by Legacy Plan
May 15, 2023
While a key element of estate planning involves preparing for the distribution of a person’s assets after their death, one key issue to consider is granting a survivor the ability to make decisions regarding the actual distribution of assets.
One option is to utilize a power of appointment, which is a legal tool that can add flexibility to an estate plan by granting a beneficiary the authority to decide who will receive property or assets. In layman’s terms, it’s like granting that person a “super power” to determine who gets what. It can be used for tax planning, protecting assets, directing income and maintaining control over the disposition of property or assets.
In a traditional estate plan, an individual typically decides how their assets will be distributed after their death. They may create a will or establish a trust, specifying the beneficiaries and the assets each beneficiary will receive. With a will, the personal representative or executor follows the testator’s instructions and decisions that were made while they were still alive. It’s the same situation with a successor trustee, who follows that grantor’s wishes and instructions that were determined and specified in the trust language during their lifetime.
In contrast, a power of appointment arrangement provides more flexibility in the distribution and management of assets as the individual – known as the “grantor” – essentially delegates the decision-making authority to a trusted person of their choosing, known as the “holder.”
How does a power of appointment work?
A power of appointment allows the holder to determine who will receive property or assets in any way they choose. The holder can change the disposition of property or assets, even if it conflicts with the original intention of the grantor, who created the power of appointment.
For example, a power of appointment can allow a grandchild to decide who will receive the family vacation home after their grandparents pass away. If the grandchild has a power of appointment, they can decide to give the vacation home to their siblings, sell it and divide the proceeds, or keep it for themselves.
There are three main types of powers of appointment: general, limited and special.
A general power of appointment allows the holder to distribute assets to anyone they want, including themselves, their creditors or their estate.
A limited power of appointment allows the holder to appoint assets to a limited group of people, such as their descendants or their spouse.
A special power of appointment enables the grantor to appoint the appointive property to anyone they want, but only if they meet certain conditions, such as reaching a certain age or getting married.
What are some examples of how a power of appointment may be used?
A power of appointment can be used in various ways, such as:
Providing for changing family dynamics
The use of a power of appointment in estate planning can offer adaptability and flexibility in addressing changing family dynamics in the future. By allowing the holder to distribute assets based on the beneficiaries’ needs and circ*mstances at the time of distribution, a power of appointment can help ensure that the grantor’s intentions are upheld while providing for the well-being of the beneficiaries. This flexibility can be particularly useful in situations where family dynamics change after the grantor’s death, such as the birth or adoption of additional children, marriages or divorces, or changing financial needs among the beneficiaries.
Consider a scenario in which the grantor establishes a trust for the benefit of their three children and grants a limited power of appointment to the eldest child. After the grantor’s death, one of the children gets married and has a child. The holder of the power of appointment, recognizing the increased financial needs of the married child, can decide to distribute a larger share of the trust assets to that child to support their growing family.
A power of appointment can also help address new relationships that emerge after the grantor’s death, such as stepchildren or new spouses. By granting the power of appointment to a trusted individual, the grantor can ensure that new family members are considered in the distribution of assets, even if they were not explicitly named as beneficiaries in the original trust document. For example, the grantor establishes a trust for their children and names their spouse as the holder of a limited power of appointment. Upon the grantor’s death, the spouse remarries, and the new spouse has children from a previous marriage. The holder of the power of appointment can decide to include the stepchildren as beneficiaries, ensuring that they are provided for from the trust assets.
In some cases, a grantor may have concerns about a beneficiary’s ability to manage their inheritance responsibly due to factors such as addiction, financial mismanagement or immaturity. A power of appointment can help address these concerns by allowing the holder to delay or modify the distribution of assets based on the beneficiary’s circ*mstances and behavior. Let’s say, for example, the grantor creates a trust for the benefit of their two children, with one of the children struggling with addiction. The grantor authorizes a limited power of appointment to a trusted friend, who can assess the situation and make distributions to the struggling child only when it is deemed appropriate, such as when the child is in recovery or demonstrating financial responsibility.
Addressing unforeseen financial needs
A grantor may give a power of appointment to a trusted friend or family member to distribute assets among the beneficiaries as needed. If one beneficiary encounters financial difficulties, the holder can allocate more assets to that person to help them through the challenging period. By incorporating a power of appointment into a trust, the grantor can ensure that the trust assets can be used to address unexpected financial challenges that may arise in the future.
A power of appointment can be used as a way to set aside funds for emergencies or unexpected financial needs that may arise among the beneficiaries. The holder can assess the situation and determine if a distribution is warranted to address the financial need.
For example, consider a scenario in which the grantor establishes a trust for their children and grants a limited power of appointment to their sibling. One of the children experiences a medical emergency that results in significant medical bills not covered by insurance. The holder of the power of appointment can decide to distribute a portion of the trust assets to help cover the medical expenses, ensuring the child’s well-being.
Or, a power of appointment can provide financial support for beneficiaries’ educational expenses, especially in situations where the cost of education was not anticipated or has increased significantly.
In addition, a power of appointment can help beneficiaries adapt to changing economic conditions or financial challenges, such as job loss, business failure or fluctuations in the financial markets. For example, the grantor establishes a trust for their adult children, with the intention of providing supplemental income during their retirement. One of the children loses their job unexpectedly, causing financial hardship. The holder of the power of appointment can decide to distribute a larger share of the trust assets to the unemployed child, providing financial support during this challenging time.
Dealing with long-term care needs of beneficiaries is another area where a power of appointment can be a useful tool, especially in situations where the cost of care was not anticipated or has increased significantly due to factors such as inflation or changes in health care regulations.
Or, in another situation, a grantor could create a trust for their spouse, with the intention of providing financial support in the event of their spouse needing long-term care. After the grantor’s death, the spouse develops a chronic illness that requires expensive long-term care services. The holder of the power of appointment can distribute additional trust assets to cover the increased care expenses, ensuring the spouse’s well-being and financial security.
Preserving privacy
Unlike a will, which becomes a public record after the grantor’s death, a power of appointment can maintain privacy, as the details of the asset distribution are not part of the public probate process. Probate is a court-supervised process that involves validating a will, settling the deceased’s debts and distributing their assets to the designated beneficiaries. The probate process and its related documents, including the will, become a matter of public record, which means that anyone can access information about the deceased’s estate and the distribution of their assets.
Powers of appointment are typically used in conjunction with trusts, which are private legal arrangements that allow assets to be managed and distributed by a trustee for the benefit of designated beneficiaries. Trusts, unlike wills, do not go through the probate process and are not part of the public record. By utilizing a power of appointment within a trust, the grantor can maintain privacy concerning the distribution of trust assets.
When a holder exercises a power of appointment, the details of the asset distribution typically remain private, as they are not disclosed in public probate records. The trust document, which contains the provisions regarding the power of appointment, is also generally not publicly accessible. This confidentiality allows the grantor, holder and beneficiaries to maintain privacy regarding the distribution of assets and the specific terms of the power of appointment.
By using a power of appointment within a trust, the grantor can also protect the privacy of the beneficiaries. Since the trust document and the exercised power of appointment are not public records, information about the beneficiaries and the assets they receive remains confidential. This privacy can be particularly important for high-net-worth individuals or families who wish to avoid public scrutiny or potential security risks associated with the disclosure of their financial affairs.
Offering tax advantages
The use of a power of appointment can offer various tax advantages in estate planning, depending on the type of power (general or limited) and the specific circ*mstances of the trust or estate. In this section, we will discuss how a power of appointment can provide tax benefits and provide specific examples to illustrate its potential applications.
A limited (or special) power of appointment restricts the holder’s authority to distribute assets to a specific group of beneficiaries, excluding themselves and their creditors. Using a limited power of appointment can help minimize the estate tax liability.
Consider, for example, if the grantor establishes a trust for the benefit of their children and grants a limited power of appointment to their spouse. After the death of the grantor, the trust assets are not included in the spouse’s estate for estate tax purposes because the spouse does not have the power to appoint the assets for their own benefit or to their creditors. This exclusion can help reduce the overall estate tax liability.
Another scenario would be when a limited power of appointment and generation-skipping transfer tax (GSTT).
Using a limited power of appointment can help minimize the generation-skipping transfer tax (GSTT) by ensuring that the assets are appointed to beneficiaries who are not skip persons.
Another scenario is when the grantor establishes a trust for the benefit of their children and grandchildren and grants a limited power of appointment to their eldest child. By appointing assets to the non-skip person beneficiaries (their children), the eldest child can help minimize GSTT liabilities, as the assets are not being transferred to skip persons (grandchildren).
Also, a general power of appointment can be used to take advantage of the unlimited marital deduction for estate tax purposes. When assets are transferred to a surviving spouse who has a general power of appointment, they qualify for the marital deduction, effectively deferring estate taxes until the surviving spouse’s death.
Or, let’s say the grantor establishes a trust for the benefit of their spouse and grants the spouse a general power of appointment over the trust assets. Upon the grantor’s death, the trust assets pass to the spouse and qualify for the unlimited marital deduction, deferring estate tax liability until the spouse’s death.
Another area where a general power of appointment can be used is to make charitable donations from the trust, which may qualify for an estate tax charitable deduction.
For example, the grantor would establish a trust for the benefit of their children and grant a general power of appointment to their eldest child. Then the holder of the power of appointment can choose to donate a portion of the trust assets to a qualified charity, potentially reducing the estate’s taxable value and taking advantage of the estate tax charitable deduction.
