Powers of Appointment – An Essential Tool For Building Flexibility Into Your Estate Plan

The ideal estate plan is one that not only satisfies all of a person’s current goals and objectives, but also provides flexibility to allow for changes both during the person’s life, as well as changing circumstances affecting the lives of their children and other loved-ones.  People typically recognize that they can modify wills and revocable trusts at any time.  But they are often surprised to learn that even an irrevocable trust – such as the Medicaid Asset Protection Trust that is commonly used as a Medicaid planning device – can be drafted to allow for changes not only in the choice of beneficiaries, but also the manner in which a beneficiary will receive an inheritance.

The magical planning tool that allows for such flexibility is known as a “power of appointment.”  A power of appointment may be either “general” or “limited” (which is also sometimes referred to as a “special” power of appointment).  A general power of appointment authorizes the power holder to direct the property over which the power is granted to any person or entity.  A limited power of appointment grants the power holder authority to direct the designated property to a more limited class of persons or entities, often limited to the descendants of the person granting the power.

Powers of appointment are typically included in wills and trusts, but can also be incorporated in other legal instruments such as deeds.  Why would someone consider incorporate a power of appointment as part of their estate plan?  Because life happens!  As but one example, one spouse will sometimes outlive the other spouse by many years, and changing circumstances may render the original planning unsatisfactory to the surviving spouse. 

Assume, for example, that in 2007 Sam and Mary met with their attorney to work on their estate planning.  The couple agreed that upon the first spouse’s death the deceased spouse’s assets would be left in a protective trust for the surviving spouse, and after both of their deaths, their combined assets would be divided equally between their two children, Paul and Jennie.  After learning the many benefits of leaving assets in protective trusts for their children, Sam and Mary executed revocable trusts providing that after both of their deaths the couple’s assets were to pass equally into protective trust shares for their children.

Relying on their attorney’s sage advice, Sam and Mary’s revocable trusts included limited powers of appointment authorizing the surviving spouse to leave the deceased spouse’s trust assets among any of their descendants in any manner.  Each trust further provided that the power of appointment would be deemed exercised if the surviving spouse were to include a provision in their will or revocable trust specifically exercising the power.  In essence, each spouse afforded the surviving spouse – whoever that would be – with the “last look” at the family’s circumstances to determine if the equal asset distribution included in the original plan remained desirable.  

Fast forward to 2009 when Sam passed away.  Soon thereafter Paul, who had a seemingly stable life, saw his world fall apart.  He was laid off from his job as an executive at a large company, and at age 53 found himself unemployed for the first time in his adult life.  Six months later, as the tension in his home continued to build, Paul’s wife Sally moved out with their three children and filed for divorce. 

Mary, being distraught over her son’s changing circumstances, called her attorney for advice. While she was helping out Paul with periodic cash gifts to help keep him going, she wondered if she should change the children’s inheritances in light of the changing circumstances. She spoke to Jennie, who told her mother that Mary should feel free to leave a larger inheritance for Paul.   Mary’s attorney told her that not only could she leave more of her own trust assets to Paul’s trust share, but that she could also exercise the power of appointment provided to her under Sam’s trust to make a similar allocation of Sam’s trust assets to Paul’s trust after Mary’s death.  Accordingly, Mary decided to amend her revocable trust to leave 75% of her own trust assets to Paul, and exercised the limited power of appointment granted to her by Sam to leave the same percentage of Sam’s trust assets to Paul.

Another common use of a power of appointment is for a person executing an irrevocable trust to retain for himself the power to modify the beneficiaries under the trust without having to formally amend the trust.  Even if the retained power is never exercised, the mere inclusion of the power in the trust instrument will cause the trust assets to be includable in the trustmaker’s estate, thereby insuring that the trust assets will receive a “step-up” in cost basis for capital gains tax purposes.

In my experience powers of appointment are woefully underutilized, presumably because of a lack of understanding of the many benefits that this legal tool provides.  But any serious estate planning discussion must include a conversation about how powers of appointment may be incorporated into one's estate plan to ensure that the desired objectives can be realized.

An Estate Plan That Didn't Work

Recently a client of one of my litigation partners called me. This client – I’ll call him “Robert” – is, along with his brother, the beneficiary under his mother “Eleanor’s” will. Eleanor, who died in 2008 a resident of New Jersey, had a gross estate of over $6 million. Eleanor’s husband had predeceased her some years before her death.

I knew from my partner that Robert once had a thriving business, but that the “Great Recession” has left him with potential liabilities to various creditors in the millions of dollars. Robert’s creditors would surely be interested in getting their hands on Robert’s share of his mother’s estate.

Robert explained to me that he needed to “set-up” the trust established under his mother’s will for the benefit of he and his children. To determine what exactly needed to be done, I obtained from the New Jersey law firm that was administering Eleanor’s estate copies of her will and the filed estate tax returns.

In reviewing Eleanor’s will, I determined that Eleanor had established generation skipping trusts for both Robert and his brother “Alan.” Since Eleanor’s generation skipping tax exemption was $2 million at the time of her death in 2008, each of her son’s respective generation skipping trusts will be funded with $1 million. The good news is that if properly administered, the assets in each of her son’s trusts should be protected from the reach of their creditors, as well as creditors of any of their descendants. Assets in Robert’s trust can thus be used to pay for the “needs” of both himself and his descendants without being subject to invasion by any of their creditors.

While the generation skipping trusts established under the will might be deemed a planning “success”, other aspects of her estate plan leave much to be desired. In addition to the $1 million to be funded to his generation skipping trust, Robert is in line to inherit over $900,000 as an “outright” distribution. The problem here is that because Robert will be receiving those “excess” funds in his own name, his many creditors will have “first dibs” on those assets. It is unlikely that Robert will ever see a dime of that money.

What might Eleanor have done differently to protect her sons’ entire inheritance? Quite simply, she could have established “lifetime protective trusts” for each of her sons to be funded with their share of the inheritance in excess of the generation skipping tax exemption amount. Each such trust could have been designed to be accessible by Robert and Alan for their needs, but also to be out of the reach of their creditor claims.

So, why didn’t a woman of such means have such a provision in place? My guess is that at the time Eleanor executed her will years before her death, both of her sons were financially secure – or at least appeared to be. Her attorney likely did not focus on asset protection as an important element of Eleanor’s planning, but was rather more concerned with maximizing the generation skipping tax exemption. Robert’s financial condition did not begin to unravel until around the time of Eleanor’s death, and by then the die had been cast.

The other major problem with Eleanor’s estate plan was that from her over $6 million estate, the total estate tax bill exceeded $2.2 million. While her estate plan effectively manages the generation skipping tax exemption, Eleanor could have implemented a number of strategies that could have minimized, or even eliminated, her estate tax obligation. The attorney who drafted Eleanor’s will surely had the expertise to have implemented estate tax savings strategies. But such “advanced planning” techniques require a significant financial commitment from the client, and perhaps Eleanor was unwilling to get past the “cost” to engage in any of those advanced planning techniques. Or, perhaps she believed that Congress would have completely repealed the estate tax by the time of her death. Whatever the reason, a significant portion of Eleanor’s personal wealth was diverted to the government for its use, rather than to her loved ones.

What, Did She Forget To Send A Mother's Day Card?

As reported this week in the Village Voice, a Manhattanite left her $8.4 million estate -- including two apartments in the Dakota (the building where John Lennon lived when he was murdered) -- to her long-time butler.

The decedent's will specifically disinherited her daughter and two grandchildren.

Avoiding Chaos When the "Glue" is Gone

All too often people have a "blind spot" when it comes to assessing the relationships among their children and other close family members. When I meet with clients to discuss their estate planning goals and objectives, in many instances they take the "just leave all the property equally to the kids and everything will work out" approach.

But as pointed out here, the children may only "play nice" as long as at least one of the parents is living. Once the parents have died, the family "glue" breaks down, and in all too many cases the knives may come out.

While the kids may surely fight about the money and other financial assets, as the linked article points out, it is with the personal property that a lot of the serious warfare occurs. After all, a bank account can be divided; the grandfather clock cannot.

In creating an estate plan, it is essential that serious discussion take place between you and your attorney regarding the disposition of personal effects. The wisest course of action is to specifically designate in a will, trust, or personal property memorandum which items of the significant tangible personal property -- both in a monetary and sentimental sense -- goes to which beneficiary.