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Heckerling 2019: Day 4

Read About Heckerling Day 3

Powers of appointment is a planning technique allowing for great flexibility.  In many circumstances the powerholder has the ability to postpone making decisions until a later date. The presentation discussed the reasons for giving powers of appointment including the benefits and pitfalls of doing so.  Combined with the written material the best ways to effectively exercise the power, modify existing powers and the various characteristics of these powers were considered.

Most powers of appointment are non-fiduciary powers of disposition over property.  The power was originally granted by the property owner (the “grantor, donor”) either in an inter-vivos instrument (Trust Agreement) or in a Will.  The person traditionally given the power is called the “donee” or “powerholder”. The significance of this power being non-fiduciary allows the powerholder to act within the power stated without having the responsibility to act in the best interests of the appointees as long as the exercise does not violate public policy.  Although powers can be granted in a fiduciary capacity it is much less common.

Powers of appointment can be general or non-general in nature, can be exercisable currently or upon the occurrence of an event or specified time or the meeting of an ascertainable standard.  There are major tax differences between general and non-general powers and considerations of these tax effects must be analyzed in determining what type of power should be given.

Some powers must be exercised (”imperative”) and if not the court having jurisdiction will exercise it.  Powers which need not be exercised (“non-imperative”) are much more typical and name the takers to the property in the default of such exercise.

The “doctrine of relation back” should be clearly understood that the powerholder does not own the property but simply has the right to appoint it.  As the name indicates the property is technically passing from the donor to the donee.  However, for tax purposes the doctrine of relation back is not always followed and the powerholder could be considered the holder of such assets.

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Tax Treatment of Powers of Appointment

 General powers of appointment are defined by IRC Sec. 2041.  The following are excepted from the definition and would eliminate the potential tax burden of the powerholder:

  • If the powerholders authority is limited by an ascertainable standard.
  • If the power is exercisable only in conjunction with the donor of the power; or
  • If the powerholder can exercise the power only in conjunction with a person having an adverse interest in the property.

On death the estate of the powerholder is required to include all assets over which the power is held if it is a general power of appointment.  The mere existence of the power is all that is required even if not exercised.  Under certain circumstances if the powerholder was unaware or incapable of exercising the power the estate may recover from the recipient of the property the taxes assessed.

The release or lapse of a general power of appointment is deemed to be a transfer of property by the powerholder.  However, under IRC Sec. 2514(e) this release or lapse is only a transfer of property to the extent it exceeds the value of $5,000 or 5% of the total value of the assets out of which, or the proceeds of which, the exercise of the lapsed power that could be satisfied.  This “5 and 5” power may lapse annually without any transfer tax ramifications thus allowing a beneficiary the right to take any amount from a trust as long it does not exceed these amounts. The withdrawal rights in certain trusts (often referred to as a “Crummey Power”) are structured to lapse within the “5 and 5” power.  Where withdrawals without any limitations would exceed the annual non-taxable amount the use of “hanging” powers avoid the possible transfer tax until the trust is large enough to fully cover the total value of assets that could be withdrawn.

Non-general powers of appointment usually have no transfer tax effects.  However, if the release or lapse has an effect on the other interests held by the powerholder then a potential transfer tax may be generated.

Exercising a Power to Create a Power: Taxation and the Delaware Tax Trap

It is not usual for a powerholder to exercise a power in order to create a new power of appointment.  If the power is a general power of appointment and is exercised by Will the appointive assets it will be subject to federal estate tax.  If the general power of appointment is exercised inter vivos then there will be a deemed transfer of assets subject to federal gift tax.

If the power is a non-general power of appointment and used to create a new second power then it will only have tax consequences if it satisfies the criteria of IRC Sec. 2041(a)(3) or Sec. 2514(d) commonly referred to as the “Delaware Tax Trap”.

In simple terms, the exercise of a non-general power of appointment to create a new power of appointment that has the effect of postponing the period of the Rule Against Perpetuities converts the non-general power of appointment into a taxable power for purposes of IRC Sec. 2041 and Sec. 2514.

The name “Delaware Tax Trap” is derived from the fact that usually the creation of a new non-general power of appointment from an old non-general power of appointment would not extend the Rule Against Perpetuities, thus the “lookback or relate back” period for perpetuities purposes would be the old non-general power of appointment date.  However, under Delaware law even the exercise of non-general power of appointment changes the date of creation to the new non-general power of appointment.

This so called trap sometimes is triggered purposely in order to generate estate tax or gift tax rather than generation-skipping tax transfer tax.

State perpetuities law must be reviewed and analyzed thoroughly to determine how the exercise of a non-general power of appointment creating a new power will be treated.

There are many additional reasons to use powers of appointment among them are:

  • To allow changes to be made to an existing Trust. Change of administrative provisions, investment provisions, or dispositive provisions.
  • For transfer tax or income tax purposes.
  • For spousal protection purposes.
  • Moving taxing Jurisdictions
  • Basis adjustments

Continue on to Day 5 of the Heckerling

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