Christopher Stoneman Estate Planning Articles

IX - Powers of Appointment

Like the disclaimer, which we will be discussing in a later article, the power of appointment is an under-utilized estate-planning instrument which affords a means of mitigating at least the material finality of death.  It is, as once dubbed, a weapon that can fire around corners - in the sense that it can have a profound beneficial effect upon targets which the rifleman cannot descry but of whose probable existence he can hardly fail to be aware.  In short, although obviously not entirely risk-free - curved barrels are inherently tricky - the power of appointment may provide a desirable degree of flexibility.
                                                    
1.  Non-tax considerations.

A.  General.

Black’s Dictionary offers the following basic definition:

A power or authority conferred by one person by deed or will upon another (called the “donee”) to appoint, that is, to select and nominate, the person or persons who are to receive and enjoy an estate or an income therefrom or from a fund....

Thus, the power of appointment (not to be confused, as it sometimes is, with its cousin the power of attorney) involves the granting by one person to another of the power to decide who shall receive certain property - or the benefit of a trust comprising certain property - at some point in the future.  Typically, a testator may establish a trust for the benefit of, say, a daughter of his, giving her the right to receive the income and perhaps principal from the trust for life.  Since, hopefully, her death will not occur for many years, long after the testator’s death, he decides to give her a major say in calling the shots in determining what is to happen to the trust property at her death.  This, he reasons, will enable her to take into account whatever may have occurred during her lifetime. The breadth of this power (in the case of one which must be exercised by will, a testamentary power) must be set by the donor by prescribing the persons or class of persons in whose favor the donee  may exercise the power.*  In addition, the donor must of course define the property over which the power may be exercised (the appointive property) as well as the manner of such exercise.  It is also highly desirable, if not essential, to expressly provide what is to happen to the appointive property  if - as often occurs -  the donee intentionally or accidentally fails to effectively exercise the power.

The foregoing may perhaps be best illustrated with an example or two, with sample language.  Suppose that a testator, T, has two daughters, each of whom has children.  T also has several siblings - all comfortably off - and they have all begotten a steady supply of offspring.  T is a loyal and enthusiastic supporter of the college which he and both his daughters attended.  In his will T  creates a separate trust for each of his daughters by the terms of which each daughter receives all of the trust income and as much of the trust principal as the trustee determines to be advisable for her maintenance.  T’s will goes on to provide:

Upon my daughter’s death my Trustee shall add all then accrued and all then undistributed income to the then remaining principal of this trust and shall distribute said principal, as so augmented, as my daughter, by express    reference** in her duly probated will, shall appoint to or in trust for the benefit of my lineal descendants, whether then living or born after my death, without regard to equality among, and with full power to exclude any one or                more of, them.  If and to the extent, if any, that my daughter shall fail to effectively exercise the foregoing power, the property as to which said power has not been so exercised shall be distributed to*** my lineal descendants living at the time of such failure of appointment, per stirpes, or, if there are none of these then living, to the then living lineal descendants of my parents, per stirpes, or, if there are none of these then living, to [T’s alma mater], for its general purposes.       

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*  And, if the donor is so minded, by imposing limitations or conditions upon the scope of the exercise.  For example, by providing that the donee may give his or her spouse the right to income from a trust for
the spouse’s benefit and that that income will terminate in the event of the spouse’s remarriage.
** The purpose of this phrase is to negate the possibility of an accidental exercise of the power by language in the will (a residuary clause purporting to dispose of everything not specifically disposed of) which some
courts have held will trigger the exercise of a testamentary power of appointment.
*** The person(s) designated to take if the power is not fully exercised are known as takers in default.  In the absence of such a designation, the donee’s failure to exercise the power will result in passage of the unappointed property under the will of the donor, who may have gone to his or her reward decades earlier.             
                   

Or suppose, in the alternative, that T wishes to give each of his daughters complete discretion to decide what shall happen to her trust at her death.  Leaving for discussion below the tax consequences of what this may entail, his will might provide as follows:

Upon my daughter’s death my Trustee shall add all then accrued and all then undistributed income to the then remaining principal of this trust and shall distribute said principal, as so augmented, to or in trust for the benefit of such persons or entities, including, without limitation, her estate, her creditors and the creditors of her estate, as she by express reference in her duly probated will shall appoint.  If and to the extent, if any, that my daughter shall fail to effectively exercise the foregoing power, the property as to which said power has not been so exercised shall be distributed to my lineal descendants living at the time  of such failure of appointment, per stirpes, or, if there are none of these then living, to the then living descendants of my parents, per stirpes, or, if there are none of these then living, to [T’s alma mater], for its general purposes.

B.  Rule Against Perpetuities.

Although it is beyond the scope of this article to go at any great depth into the bane of countless generations of law students, the ancient rule of Anglo-American jurisprudence known as the Rule Against Perpetuities,* it may be well to at least post a cautionary warning.  It is implicit - whether or not stated in the instrument which creates the power - that it may not be executed in such a fashion as to violate the Rule.  Inasmuch as the holder of a power of appointment is not regarded as the owner of the appointive property, the Rule must be applied with reference to the situation at the death of the donor (who was the owner) and not at the death of the donee.  The “life in being” requirement must be satisfied on the basis of the state of affairs determined as at the time of the creation of the power, not at the time of its exercise.  Thus, to go back to the first example, T’s daughter may exercise her testamentary power of appointment in such a fashion as to benefit lineal descendants of hers who had not been born at her death (or, of course, at her father’s death), but the appointive property must vest in (i.e., become owned by) an entity, a person or persons (whenever born) before the end of the perpetuities period.  For this reason - and in order to avoid problems which flow from violation of the Rule - T’s daughter’s exercise of her father’s power of appointment should be so drafted as to ensure that the appointive property vests at or before the end of the perpetuities period.  While specific reference to the Rule may in many instances be unnecessary, assume that the daughter has dynastic aspirations and wishes to exercise her power to create a trust for her lineal descendants for the maximum allowable period. The following language in
her will would conform with the Rule:

The foregoing trust shall terminate upon the first to occur of the following events, namely, (a) the death of the last to die of my lineal descendants, whenever born, and (b) the twenty-first (21st) anniversary of the day before the death of the last die of my lineal descendants who were living at the death of my father.  Upon such termination my Trustee shall distribute the principal of such trust as then constituted, together with all then accrued and all then undistributed income, to my then living lineal descendants, per stirpes, or, if there are none of these, to my father’s then living lineal descendants, per stirpes, or, if there are none of these, to
[daughter’s alma mater], for its general purposes.

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* Classically defined and simply stated, the Rule requires that an interest in property (for example, an interest created by a trust agreement or by the exercise of a power of appointment) must “vest” within the period (the perpetuities period) which ends not later than 21 years after the death of some person) the measuring life) who was already in existence at the time when the trust or the power of appointment was created.

2.  Tax considerations.

A.  In general

There are important transfer-tax aspects to the granting and exercise of certain - but not all - powers of appointment. It is with the federal estate tax that the issue most frequently arises.

Here the main consideration is whether the power in question is what the Internal Revenue Code calls a general power.  A general power of appointment is defined by Section 2041(b) of the Internal Revenue Code as, with certain important exceptions,* 

a power which is exercisable in favor of the decedent, his estate, his creditors, or** the creditors of his estate

If at a decedent’s death, there is property

(i)   over which he has a general power of appointment,*** or

(ii)  with respect to which he has at any time exercised or released such a power by a disposition which if it were of property owned by the decedent, would have required inclusion in his gross estate under Code Sections 2935 (Certain Gifts within 3 years of Death), 2036 (Transfers with Retained Life Estate), 2037 (Transfers Taking Effect at Death) and 2038 (Revocable Transfers) the value of that property will be included in his gross estate.

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*  While a detailed analysis of  Section 2041 is beyond the scope of this article, it may be noted that a primary exception to the definition of “general” is set out in subsection (b)(1)(A) of that section. Thus,
“power[s] to consume, invade, or appropriate property for the benefit of the decedent which [are] limited by an ascertainable standard relating to the health, education, support, or maintenance of the decedent”
(emphasis added) are not subject to taxation as explained in the text.
**  Any one of these three will result in general power of appointment status.
***  Note that except in the unlikely event that the power was created before October 21, 1942, it is immaterial whether the power is exercised.  The mere existence of the power is sufficient to warrant inclusion.

B.  “5 and 5” powers.

In conclusion, a word or two about the lapse of a general power of appointment - i.e., failure to exercise such a power (as distinguished from an affirmative act to release it). As we have noted, mere ownership of the power at death is sufficient to warrant tax inclusion.  No exercise is needed; and an express disavowal of the power will not necessarily* remove the power from the estate.  But suppose, for example, that a solicitous parent sets up a trust for his son, S, for life and gives S the unrestricted right, on his say-so alone, to withdraw a certain amount each year out of the trust principal to use for his own purposes, whatever these might be - a trip to Tibet, S’s son’s college tuition, etc.  Clearly, a general  power of appointment.  S avails himself of the paternal generosity for the first five years after his dad’s death and then decides to refrain from further such invasions.  S dies 20 years later, having in effect allowed his limited** general power to “lapse” for each of years six through 20 of the trust’s existence.  When totted up and pulled into S’s estate, the amounts which he declined to withdraw would constitute a significant and expensive increase in his estate.

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*    The criteria for effective disavowal will be discussed in a subsequent article on Disclaimers.
**  i.e., limited as to amount, not as to purpose.

Section 2041(b)(2) provides limited relief and states that the lapses occasioned by S’s failure to withdraw all or a part of the amounts to which the trust entitled him, will only constitute potentially taxable “releases”

to the extent that the property, which could have been appointed by the exercise of such lapsed powers, exceeded in value, at the time of such lapse, the greater of the following amounts:
                    (A)   $5,000. or
                    (B)   5 percent of the aggregate value, at the time of such lapse, of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could have been satisfied.

The following language illustrates the so-called “5 and 5” power at work:

In addition to the foregoing, the Trustee shall distribute to my said son so much of said principal as he from time to time directs in writing, but such distributions shall not exceed in any one calendar year (the first such year to begin on the date of my death and to end on the 31st of December next following) exceed the greater of (A) five thousand dollars ($5,000), or (B) five percent (5%) of the value of said principal on the first day of such calendar year.  This limited right of withdrawal shall be noncumulative.*     
              

The ( b)(2) statutory “anti-lapse”  exception has led draftsmen to use the 5 and 5 power as a  handy means of giving trust beneficiaries a modest measure of nontaxable independence from the fiscal control of their trustee.  

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*  i.e., if not currently used, the power shall not carry over from one year to the next.

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