Ten Tremont Street, Suite 600 | Boston, MA 02108
www.bovelanga.com | p 617.720.6040 | f 617.720.1919
Using the Power of Appointment to Protect Assets – More Power
Than You Ever Imagined*
Alexander A. Bove, Jr.
Editor’s Synopsis: Powers of appointment can be used in very flexible and creative manners as
an additional asset protection strategy. As a very simple example, in some circumstances, a
donor could create a trust with an income interest for the donor, but giving a third party the
power to appoint the assets to a new trust for the donor’s spouse (which power might be
exercised if the donor subsequently had creditor problems). The article explores a number of
creative planning alternatives, addresses the tax effects of varying types of powers of
appointment, and gives practical guidance on how to achieve flexibility and asset protection
while avoiding potentially devastating tax consequences.
TABLE OF CONTENTS
Introduction
I.
What Is a Power of Appointment and Why Is It Such a Great Tool?
II.
Powers and Asset Protection
A. Using Powers to Establish Asset Protection Trusts in Non-Asset Protection States
B. Protective Restrictions and Conditions on Powers
1. Powers Subject to Consent
2. Concurrent Powers
3. Powers From Nowhere
III.
The Fraudulent Transfer Question
A. General Relevance to Powers of Appointment
B. Non-Trust Use of Powers
IV.
Tax Considerations
A. General Power of Appointment Retained by the Donor
B. Special Power of Appointment Retained by the Donor
C. General Power of Appointment Granted to Another
D. Special Power of Appointment Granted to Another
E. Joint Powers
F. Powers Subject to Consent
G. Hybrid Power – The “Delaware Tax Trap”
V.
Page 2
Conclusion
INTRODUCTION
Of all the sophisticated tools used for asset protection planning, one of the most effective
but vastly underused, except in elementary ways, is the power of appointment. Historically (and
habitually), use of the power has been either to grant someone other than the original owner of
that property the power to direct ownership of the property, or to reserve for the owner of the
property the power to redirect the ownership of that property by exercising the reserved power.
By and large, the overwhelming purpose of the use of powers of appointment by estate planners
has been to affect the avoidance of the deliberate incurrence of income, gift, or estate tax
liabilities. But in fact, there are so many non-tax possibilities surrounding the use of powers of
appointment, particularly for asset protection purposes, that at least a volume could be written
about them. This discussion offers a number of those possibilities and explains how they may be
creatively used to protect assets of the grantor and her family.
I.
WHAT IS A POWER OF APPOINTMENT AND WHY IS IT SUCH A GREAT TOOL?
At the risk of sounding too basic, a power of appointment is simply the power to dispose
of property. 1 A power that by its terms cannot directly or indirectly benefit a powerholder is
called a “special” or “non-general” power, while one that can benefit the powerholder is
regarded as a general power.
The power can be granted to another or reserved by the donor (the person creating the
power), but in either event, the key and most useful feature for asset protection purposes is that
for property law purposes, the powerholder does not own, that is, he has no interest in the
property subject to the power, because the power is not considered an interest in property. 2
Contrary to what some believe, and contrary to our tax law concept, this applies to one holding a
general power as well as one holding a special power. 3
The terms of the power are established by the donor and will govern the conditions of
exercise, the objects, and the extent of the power. One of the significant planning benefits of the
Page 3
power in this regard is that such provisions can be extremely flexible and are limited only by
public policy and, in those states that still have it, the rule against perpetuities. 4 Thus, the donor
could provide that the power would begin and end on a certain date, or at a certain age of the
powerholder, or almost any other condition. The power could be transferrable to another or
automatically pass to another on a powerholder’s death or disability (a “cascading power”), it
could terminate on divorce of the powerholder, and it could require consent of another for its
exercise.
In the context of this discussion, it is very important to distinguish powers of appointment
that are fiduciary versus those that are non-fiduciary. A trustee with discretionary powers, for
example, holds a fiduciary power of appointment, which must be exercised (or not) within the
scope of the trustee’s fiduciary duty. The holder of a non-fiduciary power, on the other hand, is
governed only by two rules: the language (terms and provisions) of the grant of power, and the
prohibition of committing a fraud on the power (as, for example, where a holder of a special
power receives compensation for exercising the power in favor of a particular appointee). Note
also that a power can be a fiduciary one even though held by a non-trustee. For instance, where
the settlor grants his sister the power to appoint trust principal for the benefit of her children’s
health and education, or where powers are given to a trust protector to carry out the purposes of
the trust. 5 In sum, the flexibility of the power of appointment is almost unlimited, and when
combined with the added flexibility offered by a trust, creative use of the power can create a
protective arrangement virtually impenetrable by creditors.
II.
POWERS AND ASSET PROTECTION
A. USING POWERS TO ESTABLISH ASSET PROTECTION TRUSTS IN NON-ASSET PROTECTION
STATES
In most asset protection trusts (APTs), the drafters will have the settlor retain a special
testamentary power of appointment for the primary purpose of avoiding a gift tax on funding. 6
A secondary benefit is that it offers the settlor the ability to change the disposition of the trust
Page 4
property at death, but in many situations, this feature is not of great interest or use. The settlor
would establish his APT in either one of the several U.S. states that has adopted APT legislation
or one of the handful of desirable offshore APT jurisdictions. Many settlors would rather settle
their trust locally, but have been led to believe they cannot establish an APT in a state that has no
specific legislation allowing the same. This is not so. The mistaken belief is based on
spendthrift trust law (which applies in the non-APT states) that allows creditors of a settlor to
reach the assets of a self-settled trust to the extent the trust allows payment to him. If, however,
distributions are, for example, limited to the income, then absent a fraudulent transfer, the
principal of the trust would be protected, even in a non-APT state. 7 But even the income (if
discretionary) would be protected in an APT state, until it is paid out to the settlor.
A comparable protective result could be realized in a non-APT state by having the settlor
establish an income-only trust for his own benefit, giving another party, say, one of his children,
a special power of appointment in favor of the settlor’s spouse and issue (other than the
powerholder). If the trust is attacked (or about to be) by a creditor, the child could exercise her
power (reserving the right to revoke the exercise) and appoint the trust property to a new trust for
the benefit of the settlor’s spouse while she remains a spouse. When the coast became clear and
the litigation against the settlor is resolved, the child could re-exercise her power and appoint the
property back to the original trust for the benefit of the settlor. Meanwhile, the income from the
“new” trust could be paid out to the settlor’s spouse, presumably offering some benefit to the
settlor. (Avoiding a taxable gift in such a situation is discussed later in this article.) To make
matters more difficult for the settlor’s creditors, the new trust could be settled in another state.
Another version of the plan would be to grant the spouse a special power and she would
move the assets away from the creditor’s reach. Her power could terminate in the event of
separation or divorce and pass to a child.
Note that a court could neither force an exercise of the power nor enjoin the exercise, 8
except, perhaps, where the settlor’s transfer to the trust was a fraudulent transfer or where the
powerholder was the settlor of the trust. 9 In regards to the latter, at least one attorney has
Page 5
proposed an arrangement that would accomplish estate tax savings and asset protection for the
settlor. Where a couple has an unequal estate, the wealthy spouse would establish an inter vivos
QTIP for the other spouse, granting the other spouse a broad special testamentary power of
appointment. (A “broad” special power can be exercised in favor of anyone in the world except
the powerholder, his creditors, or his estate.) The option (read: hope) is that the spouse would
establish a discretionary trust for the benefit of the settlor/husband and on death exercise her
power in favor of that trust. 10 The concerns that arise here are twofold: first, that the spouse for
one reason or another may not exercise her power in such a way. Second, the trust established
by the donee spouse and funded with the wealthy spouse’s assets might be viewed as a selfsettled spendthrift trust by the settlor/husband under the “relation back” doctrine. This doctrine
holds that a transfer that is the subject of the exercise of a power is not a transfer by the
powerholder (as she has no interest to transfer) but rather it is a continuation of the transfer made
by the donor (here the settlor/husband) and completed by the powerholder under authority given
to her by the donor. 11 Commentators have observed that the relation back doctrine is provided as
a means of rendering the transaction legally “sound” from a property law standpoint, as without
it, no one would be making the transfer. Thus, it is not clear that a court would actually hold that
it was a transfer from the donor to a trust for his own benefit through a powerholder’s
discretionary exercise of a power of appointment, but it is a risk.
There are ways to help with these two concerns, however. As to the first concern (that
the spouse may not exercise the power), one strategy would be to make the spouse’s exercise of
the power subject to the consent of another, say, one of the settlor’s children. Of course, this
may not help if the spouse and child cannot agree, but at least it would prevent the spouse from
exercising the power in some unexpected way. Another possibility is to grant the power to
someone other than the spouse, again perhaps to one or two children, which should certainly
increase the odds greatly if the donor spouse still has a large estate. As for the second concern
(the relation back doctrine), this is easily dealt with by exercising the power to establish the trust
in an APT state where such a doctrine would not matter.
B. PROTECTIVE RESTRICTIONS AND CONDITIONS ON POWERS
Page 6
1. POWERS SUBJECT TO CONSENT
As noted earlier, a power can be crafted to insure against involuntary exercise or an
exercise contrary to the intentions of the donor as may be known to another. For instance, a
donor could grant a broad special power to a donee (powerholder), but the exercise of the power
could be subject to the consent of a party named by the donor, or even a party to be named by a
party chosen by the donor. As already noted, a court could not force the special powerholder to
exercise her power, but further, neither could a court force the other party to consent to her
exercise. 12 As a general rule, creditors of the holder of a special power cannot reach the assets
subject to the power nor can they force the exercise of the power. 13 The same rule applies to the
holder of a general power granted by another, but with certain important exceptions. First, the
Uniform Trust Code (“UTC”) provides an exception, as it regards the holder of a general power
as the de facto owner of the property subject to the power, 14 so a review of a protector state’s
adoption of the UTC will be important. Second, some states provide that creditors can reach the
assets subject to the power if the powerholder’s other assets are not sufficient to meet the debt. 15
Third, in any event, U.S. bankruptcy law provides that the trustee in bankruptcy “stands in the
shoes” of the debtor and so may be able to exercise the general power on behalf of the
debtor/powerholder and in favor of the bankrupt estate. 16 It is also quite possible to provide that
the exercise of a power, whether general or special, can be void or disregarded if exercised under
duress, a provision commonly used in asset protection trusts. Interestingly, this would not
protect a general power (at least in the case of domestic trusts) from being exercised by a trustee
in bankruptcy (of the general powerholder), because the trustee, who “stands in the shoes” of the
debtor/powerholder, would not be exercising the power under duress.
There are, however, two possibilities of safeguarding against this exposure. For one, as
suggested above, the exercise of the general power could require the consent of another, or the
power could be a joint power. As noted, a court cannot order a party to consent, absent a
fraudulent transfer. 17 For another, the terms of the power could provide that the power would
automatically terminate in the event bankruptcy proceedings are filed. Unfortunately, there is
Page 7
some uncertainty to this condition on account of the so-called “ipso facto” rule of bankruptcy
law, providing that automatic cancellation provisions in a contract or other “property”
arrangement will not be operative as against a trustee in bankruptcy. It is interesting to note that
this provision relates to property interests of the debtor, and as explained earlier, a power of
appointment is not an interest in property. 18 Nevertheless, it is likely that the ipso facto rule
would apply to allow the bankruptcy trustee to exercise the power notwithstanding the provisions
for termination. There appear to be no cases on the ipso facto rule that address this particular
issue, but the decisions on the rule seem to treat it as an absolute power on the part of the trustee
in bankruptcy unless the provision restricting the bankruptcy trustee falls clearly within one of
the exceptions, 19 and the simple termination of the general power conditioned on bankruptcy
does not appear to qualify as an exception. Where protection of a general power in the event of
bankruptcy is a concern, once again, the power could be made subject to the consent of another
party, or in some cases a concurrent power may be useful.
2. CONCURRENT POWERS
There is also the option of providing for concurrent powers. That is where two or more parties
have a power to appoint the same property, exercisable independently but concurrently (not
jointly). In this arrangement, it would be somewhat like a joint bank account, where the first to
withdraw funds (which itself is tantamount to the exercise of a power) effectively precludes the
other powerholder from exercising her power with respect to the appointed property. For
instance, say that Bob is granted a general power of appointment over trust property and Bill has
a concurrent special power of appointment over the same property. If Bill exercises his power
and irrevocably appoints the trust property, then Bob’s power becomes meaningless, as the
property has been removed from the trust and there is no longer any property for Bob to appoint.
This would, of course, frustrate any creditors of Bob seeking to reach the assets through Bob’s
general power, as well as Bob’s trustee in bankruptcy, if it came to that. It is important to note
that this would not be the outcome if the powers were granted directly over non-trust property,
such as real estate. In that event, Bill’s exercise of his power would not affect Bob’s power,
which would “follow” the property until released or irrevocably exercised. It is also important to
Page 8
note that Bill’s exercise of the power does not give rise to a fraudulent transfer (see discussion
below) as it is not a transfer by Bill.
Thus, as illustrated, where the powers are held under trust without reference to specific
property, if a general powerholder had a concurrent power with a special powerholder, and the
general powerholder was facing bankruptcy or a creditor attack, the special powerholder could
exercise his power to move the trust assets out of harm’s way. The important difference between
concurrent powerholders and joint tenants is that the powerholders have no property interests in
the assets and are not accountable to each other in any way. There is only the responsibility to
comply with the terms of the power and not to commit a fraud on the power. 20
3. POWERS FROM NOWHERE
The power to grant a power of appointment is not at all unusual for tax purposes, but most
planners who use them seem to have overlooked their potential for asset protection purposes. In
dynasty-type trusts, it is frequently recommended that the trustee be given the power to grant a
general power to a beneficiary in order to correct or avoid a potential exposure to the generationskipping transfer (“GST”) tax. 21 In fact, the power to grant a power may, but certainly need not
be, restricted to a trustee. And whether the power is held by the trustee, a protector, or some
other party, it can be a very effective tool to remove trust assets from the reaches of a
beneficiary’s creditors. For instance, say that Claude establishes a trust for the benefit of his
children and grandchildren; the trustee has the power to grant powers of appointment to the
beneficiaries, and a protector has at the same time, the power to grant special powers of
appointment. To avoid a GST tax, the trustee grants a lifetime general power of appointment to
one of Claude’s children (which generally causes the trust assets to be subject to the Federal
estate tax in that child’s estate rather than being subject to the GST tax). Later, that child has a
financial downturn and fears that his creditors could force a bankruptcy filing. In the meanwhile,
the protector grants a special power of appointment over the child’s share of the trust to another
child, who subsequently exercises her power (on a revocable basis), removing the assets from the
reach of the debtor child’s creditors.
Page 9
III.
THE FRAUDULENT TRANSFER QUESTION
A. GENERAL RELEVANCE TO POWERS OF APPOINTMENT
The fraudulent transfer issue is directly and critically related to powers and will be examined
in three instances. The first is as to the donor, who may, for example, transfer assets to an asset
protection trust where she is a discretionary beneficiary but where another party has a special
power of appointment. If the transfer is found to be a fraudulent one as contemplated under the
Uniform Fraudulent Transfer Act, 22 then a court may order it rescinded, and the trust will offer
no protection, nor would the exercise of the power by the powerholder. The second instance is
where a donee who possesses a general power of appointment exercises that power in an effort to
remove the property subject to the power from the reach of his creditors, and the third instance is
where a special powerholder has exercised his power in a way that removes the appointed
property from the donor’s creditors.
As to the second instance, where a general powerholder exercises his power to remove the
property from the reach of his creditors, this action is deemed to convert the power from a mere
power (and not an interest in property) to an acquisition of the property by the general
powerholder and a subsequent transfer of what then becomes an interest in the property. Thus,
this is not deemed to be a transfer by the donor of the power but by the general powerholder
herself. 23 Even the theory that a general power created by someone other than the powerholder
is not reachable by the powerholder’s creditors only holds where the power remains
unexercised. 24
The third instance deals with the question of whether a transfer by a special powerholder
can be a fraudulent transfer by the donor of the power, which, at first impression can appear
confusing, since the powerholder appears to be making the transfer. In fact, property law
provides that, except as noted above where a general powerholder exercises the power, it is the
original transfer by the donor that is the relevant act for fraudulent transfer purposes and not the
Page 10
subsequent exercise of the special power. 25 Therefore, unless the donor reacquires the property,
the only relevant date to consider for fraudulent transfer purposes by creditors of the donor is the
date of the original transfer by the donor. Subsequent exercises of a special power over the
transferred property have no bearing on the issue.
If we look again at the example above where the settlor established an income-only trust,
it is the date of the donor’s transfer to the trust that is relevant and not the child’s subsequent
moving of the assets out of the creditor’s reach by exercise of the special power. Unless the
exercise was made or attempted within the period of limitations that applied to the settlor’s
original transfer, there would be no basis for a court to interfere with the exercise or to hold the
transfer fraudulent.
B. NON-TRUST USE OF POWERS
It is interesting to observe that most attorneys use powers only in connection with trusts.
This may be due to the fact that in virtually all of the treatises dealing with powers, notably
including the Restatement of Property, every example illustrates a power granted in a trust. Of
course, while it may be more appropriate to include a power in a trust because that is usually the
main dispositive instrument in an estate plan, there is absolutely no reason why powers cannot be
granted outside trusts, such as with deeds to real estate, patents, royalties, membership interests
in LLCs, shares of a closely held corporation, even promissory notes. In fact, that possibility
lends an almost never-used asset protection feature to such assets. From a practical standpoint,
this approach often was not recognized before, since these assets often are not placed in trust,
because the planner feels that keeping them out of trust may be far simpler and less costly.
Real estate may be the simplest of these items that may be protected by a power. Here it
is merely a matter of recording the grant (or reservation) of the power in a deed and recording the
deed. No trust is involved or required. For instance, say that parents deed their residence to their
three children, reserving a life estate for themselves, and also reserving lifetime and testamentary
special powers to appoint the property. Although the life estate arrangement is common, the
Page 11
reserved power in the remainder is not. Without the reserved powers, the children’s remainder
interests are subject to the children’s creditors, divorce, and even transfers of the remainder
interests without the parents’ knowledge or consent. The reservation of the special powers, on
the other hand, provides parents with control over the disposition of the property, protection from
children’s problems, and the ability to sidestep any undesirable transfer of the remainder. In
drafting powers in this type of situation, attorneys must consider the options of joint and survivor
exercise and exercise by a personal representative of the powerholder, among other things. 26
As suggested, powers can also be granted or reserved on other types of property. While
there is no limitation on the type of property that may be subject to a power, a power over
tangible personal property presents practical problems in its application, except in those cases
where ownership and transfer of such property is dependent on certification of ownership and
title, such as with an automobile, an airplane, or a yacht. In these cases, a power could be
recorded on the certificate of title. But on items such as works of art, jewelry, or antiques,
ownership is typically demonstrated by possession, and transfers of ownership are effected by a
new deed of transfer created by the person in possession, thus, making it easy to ignore the
presence of a power over the property.
The granting or retention of powers over a membership interest in a limited liability
company, a partnership interest, or shares of closely held stock 27 also offer interesting
possibilities in terms of creditor protection. For instance, say that Dad transfers a 40% interest in
the family business (in any one of the three entity forms) to Son, simultaneously granting Mother
a special power of appointment over the interest. Until the power is exercised, Son is considered
the legal (and tax) owner of the interest for all purposes. If Son’s interest is attacked, Mother
could exercise her power (on a revocable basis and in accord with any restrictions in the
governing agreement) and defeat any such attack. As explained above, this would not be a
fraudulent transfer by Son, and there is no precedent of a court enjoining Mother’s exercise of
the power, barring fraud.
IV.
Page 12
TAX CONSIDERATIONS
From a federal tax perspective, the use, application, exercise, and lapse of powers of
appointment may be one of the trickiest and most confusing issues we encounter in estate and tax
planning. Where powers are to be granted, retained, released, exercised, or some combination
thereof in a plan designed to protect assets, it is essential to understand the tax ramifications of
all such acts. Following is a working discussion of the tax considerations that accompany
powers of appointment. It is basically broken down into two parts: powers retained by the donor,
and powers granted to others. Where both categories are involved through concurrent powers,
the income tax consequences of powers retained by the donor would prevail. 28 Note, however,
that the discussion is not exhaustive of every possible situation and only touches upon
generation-skipping issues.
A. GENERAL POWER OF APPOINTMENT RETAINED BY THE DONOR
When a person makes a transfer, whether in trust or otherwise, and reserves the power to
recover the property (as through the exercise of a general power), he has not – in the eyes of the
tax law – relinquished dominion and control over the property. Thus, he has made no completed
taxable gift of the property. 29 Because the donor has not made a completed gift, the income and
losses relating to the property will pass through to the donor of the power for federal income tax
purposes, 30 even though from a property law standpoint he no longer owns the property.
On the donor’s death, if he continues to hold the power, the full value of the property subject
to the power will be included in the donor’s estate, but not under the Internal Revenue Code
(“Code”) section governing powers of appointment (Section 2041). Rather, the property is
included under the Code sections relating to retained control over a transfer. 31 This is because
Sections 2041 (estate tax) and 2514 (gift tax), dealing with powers of appointment, are
concerned only with powers granted to the decedent or donee by another person. 32 A reserved
power, on the other hand, is viewed as being the same as retained enjoyment (Section 2036) or
retained control (Section 2038) and this also causes property subject to those sections to fall
within the scope of Code Section 2035 (transfer within three years of death). For this reason, an
Page 13
exercise or release of the reserved power by the donor within three years of the donor’s death
will result in estate tax inclusion of the date of death fair market value of the property subject to
the exercise or release, 33 instead of only the amount of the adjusted lifetime taxable gift, which
would be the case where the donor grants a general power of appointment to another party.
B. SPECIAL POWER OF APPOINTMENT RETAINED BY THE DONOR
A special power of appointment, whether narrow or broad – when it is created through a
reserved power by the donor, is likewise not treated as a power of appointment under Section
2041, but rather, as with the general power, as a retained power under Section 2036 or 2038 for
estate tax purposes, as explained above. As is the case with the retained general power, the
donor has not made a completed gift. 34 Accordingly, the income and losses relating to the
property subject to the power will pass through to the donor/powerholder, because he continues
to be regarded as the owner of the property for tax purposes. 35
Interestingly, the only Code section specifically stating that a transfer that is subject to
the transferor’s retained power to control beneficial enjoyment will cause the income or losses on
that property to be passed through to the powerholder, deals with a transfer to a trust (under the
so-called grantor trust rules). 36 Nevertheless, it would be naïve to assume, based on this Code
section that the concept and tax results apply only to transfers to trusts and would not apply to
non-trust transfers (e.g., a power reserved in a deed). If that were so, it would permit a donor
who made a transfer with a reserved power to temporarily and repeatedly shift taxable income
among an unlimited number of recipients without ever making a completed gift.
For instance, Dan could deed his income-producing property (not through a trust) to Son
number 1, reserving a special lifetime power of appointment in the deed. Four months later, Dan
could revocably exercise the power in favor of Son number 2. Three months after that, Dan
could revocably exercise the power in favor of Son number 3, and so on, and so on. If we accept
the “no trust-no tax” argument, Dan would have shifted the taxable income among his chosen
Page 14
donees at will without ever having made a completed gift! This is an unlikely result, to say the
least.
It should be noted, however, that for the calendar year 2010, if the transfer with a
reserved special power of appointment in the donor is made to a non-grantor trust, the transfer is
treated as a completed gift, despite the regulations discussed above stating that the gift would be
incomplete. This result is dictated by temporary Code Section 2511(c) which took effect on
January 1, 2010 and expires on December 31, 2010. The same transfers to grantor trusts and
outright to donees will not be considered completed gifts where the donor has retained a special
power of appointment. Of course, except where Section 2511(c) applies, there would be a
completed gift when the donor/powerholder irrevocably exercises or releases the power. 37
In any event (i.e., with or without Section 2511(c)), as with the retained general power,
the full value of the property subject to the special power will be in the donor/powerholder’s
estate on his death, 38 and a release or exercise of the power within the three years of death will
similarly bring the full value into the estate. 39
C. GENERAL POWER OF APPOINTMENT GRANTED TO ANOTHER
When a general power of appointment is granted to a third party and the donor has
otherwise given up all dominion and control, a completed gift has been made. 40 Even this result
may be clouded, however, if – for example – the third party has a concurrent general power with
the donor. In that situation, there may be no completed gift until the donee/powerholder
exercises his power. For instance, suppose that George creates a trust, reserving the right to
withdraw the income and corpus. The trust also contains a provision allowing his brother Jeb to
withdraw the income and corpus. Until Jeb makes a withdrawal, there is no completed gift. (In
the meantime, George will be taxed on the trust income, as explained below. 41)
If the donee/general powerholder dies, the full value of the property subject to the power
will be includable in his estate, unless the power falls under one of the exceptions to the general
Page 15
power. 42 One of the most common and useful exceptions is where the exercise of the power is
governed by an “ascertainable standard,” such as health, education, maintenance, and support.
This is deemed to place adequate limitations on the powerholder, with the result that he does not
have a carte blanche “to consume the property, and his actions are reviewable by a court.” 43 This
is probably so even though the standard may be subject to the powerholder’s “sole and absolute
discretion,” because a trustee’s exercise of discretion is always reviewable by a court. The other
exceptions to a general power include powers that are exercisable only with the consent of the
donor or with the consent of an adverse party (someone whose interest would be adversely
affected by the exercise of the power).
In order to be treated as general power for tax purposes, it is not necessary that the power
be exercisable in favor of all of: the powerholder, his creditors, his estate, and the creditors of his
estate. Section 2041 recites these in the alternative, so the inclusion of any one of them will
make the power a general power. Further, in some cases, the inclusion can be even more subtle,
such as where payments are permitted to or for a dependent of the powerholder. If the power can
be exercised to make a payment that would discharge a powerholder’s legal obligation of
support, then it would be deemed to be payable to his creditors and therefore includable in his
estate on his death. 44 To avoid this exposure, especially in a trust, the language governing the
power could provide that the power could not be exercised in a way that would have the effect of
discharging any of the powerholder’s legal obligations, including the obligation of support.
A sole general powerholder over property will be treated as the owner of the property for
income tax purposes, and so all income and losses on the property subject to the power will pass
through to the powerholder. As noted above, however, the Code section dealing with this tax
consequence relates to a power held under a trust. 45 Nevertheless, few, if any, would argue that
the sole holder of a general power of appointment over property should not or would not be
taxed on the income, because for every other tax purpose, he is unquestionably treated as the
owner (except where an ascertainable standard applies, as discussed later). 46 That is, the
property subject to the power is in his estate on death; he can make a gift of it by exercising or
Page 16
releasing the power; he could receive consideration for exercising the power; and he can, of
course, simply appoint the property outright to himself or his creditors.
The question of who is taxed on the income may be more appropriate when there is more
than one general powerholder, such as when the donor and the donee both hold a general power.
In the case of a trust where the grantor and another party both hold a general power, the nod is
given to the grantor of the trust (the donor of the power) and the trust income is taxed to him. 47
If the donee exercised his power, that can change the result, and it can also be changed if the
concurrent powers are held outside a trust.
For example, if George deposits $10,000 in a bank account in the joint names of himself
and his sister, Georgia, in a state where each joint tenant has the right to withdraw the whole of
the account, there is no gift to Georgia and no income will be taxed to her until she has exercised
her right of withdrawal over the account. 48 The issues relating to a grant of a power to another
also arise when a donee is given a withdrawal power over property, such as in the case of a socalled Crummey power, 49 or a “five-or-five” power. 50 In both instances, as a general rule, the
powerholder is deemed to be the owner of the property or the trust – to the extent of the power –
for income and capital gains tax purposes. 51
For estate and gift tax purposes, the same rule generally applies, but an exception to the
gift tax occurs when the donee’s power is limited to the greater of 5% of the assets or $5,000,
noncumulative, each year (the so-called five-or-five power). 52 The benefit of this power is that it
allows a donee to have the equivalent of a general power of appointment over a portion of the
property while limiting the portion that will be treated as a gift if he does not exercise the power.
For example, assume that Dad establishes a trust for Daughter. The trust provides that
each year Daughter may withdraw the greater of $5,000 or 5% of the principal of the trust. To
the extent she does not make a withdrawal in a given year, the power lapses. Suppose that the
trust principal is $500,000, so that Daughter could withdraw $25,000 during the year. The fiveor-five power exception provides that a lapse of the power is not considered a gift by Daughter,
Page 17
even though the effect of the lapse is as if she withdrew the $25,000 and then immediately
recontributed it to the trust. The exception does not apply for estate tax purposes, so that
Daughter’s death in the year that the trust principal is $500,000 would result in the inclusion of
$25,000 in Daughter’s estate.
Another exception – one that is far more usable for estate planning purposes – applies
when the donee’s power is limited by an “ascertainable standard.” Even though a donee may
have the power to consume property or use it to pay his creditors, it will not be treated as a
general power if its exercise is subject to a “reasonably measurable” standard “in terms of needs
for health, education, or support (or any combination of them).” 53 This exception would allow,
for example, a settlor to name his spouse as sole trustee of a family trust (or credit shelter trust),
or would allow a child to be the sole trustee of a generation-skipping trust, even though the
spouse or child trustee/powerholder was also a discretionary beneficiary of that trust, so long as
the trustee’s discretion was governed by an ascertainable standard. 54
If the trustee’s power is not governed by an ascertainable standard and the powerholder is
the trustee (or even if the powerholder is not the trustee but has the power to remove the existing
trustee and appoint herself as the trustee), 55 then the full value of the trust property subject to the
trustee’s discretionary power will be included in the powerholder’s estate, or, if the power is
exercised (or released) during the powerholder’s lifetime, the full value of the trust property will
constitute a taxable gift. 56 Even if only one word in the prescribed standard does not meet the
requirements, the exception is lost. Practitioners sometimes seem to enjoy walking dangerously
close to the line by using phrases such as “support in reasonable comfort” or “support in her
accustomed manner of living.” While those are certainly acceptable standards, 57 it is frightening
to think that a mere “typo” leaving out the word “support” in these cases could lead to an estate
tax disaster (and perhaps a malpractice suit).
D. SPECIAL POWER OF APPOINTMENT GRANTED TO ANOTHER
Page 18
If the donee/powerholder has only a special power of appointment, she is not deemed to
be the owner of the property subject to the power, and so as a general rule, the property subject
to the power will not be included in the powerholder’s estate, and an exercise or release of the
power will not constitute a taxable gift by the powerholder. This arrangement can be very
helpful where, for instance, the donor desires some flexibility in his plan to allow for changing
needs and circumstances of beneficiaries (possibly including himself) in the future, including a
move to protect the trust assets from creditors of the beneficiaries. For example, by giving
someone (other than a beneficiary) the lifetime and/or testamentary power to appoint corpus
among beneficiaries, the powerholder could, without any gift or estate tax consequences to the
powerholder, exercise her discretion to change the shares of the beneficiaries in the future to
accommodate their respective needs or changing tax circumstances.
An interesting question arises when the property is subject to a special power in both the
donor and the donee, and the donee exercises the power. This is not, as noted earlier, treated as a
gift by the donee (except as explained below), 58 because the donee never owned the property.
But is it a gift by the donor? It would have to be, for the reason that the donee is merely acting
as the “agent” of the donor, who has now lost dominion and control over the property;
otherwise, a person would be able to make a completed lifetime transfer of property without
consideration from one individual to another while completely bypassing the gift tax. One way
to avoid exposure to a gift tax in this case would be to provide in the language granting the
special power that any exercise of the power by the donee would continue to be subject to the
donor’s originally reserved special power. This would render the gift incomplete as to the donor,
even after the donee’s exercise of the power.
Practitioners should be mindful of the situation where the special powerholder is also an
income beneficiary of the trust property over which the power is held. In that event, an exercise
of the power could result in a gift by the powerholder. For example, suppose that Alexander
creates a trust providing an income interest for the benefit of his daughter, Adrienne, and on her
death, to her children. He grants Adrienne the lifetime and testamentary power to appoint the
principal to her issue. If Adrienne exercises her lifetime power and appoints principal to a child,
Page 19
the exercise of the power will constitute a gift by Adrienne of the present value of the income
interest lost by Adrienne as a result of the reduction of principal. 59 It will not constitute a further
gift by Alexander as he made a completed gift of the corpus when he established and funded the
trust.
One would think that the above problem could be circumvented by making the special
power subject to an ascertainable standard. While it appears this argument is supportable, the
IRS has rejected it, stating that the transfer of the income interest was nevertheless a gift. 60
For income tax purposes, the existence of a special power will not affect the powerholder,
but it is very likely to affect the donor of the power, and it can also hold traps for the unwary.
For instance, if the powerholder is the grantor’s spouse, and if the spouse was not legally
separated from the donor at the time of the transfer, any powers held by the spouse are treated as
being held by the donor. 61 Moreover, Section 674 of the grantor trust rules deals in large part
with powers of appointment, is very complicated, and contains numerous exceptions resulting in
different income tax consequences.
Generally, though, if the donor (grantor) has the power (including a power held by the
donor’s spouse) to control the beneficial enjoyment of the corpus or income, the donor will be
taxed on the trust income. 62 The same result will apply if the power is held by a third party who
does not have an adverse interest in the trust. 63 Furthermore, if the power is held by a trustee and
the trustee is not an independent party as defined by Section 672, then once again the donor will
be taxed on trust income. 64 There are a variety of exceptions to these general rules, detailed in
Section 674. One of the several exceptions applies if the power extends only to trust
beneficiaries other than the donor or the donor’s spouse and is limited to a “reasonably definite
external standard;” in that event, the donor will not be taxed on the income. 65
With all these special rules and exceptions, it is easy to see how unexpected and probably
unwanted tax results can occur. For example, take the case where a broad special lifetime power
is granted to, say, the donor’s brother, over a trust for the benefit of the donor’s children.
Page 20
Because this arrangement does not fall under any of the exceptions to Section 674, the donor will
be taxed on all income from the trust, despite the fact that (1) he has no direct or indirect control
over the beneficial enjoyment of the trust and (2) he made a completed gift when he transferred
property to the trust.
This arrangement can actually produce a tax advantage in the right circumstances.
Although the income of the trust is taxed to the donor, it cannot be paid to him, and in the typical
case, both the income and the trust corpus are excluded from the donor’s estate. In addition, the
Internal Revenue Service has ruled that the donor’s payment of the income tax on the trust
income is not considered an additional gift to the beneficiaries. 66 As a result, the “after-tax”
income will accumulate or pass tax-free to the trust (or the beneficiaries), and the donor’s estate
will be reduced by the tax paid on the income, at no gift tax cost.
E. JOINT POWERS
As illustrated earlier, the use of joint powers can be very helpful when one wants to make
a completed transfer for tax purposes and yet prevent the donee/general powerholder from
having unrestricted control over the transferred property, or if one wants to protect the
transferred property from the creditors of the powerholder. 67 A joint power is one that must be
exercised by all the joint powerholders (unless otherwise noted, this discussion will contemplate
only two joint powerholders). On the death of one of the joint powerholders, the power would
lapse, unless the language creating the power directs otherwise.
As simple as a joint power may appear, the estate and gift tax considerations can be
tricky. For instance, whether the power is general or special as to either powerholder will
depend on whether either powerholder is a permissible appointee or a taker in default. If one of
the powerholders is a permissible appointee 68 and the other is a “non-adverse” party, 69 then the
power is a general power as to the permissible appointee and a limited power as to the nonadverse party.
Page 21
To illustrate, assume that Don grants a joint power to Dave and Doug, which may be
exercised in favor of Dave. On Dave’s death, any unappointed property will pass to Doug (thus,
Doug is a taker in default). In this situation, Dave’s power is a limited one, because Doug is an
adverse party. If Doug were not a taker in default, Dave’s power would be a general one,
because it could be exercised in Dave’s favor without the consent of an adverse party. This is
the case even though Doug could prevent Dave from exercising the power simply by refusing to
join in the exercise.
The consequences of a general power would be that on Dave’s death, the property subject
to the power would be included in his estate and any exercise of the power during Dave’s
lifetime would be a taxable gift by Dave. The disadvantageous tax results could be avoided if
the power was subject to an ascertainable standard as discussed above. 70 In addition, if the
power is exercisable only with the consent of the donor, it will be considered a limited power,
but then the property would be included in the donor’s estate on his death. 71
If both the joint powerholders are permissible appointees, the property subject to the
power is treated for tax purposes as if it were jointly held property, but without the contribution
furnished test. That is, each of the joint powerholders would be treated as the owner of a
proportionate share of the property for income, gift, and estate tax purposes. If one of the two
joint powerholders died, only half the property would be included in his estate. 72 Remember,
this does not affect the disposition of the property. If the joint power remains unexercised, the
property will pass to the vested owners or the takers in default, as the case may be.
For example, suppose that Xavier deeds property to Xeno, but in the deed, he grants Jack
and Jill the joint power to appoint the property to anyone, including themselves. On Jack’s
death, one-half the property will be included in his estate. On Jill’s subsequent death, however,
none of the property will be included in her estate, because after Jack dies, she can no longer
exercise the power. If Jack and Jill died simultaneously, half of the property would be included
in each of their estates. 73 In any event, absent an exercise, the property remains in the hands of
Xeno, the vested owner.
Page 22
F. POWERS SUBJECT TO CONSENT
In most respects, the tax consequences of a general power subject to consent are the same
as those of joint powers, but with a couple of important differences. First, where the power is
subject to consent, it is not a joint power. It is a power held only by one party, but subject to the
consent of another in order to have a valid exercise. Thus, if the consentor is a taker in default,
this would make him an adverse party and the powerholder’s power would be a non-general
(special) power. 74 Similarly, if the consenter died before the power was exercised, the power
would terminate, unless the terms of the power provided otherwise, such as a successor
consentor or a provision that consent is no longer required. Whether such a termination would
constitute a lapse of the power and thus a taxable gift is unclear, but such a result would seem
inappropriate, though certainly not impossible. The IRS could take the position that the general
power simply lapsed on the death of the consentor and is thus the same as a power that lapses by
its terms (e.g., after a period of time). In such a case, and with only special exceptions, the lapse
of the power would constitute a gift by the powerholder. 75
G. HYBRID POWERS – THE “DELAWARE TAX TRAP”
Powers that fall under this category (i.e., special powers that can be exercised to create
another special power that can be exercised to postpone the vesting of ownership without
reference to the rule against perpetuities) can, in a sense, be treated as either general or special,
depending on the exercise of the power, but only for tax purposes. For property law purposes,
they generally begin and end as special powers. In part, our transfer tax laws (gift and estate
taxes) take into consideration the common law rule that noncharitable interests cannot be
deferred forever; at some point (typically governed by the rule against perpetuities, or “RAP”),
the interest must vest in a non-charitable beneficiary. Hence, the imposition of a transfer tax on
individual wealth would be reasonably predictable for each family, at least (roughly) every 100
years. If the provisions of a deed, trust, or other arrangements have the effect of postponing the
Page 23
vesting of an interest beyond the RAP, those provisions in the instrument will be ignored and the
interest will automatically vest within the period allowed by the rule against perpetuities.
One state (Delaware), however, had a law that, through the creation and exercise of
successive special powers of appointment, would allow the vesting of a noncharitable interest to
be postponed beyond the rule against perpetuities. Viewing this as a means of indefinitely
deferring the imposition of a transfer tax, Congress enacted Code Sections 2514(d) and
2041(a)(3), which impose a transfer tax on the exercise of a special power of appointment which
is used to create another special power, the subsequent exercise of which could postpone the
vesting of ownership without reference to the creation of the first power (which would ordinarily
start the running of the RAP).
If the donee of a special power exercised the power in the manner contemplated by
Sections 2514(d) and 2041(a)(3), the special power would be treated as a general power, the
exercise of which would be a gift, or if the powerholder died, the property subject to the exercise
would be includable in his estate. Since the effect of this law would be to impose a gift or estate
tax on an individual who never actually owned the property because he only possessed a special
power of appointment, it is viewed as a tax trap, and, because of its original relation to Delaware,
it is called and commonly referred to, as the “Delaware Tax Trap.” 76
As it turned out, though, the Delaware Tax Trap could actually be used as a bail-out of an
otherwise troublesome GST tax problem. Under this strategy, the beneficiary (whose estate
would otherwise be skipped and would be subject to GST tax because she held only a special
power of appointment) would be granted a special power that would be intentionally exercised in
the “prohibited” fashion, causing the property or a specified portion of it to be included in her
estate under the Delaware Tax Trap, thus avoiding the possibly higher GST tax.
In the meantime, nearly twenty states have repealed their rule against perpetuities law. In
those states, exposure to the Delaware Tax Trap could become even more of a problem, because,
in the typical case, and since a trust could now last forever, the states did not require that the
exercise of a special power of appointment (created under a preceding special power) be
Page 24
restricted to a time period based on the creation of the original special power. It seems now,
however, that such states are beginning to officially recognize this potential tax problem and are
taking steps to reduce or eliminate the exposure to the Delaware Tax Trap by adopting a rule
declaring that the exercise of a special power, which arises from the exercise of a previous
special power, will – by state’s law – be measured from, or be deemed to have been created on,
the grant of the original special power. 77
The Delaware Tax Trap does not apply to the grant or exercise of a general power
because, as discussed above, the possession of a general power will cause inclusion in the
powerholder’s estate, and the exercise (or lapse) of a general power will start the running of a
new perpetuities period. 78
V.
CONCLUSION
Powers of appointment are regarded by some (certainly including this author) as one of
the most flexible estate, property, and tax planning tools available today. They can be used to
build extensive flexibility into an estate plan with or without tax consequences, and they can be
used to protect property from a powerholder’s creditors, while still offering the opportunity for
the powerholder to enjoy the property. But practitioners using powers of appointment must also
be ever mindful of the somewhat complicated tax ramifications of powers in order to realize their
optimum potential in an estate plan.
1
RESTATEMENT (SECOND) OF PROPERTY §11.1 (1986).
2
Id. §13.6 cmt. B (1986).
3
Clapp v. Ingraham, 126 Mass. 200, 203 (1879); RESTATEMENT (SECOND) OF PROPERTY §13.4 (1986).
4
As a general rule, for general powers and exercised powers that create vested interests, the commencement of the
period of the Rule Against Perpetuities for unexercised special powers runs from the date of the donor’s transfer,
and for general powers, from the date of the grant or lapse of the power. RESTATEMENT (SECOND) OF PROPERTY
§§1.2 cmt. d, 1.4 (1983).
5
Alexander A. Bove, Jr., The Protector: Trust(y) Watchdog or Expensive Exotic Pet?, ACTEC ANNUAL MEETING
(2003).
6
Treas. Reg. §25.2511-2(c).
Page 25
7
RESTATEMENT (SECOND) OF TRUSTS §156 (1959).
8
RESTATEMENT (SECOND) OF PROPERTY §13.6 (1986); In Re Hicks, 22 B.R. 243 (D.Ga. 1982).
9
In Re Shurley, 171 B.R. 769 (W.D.Tex. 1994).
10
Barry A. Nelson, Asset Protection for Estate Planners, 43 U. MIAMI HECKERLING INST. ON EST. PL. ch. 18 (2009).
11
RESTATEMENT (SECOND) OF PROPERTY PART V (1986).
12
See supra note 8.
13
RESTATEMENT (SECOND) OF PROPERTY §13.6 (1986); Hicks, 22 B.R. 243.
14
UNIF. TRUST CODE §505 (2000).
15
RESTATEMENT (SECOND) OF PROPERTY §13.2 and Statutory Notes (1986).
16
11 U.S.C. §541(b)(1).
17
See supra note 8.
18
See supra note 11.
19
11 U.S.C. §365.
20
Whereas a general powerholder may benefit from his own exercise, a special powerholder may not and if he does,
or if he continues to violate the terms of power, this would be a fraud on the power and would be void.
21
Jonathan G. Blattmachr, Madeline J. Rivlin & Georgiana J. Slade, Selected Planning and Drafting Aspects of
Generation-Skipping Transfer Taxation, THE CHASE REVIEW (Spring 1996).
22
Unif. Trans. Act §§4,5, see also Clapp v. Ingraham, 126 Mass. 200, 203 (1879); RESTATEMENT (SECOND) OF
PROPERTY §13.4 (1986).
23
RESTATEMENT (SECOND) OF PROPERTY § 13.5 cmt. a (1986).
24
Clapp, 126 Mass. at 203; RESTATEMENT (SECOND) OF PROPERTY §13.1, illus. 4 (1986).
25
RESTATEMENT (SECOND) OF PROPERTY PART V, introductory note: The “Relation-Back” Doctrine (1986).
26
Alexander A. Bove, Jr., Exercising Powers of Appointment: A Simple Task or Tricky Business?, 28 EST. PL. 277
(June 2001); Alexander A. Bove, Jr., Powers of Appointment: More (Taxwise) Than Meets the Eye, 28 EST. PL. 496
(October 2001).
27
Although not impossible, granting or reserving a power of appointment in publicly held securities per se would
admittedly pose a practical problem, as it would be unlikely for a transfer agent to accept such arrangement.
28
I.R.C. §678(b).
29
Treas. Reg. § 25.2511-2(b), 2(c).
30
See I.R.C. §§674, 676; Corliss v. Bowers, 281 U.S. 376 (1930); Hawaiian Trust Co. v. Kanne, 172 F.2d 74 (9th
Cir. 1949).
31
I.R.C. §§2036, 2038.
32
Treas. Reg. § 20.2041-1(b)(2); Treas. Reg. § 25.2514-1(b)(2).
33
I.R.C. §2035(a).
34
Treas. Reg. § 25.2511-2(b), 2(c).
35
I.R.C. §§674, 676; Corliss, 281 U.S. 376; Kanne, 172 F.2d 74.
Page 26
36
I.R.C. §674 (and I.R.C. §676 if a general power is retained).
37
Treas. Reg. § 25.2511-2(b).
38
I.R.C. §§2036, 2038.
39
I.R.C. §2035(a).
40
Treas. Reg. § 25.2511-2(b).
41
I.R.C. §678(b); see infra notes 44 & 50 and accompanying text.
42
I.R.C. §2041(b).
43
See, e.g., Matter of Stillman, 433 N.Y.S.2d 701 (1980).
44
Treas. Reg. § 20.2041-1(c)(1).
45
I.R.C. §678(a)(1).
46
See infra notes 52-56 and accompanying text.
47
I.R.C. §678(b).
48
Treas. Reg. § 25.2511-1(h)(4).
49
Crummey v. C.I.R., 397 F.2d 82 (9th Cir. 1968); Rev. Rul. 73-405, 1973-2 C.B. 721.
50
I.R.C. §§2041(b)(2), 2514(e); see infra note 51 and accompanying text.
51
I.R.C. §678(a)(1); Rev. Rul. 67-241, 1967-2 C.B. 225.
52
I.R.C. §2514(e).
53
Treas. Reg. § 20.2041-1(c)(2); Treas. Reg. § 25.2514-1(c)(2).
54
Rev. Rul. 78-398, 1978-2 C.B. 237.
55
Treas. Reg. § 20.2041-1(b)(1).
56
Treas. Reg. § 20.2041-1(b)(1); Treas. Reg. § 25.2514-1(b).
57
Treas. Reg. § 20.2041-1(c)(2); Treas. Reg. § 25.2514-1(c)(2).
58
See infra notes 58 & 59 and accompanying text.
59
Estate of Regester v. C.I.R., 83 T.C. 1 (1984); TAM 9419007 (May 13, 1994).
60
PLR 9451049 (December 23, 1994).
61
I.R.C. §672(e).
62
I.R.C. §674(a).
63
Id.
64
See generally I.R.C. §674(c).
65
I.R.C. §§674(b)(5) (exception only for corpus income; exception applies even if donor or donor’s spouse is
trustee); 674(d).
66
Rev. Rul. 2004-64, 2004-2 C.B. 7.
67
See supra note 17 and accompanying text. For an analysis of the nontax aspects of exercising powers of
appointment, see Alexander A. Bove, Jr., Exercising Powers of Appointment: A Simple Task or Tricky Business?, 28
EST. PL. 277 (June 2001).
Page 27
68
A person would be a permissible appointee if the power can be exercised in favor of any one of the following: the
powerholder himself, his creditors, his estate, or the creditors of his estate. See Treas. Reg. § 20.2041-3(c)(2);
Treas. Reg. § 25.2514-3(b)(2).
69
Treas. Reg. § 20.2041-3(c)(2); Treas. Reg. § 25.2514-3(b)(2).
70
See supra notes 52 & 53 and accompanying text.
71
I.R.C. §2038(a)(1); see Estate of Grossman v. Commissioner, 27 T.C. 707 (1957); Rev. Rul. 70-513, 1970-2 C.B.
194; Rev. Rul. 55-683, 1955-2 C.B. 603.
72
I.R.C. §2041(b)(1)(C)(iii).
73
Id.
74
See I.R.C. §2041(b)(1)(C)(ii).
75
I.R.C. §2514(e).
76
See generally Jonathan Blattmachr & Jeffrey Pennell, Using Delaware Tax Trap To Avoid Generation-Skipping
Taxes, 68 J. TAX’N 242 (1988).
77
See, e.g., ALASKA STAT. § 34.27.051 (2001); DEL. CODE ANN. tit. 25, § 504 (2000).
78
RESTATEMENT (SECOND) OF PROPERTY §1.2 cmt. d (1983).
Copyright © 2013 by Alexander A. Bove, Jr. All rights reserved. [Based on the author’s article
of the same title that appeared in The ACTEC Law Journal, Vol. 36. No 2. Fall 2010
Page 28