A power of appointment is a useful estate planning tool. It can add flexibility to your estate plan and provide tax and asset protection benefits. Before creating a power of appointment, you must speak with a qualified estate planning professional to ensure that you are taking the proper steps.
The uncertainty of the COVID-19 pandemic and its aftermath has motivated many individuals to create estate plans. Whether it be because of urgency, indecision, or limitations in your ability to detail specific bequests and list property items, many are opting to include in their plan a specific clause granting another power of appointment. With a power of appointment, instead of making final distribution decisions yourself in advance, you are giving someone else the ability to make these decisions after your death.
Before you decide to include a power of appointment in your estate plan, it is critical to understand the consequences of giving this power and whether or not it makes sense for you and your family.
A power of appointment is a power given by one individual (the “donor”) to another (the “donee” or “holder” of the power of appointment) to distribute property. Typically, a holder can exercise this power at any point during their lifetime.
There are two types of powers of appointment: general and limited.
- General power of appointment. With a general power of appointment, the holder can exercise their power in favor of any individual or organization, including him or herself.
Limited power of appointment. With a limited power of appointment, the holder can exercise their power in favor of certain classes of potential recipients (i.e., the donor’s grandchildren or charity organizations). The holder cannot exercise their power in favor
- The holder
- The holder's estate
- Creditors of the holder
- Creditors of the holder's estate
Powers of appointment are appropriate when you want to add flexibility to your estate plan. The world does not stop moving when you die, and by using a power of appointment, you can postpone the ultimate decision of how you want your property distributed at least one generation. The holder has the ability after your death to reevaluate any changed circumstances of the family or tax law to determine the best possible outcome of your assets.
For example, you could grant a power of appointment to your son to distribute a portion of your estate to your young grandchildren. Your son could then take into account the actual future needs of your grandchildren, such as whether one needs additional funds for postgraduate education, and another became addicted to drugs and would use the funds inappropriately. Your son can ensure that your inheritance is being put to good use.
There are estate, gift, transfer and income tax implications of creating a power of appointment. The tax laws are complex, and there are exceptions, but the general rules are described below. It is very important to speak with an experienced professional before creating a power of appointment.
The estate tax implications vary depending on whether the power of appointment is general or limited.
- The holder of a general power of appointment will be subject to estate tax on the property whether or not the general power of appointment is exercised. The holder is treated as the owner of the property.
- The holder of a limited power of appointment generally will not be subject to estate tax if he or she exercises or releases the power of appointment.
As with estate tax, the implications for gift tax also depend on whether the power of appointment is general or limited.
- The holder of a general power of appointment will be subject to gift tax if he or she exercises or releases their power to the extent that the property is passed to someone other than the power holder.
- The holder of a limited power of appointment will not be subject to gift tax if he or she exercises or releases their power.
A power of appointment can reduce transfer tax by causing a trust that is not exempt from generation-skipping tax (“GST”) to be subject to estate tax instead of GST. This is helpful because GST is currently taxed at 40%, the highest marginal estate tax rate for distributions that skip a generation and go to a beneficiary at least 37.5 years younger than the donor. As of 2020, the exempted amount for GST is $12.06 million.
Federal income tax
In general, a holder of a general power of attorney is treated as the owner of the property for federal income tax purposes. Whereas, the holder of a limited power of appointment is not subject to federal income tax.
Creating a power of appointment puts a large burden on the person that you chose to be the holder. The first step that you must take is to have an open discussion with the individual that you are choosing to be the holder of the power of appointment. This person must be someone who you trust and who understands your wishes.
Secondly, you must have clear communication with your family. Explaining your plan to create a power of appointment to your family beforehand will go a long way in avoiding challenges and family disputes. It will give you a chance to answer any questions and provide reasoning for your choices.
Finally, you should consider whether you want to limit the power of appointment. For example, you could restrict:
- Who the holder can distribute the property to
- When the holder can distribute the property
- What property the holder has the power to appoint
The holder of the power of appointment is under no duty to exercise their power. He or she can release the power or let it lapse. Therefore, it is wise to name an individual(s) or organization who should receive the property if the power of appointment is not exercised. This person is called the taker in default.