5 Things to Know About the 'Power' of Powers of Appointment

An important aspect of your estate plan could be the flexibility you allow (or do not allow) via powers of appointment. Trusts with powers of appointment offer the possibility of altering an estate plan that seems otherwise unchangeable. Katten attorneys Adam Damerow, Benji Lavin and Hadar Danieli have discussed the “power” of powers of appointment at a recent Katten Private Wealth Seminar and have taken the presentation “on the road” to additional audiences.  Attendees learned about powers of appointment generally, the different “flavors,” and other creative, practical uses of powers of appointment in an estate plan. 

Below, are five points that illustrate the power that this estate planning tool can provide.

1) What is a power of appointment?

Powers of appointment are rights granted pursuant to a governing instrument (typically a will or trust) by a third party (the “donor”) to another person (the “donee” or “powerholder”) that allows the donee to direct the distribution of assets (the “appointive property”) governed by the instrument. A power of appointment empowers the powerholder to direct distribution of the appointive property among a class of persons, entities and/or charities (collectively, the “permissible appointees”). The determination as to who constitutes a permissible appointee is at the discretion of the donor. The powerholder typically is allowed to determine the timing and the terms upon which the appointees receive the appointive property. The exercise of a power of appointment is (typically) not mandatory but rather at the discretion of the powerholder. If a powerholder does not exercise the power of appointment, the appointive property is distributed to the “takers-in-default”. 

Importantly (and discussed more below), the powerholder is typically not considered the legal owner of the appointive property. The exercise of a power of appointment is typically treated as a transfer of property from the donor to the appointee(s) due to a legal concept known as the “relation back doctrine”.  A powerholder can wear multiple “hats” as it relates to the exercise of a power of appointment.  In general, though applicable state law may have nuances, a powerholder can also be the trustee (or other “directed party”), and the powerholder may be the beneficial owner of the appointive property.

2) 'Flavors' of powers of appointment

Although not necessarily in different shapes and sizes, there are many different types or “flavors” of powers of appointment. A general power of appointment (GPA) allows the powerholder to exercise the power in favor of anyone, including the powerholder, the powerholder’s estate, the powerholder’s creditors and creditors of the powerholder’s estate. The holder of a presently exercisable GPA is treated as the owner of the appointive property, which is important for debt-creditor, income, gift, estate and generation-skipping transfer (GST) tax purposes.

A nongeneral power of appointment, also referred to as a limited or special power of appointment (LPA), is any power of appointment that is not a GPA. Other “flavors” of power of appointment may fall under the respective categories of GPAs or LPAs but may have other distinctions, such as:

• Presently Exercisable – a power of appointment that is exercisable by the powerholder at the time in question;
• Testamentary – power of appointment that is only exercisable by the powerholder’s Will;
• Postponed – not exercisable until the occurrence of a specified event (such as attaining a specific age);
• Exclusionary – donor authorizes the powerholder to appoint property to any one or more of the permissible appointees, to the exclusion of others;
• Nonexclusionary – donor specifies that the powerholder cannot exercise the power that excludes any permissible appointee;
• Imperative – a power of appointment that must be exercised; and
• Non-imperative – a power of appointment that need not be exercised by the powerholder.

3) Different tax consequences for different powers of appointment

Generally, the tax consequences of a power of appointment are determined based on whether the power of appointment is a GPA or an LPA. As noted above, the powerholder of a presently exercisable GPA is deemed the owner of the appointive property. This means the property is includible in the powerholder’s gross estate (subject to some exceptions) and, therefore, subject to estate tax and possibly basis adjustment. The exercise or release of a GPA during the lifetime of the powerholder is deemed a transfer of property and subject to gift tax. The appointive property subject to a GPA may be includible in the powerholder’s gross estate even if the powerholder is not aware of the GPA.

Conversely, property subject to a powerholder’s LPA is not includible in the powerholder’s gross estate and thus does not receive a basis adjustment. Generally, the exercise or release of an LPA by the powerholder is not a transfer of property by the powerholder and is therefore not subject to gift tax as to the powerholder (but may be subject to gift tax as to the donor, due to the relation back doctrine). This rule for LPAs is subject to certain exceptions that would require its own post, but if the powerholder is also a trust beneficiary, that should cause some added attention to the gift tax consequences as to the powerholder.

4) Formula general powers of appointment

One main objective of estate planning generally is the minimization of gift, estate and GST taxes, especially in recent years because of the increased gift, estate and GST tax exemptions (due to sunset on January 1, 2026). However, even with the currently increased exemptions, appreciated trust assets are still subject to potentially significant income tax liability. Under the right circumstances, utilizing a GPA may allow the parties involved to take full advantage of the above exemptions while also minimizing the income tax liability. There may be some benefits to estate tax inclusion for certain lower wealth beneficiaries, namely the ability to receive a basis step up in the assets, preventing imposition of the GST tax and a restart of the rule against perpetuities. 

This is another topic that deserves its own article, but in short, a formula GPA grants a trust beneficiary a testamentary GPA over a “defined portion” of trust assets in favor of the beneficiary’s estate. The “defined portion” would be the largest portion of trust assets that could be included in the beneficiary’s federal estate without increasing the total amount of all inheritance/estate/death/GST taxes payable at the beneficiary’s death over and above the amount that would have been payable absent the GPA. This concept was recently allowed by the IRS in Private Letter Ruling 202206008.

What circumstances should exist to maximize the benefit of a formula GPA? Consider the following:

• Trust beneficiaries who will have/anticipate to have estate tax exemption remaining at death;
• Assets anticipated to appreciate significantly so that the step up in basis would be impactful;
• Allocating GST over a non-exempt GST trust so that a prior GST allocation is not wasted on certain assets and
• “Upstream” planning (i.e., granting a testamentary formula GPA to a generation older than the donor). 

Powers of appointment are an important arrow in the quiver of any good estate plan. Private wealth counsel at Katten can advise on the benefits and drawbacks of including various types of powers of appointment.