides an added layer of flexibility in an estate plan. For example, suppose that a husband has established a trust for the benefit of his wife after he dies. The trust authorizes the wife to exercise a limited power of appointment over the trust assets on her death allowing her to appoint to her descendants. If she fails to exercise this power, the trust assets will be divided equally and held in further trust for each of their children. Now, what if one child recently created and sold the next big app and as a result is a multi-millionaire, whereas the other child works for a non-profit organization and has a significantly smaller net worth? The wife may wish to exercise her limited power of appointment to direct that all or a larger portion of the remaining assets in her husband’s trust be held for the benefit of the child working at the non-profit organization since his assets are substantially less than the child who developed the app.
Powers of appointment also have various tax implications. For example, the possession of a general power of appointment will cause the assets to be includible in the donee’s estate regardless of whether he exercises the general power of appointment. The actual exercise of the general power of appointment will cause the property to be taxed to the donee for estate and gift tax purposes. Alternatively, a limited power of appointment will generally not result in estate or gift tax inclusion by the donee holding the power.
So why might someone wish to exercise a general power of appointment? For example, suppose the child who created the app discussed above accumulated an even greater amount of wealth over her lifetime. This child is the beneficiary of another trust created by her parents which allows her to exercise a general power of appointment to appoint to anyone she wishes. This child decides that her own children are successful enough and do not need additional assets upon her passing. Thus, she exercises her general power of appointment over the trust assets and appoints them to various charitable organizations. The assets over which she exercised her general power of appointment are includible in her taxable estate but at the same time qualify for a charitable deduction.
So what does this mean for the Smith and Alexanders? As mentioned in the fact pattern, Johnny was granted a limited power of appointment over assets passing to him in the Family Trust created by his parents. If Johnny had not exercised the limited power of appointment, after his death the assets remaining in his share of the Family Trust would have passed in accordance with the terms of the Family Trust (terminating on the death of the last survivor of Johnny and his four siblings at which time the remaining principal would be distributed outright to the issue of Johnny and his siblings).
In this case, Johnny exercised the limited power of appointment in favor of his spouse, Moira, directing that income be paid to her during her lifetime. Now, if Johnny and Moira had actually married, this would result in the payment of income from the Family Trust to Moira during her lifetime, with the remainder of Johnny’s share in the Family Trust distributed in accordance with the exercise of Johnny’s limited power of appointment. Depending on the wording of Johnny’s exercise of his limited power of appointment, it is possible that Twyla and Randall may have a claim that Moira is not entitled to the income from the Family Trust since she is not actually Johnny’s spouse and instead the trust assets should follow the subsequent provisions of the limited power of appointment (which, presumably, were for their benefit). Note that Johnny’s exercise of the limited power of appointment will not result in inclusion of those assets in his taxable estate.
Powers of appointment are an excellent estate planning vehicle and can provide many tax benefits. It is important to consult with an experienced estate planning attorney when considering whether to utilize powers of appointment in your estate plan.