What is a Power of Appointment?

A power of appointment is essentially the right to designate who is to own certain specified property. The essence of the concept can be illustrated through the following simple example:

D dies and his will provides that certain rental property which he owned be placed in a trust, from which all future income is to be paid to his daughter for life, with the principal going to a charity upon the daughter’s death. However, D also grants to his surviving wife, W, the right to require at any time that the trustee transfer outright ownership of the trust’s property to her or to anyone else she might designate. Thus, W holds a power of appointment over the subject property. Although W does not own the subject property, the power of appointment represents a valuable interest in the property, practically equivalent to ownership, because it is a right to obtain ownership on demand.

Power of Appointment for Future Flexibility

A power of appointment is created by the original owner of the subject property, as donor, and the person granted the power is referred to as the “power holder.” Powers of appointment are a valuable tool in estate plans, because they allow for future flexibility in the ultimate disposition of the donor’s property which is placed in a trust. Thus, at the time the trust is created the intention to provide income to a spouse or other beneficiary may be the donor’s primary objective. Although a designation of the remainder beneficiary(ies) is necessary, this may be of secondary importance to the donor, and if the remainder interest is unlikely to be received until some distant future time, the person(s) whom the family would chose to receive the interest at that point in time may be different than the choice made when the trust is established. Factors such as changes in financial circumstances, divorce, family estrangement and others may well affect future choices of beneficiaries.

For example, in a family with two adult children, an estate plan might provide that the surviving spouse is to receive trust income for life, with the remainder to be divided 50-50 between the two children. However, what if the early adult lives of the two children indicate that one of them is likely to be financially secure on his own, while the other may not be, by reason of a high risk or low-potential career path? Or perhaps one of the children presents a risk that an inheritance would be rapidly dissipated through substance abuse or other anti-social activity. The family can essentially take a wait-and-see approach to the disposition of the trust property after the death of the surviving spouse, by granting the surviving spouse a power of appointment to designate the ultimate property distribution between the children. The power of appointment could be made exercisable only upon the surviving spouse’s death (a “testamentary” power of appointment), or it could be made exercisable during the spouse’s lifetime (an “inter vivos” or “lifetime” power of appointment).

What happens if the power of appointment is never exercised? When the power of appointment is created, the trust instrument must spell out the disposition of the property in the event that the power of appointment is not exercised. This might be referred as the “default” result, or the disposition of the trust property “in default of appointment.”

General and Limited Powers of Appointment

There are two types of powers of appointment for tax purposes: a general power of appointed and a limited (or special) power of appointment. Under a limited power of appointment, the power holder is limited by the terms of the power, in the selection of persons in favor of whom the power may be exercised (“appointees”). The class of potential appointees may be narrowly limited (e.g., only the donor’s children), or may be virtually unlimited, the only limitation being that the power may not be exercised in favor of the power holder himself, the power holder’s estate, or the creditors of either. Any power of appointment that can be exercised in favor of the power holder, his creditors, or his estate or the creditors of the estate, is a general power of appointment. (It should be noted that section 20.2041-1(c) of the treasury regulations provides that a power of appointment exercisable for the purpose of discharging a legal obligation of the power holder is considered a power of appointment exercisable in favor of the power holder or the power holder’s creditors. This would include the legal obligation for support of the power holder’s minor children. )

Because the holder of a general power of appointment can appoint the property to himself or his estate or creditors, the possession of such a power represents a degree of beneficial ownership in the property only slightly removed from outright ownership. For estate tax purposes, the holder of a general power of appointment is deemed to have rights so close to outright ownership that if he or she were to die while holding the power (whether or not exercised at death), the property subject to the power must be included in the gross estate.

On the other hand, property subject to a limited power of appointment is not includable in the gross estate of the power holder (i.e., will not subject to estate tax). Accordingly, when powers of appointment are used in estate plans for trusts other than the marital deduction trust, it is important that they be structured as only limited powers; otherwise, the property subject to the power will be pulled into the gross estate of the power holder, with potentially disastrous tax consequences. With respect to marital deduction trusts, a general power of appointment is sometimes used, giving the surviving spouse absolute power over the trust property, since the property must be included in the surviving spouse’s gross estate as a condition to qualification for the marital deduction at the time of the first spouse’s death.

See also:

Wealth Transfer Taxes (in 6 minutes)

Estate Planning in Times of Unstable Estate Tax Law and Policy

Buy Sell Agreements (Cross Purchase and Stock Redemption)