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.

News and Notes

I apologize for my readers -- I'm a bit behind in posting to the blog.  To get you up to speed, here's a few recent developments in the world of estate planning, estate administration and elder law:

• An Executor is not absolved from liability for late filing of estate tax returns notwithstanding attorney's obvious malpractice (and even criminal conduct) -- In Thomas Friedman vs. U.S., 109 AFTR 2d 2012-723, the executor of an estate hired an attorney who claimed to be experienced in estate administration matters to file the federal estate tax return.  The attorney apparently suffered from a myriad of "physical and mental ailments" resulting in the attorney's neglect in properly handling the administration, including the filing of the estate tax return.  Only three years after the filing due date did the executor learn that the estate tax return had not in fact been filed.  The executor then paid the tax due, as well as interest and significant late filing penalties. The executor subsequently sought a refund of the penalties and interest, relying on the doctrine   that he reasonably relied upon the attorneys' assurances that the attorney was taking care of the filing.  The Federal District Court in Pennsylvania, citing the precedent of a 1985 Second Circuit  decision, held that a taxpayer's duty to file a timely tax return is nondelegable, and that misplaced reliance upon professional assistance will not fall within the safe harbor of reasonable cause.

•  Mere retention of a testamentary power of appointment in a irrevocable "Medicaid Trust" alone may not be sufficient to render the trust "incomplete" for gift tax purposes.  The IRS recently issued this memorandum, which provides that transfers of assets to an irrevocable trust in which the grantor retains a testamentary power of appointment, without more, constitutes a completed gift of the transferred assets and requires the filing of a federal gift tax return (assuming the value of the transferred assets exceeds $13,000).  Although when Medicaid planning for a modest estate there would be no payment of gift taxes, the troubling issue with such a determination is that if there is a completed gift during lifetime, the trust assets would not be included in the grantor's estate at their death, and thus the trust assets would not be eligible for "step up in basis" treatment.  So, in the common situation where a primary residence is transferred to such a trust, the heirs (typically the grantor's children) will inherit the home at the parent's death with the parent's "carryover" cost basis, not the (usually much higher) date of death cost basis.  If, for example, the parents have a cost basis in the home (e.g., purchase price plus capital improvements) of $50,000, and the children sell the home after the parent's death for $250,000, without the benefit of the step-up in basis, the children will pay capital gains tax on the full $200,000 gain.  One solution to this issue is to include in the trust that the grantor(s) will retain some lifetime rights over the transferred property.  Such control might include a right to trust income, or the retention of a lifetime (rather than after-death) power of appointment.  Fortunately, our firm already routinely includes such lifetime income and power of appointment powers in our "Medicaid" trusts, so I am confident that clients for whom we have created such trusts will gain the benefit of the step-up in cost basis for the trust assets upon the grantor's death.

• The options for purchasing long-term care insurance continues to shrink. Prudential recently announced that it is following other prominent companies (including MetLife and Travelers) in abandoning the individual long-term care insurance market (Prudential will still sell group long-term care policies).  This excellent Wall Street Journal article discusses the increasing difficulty consumers will have in purchasing affordable long-term care insurance, and includes tips on how to shop for those policies that remain available.