An Intro to Powers of Appointment

Examining parties to, and types of, powers of appointment

Feb 26, 2024

This is a continuation of the series on everything you ever wanted to know about estate planning trusts. For an intro and index to this series, please click here. The linked article will have a series index that gets updated periodically as well, so please bookmark it.

In a prior article in this series, we discussed how the distinction between a revocable and irrevocable trust is usually determined by whether the settlor of the trust itself can take out their own contributions to the trust. With a revocable trust, transfers can be two ways – settlor to trust, and trust to settlor – without the consent of a trustee. But, with an irrevocable trust, transfers from a settlor are one-way unless, with the consent of a trustee, a settlor repurchases property for adequate consideration (or an enforceable promise to pay adequate consideration).

Once a trust becomes irrevocable, any property that goes out may invoke the fiduciary duties of the trustee. But, there is one special exception to that outcome – the power of appointment.

What is a Power of Appointment?

A power of appointment is a power to remove income and/or principal of a trust.[1] This power is usually held by a beneficiary, or even by a third party who does not hold any of the three traditional trust “roles” of settlor, trustee, or beneficiary. While in some contexts a trustee’s distribution powers are technically treated as powers of appointment (especially when we consider decanting of trusts later in this series), any reference to a power of appointment will usually be to a power that is outside of the complete control or veto of a trustee.

In other words, a person who holds a power of appointment usually has the absolute right to exercise that power without a trustee’s consent. On occasion, trustee consent may be expressly included as a condition (often for tax or creditor protection purposes), but trustee consent is not presumed as a condition. This can create flexibility for a trust as we will later discuss.

As mentioned in the last article, there are three parties to a power of appointment which happen to shoehorn well with the three figurehead roles in a trust:

Donor: This is the person who creates a power of appointment. The donor is usually the settlor of a trust, but can also be a holder exercising a power of appointment if that power of appointment is used to create a new power of appointment.
Holder: This is the person to whom the donor grants the power of appointment to remove trust income and/or principal. The holder can usually choose one of three options for a power of appointment. One, they can exercise the power. Two, they can release the power. Three, they can allow the power to lapse by simply not exercising it when they have the chance.
Donees or Appointees: The donees, sometimes also called appointees, are the people who can benefit from the donor’s exercise of a power of appointment. Donees often includes individuals by legal definition or class, such as descendants, a spouse, and even the holder of the power. It can also include entities such as a charity, another trust, an estate, or even a creditor.

While not always necessary to have a valid power of appointment, there is usually a fourth category of involved parties called takers in default. Takers in default come into play when we shift from the green triangle above back up to the red triangle, and they can be found on the lower right-hand point.

Takers in default are the people who receive trust property that is subject to a power of appointment if the power is released, or lapses due to non-exercise - which is what causes this shift between triangles. These are often the remainder beneficiaries of a trust. Because of this, determining the takers in default requires us to shift from the analysis of the three power of appointment roles back to the analysis of the three trust roles. In other words, once a power of appointment can no longer be exercised, the trustee replaces the holder in the hierarchy of power and the takers in default replace the donees in the hierarchy of benefit.

Forms of Benefit

When a holder exercises a power of appointment, they are presumed under the laws of most states to have three options with respect to the donees. These options are:

1.      The holder can direct property directly to the donees;
2.      The holder can direct property to another trust, whether newly-created or already in existence, for the donees; or
3.      The holder can create a new power of appointment for which one or more donees is the holder.

Most powers of appointment are presumed to be exclusionary. This means that not all donees have to benefit from the donor’s exercise of the power of appointment. Instead, one or more donees can benefit to the exclusion of others. It also means that not all donees have to receive equal benefits, or the same form of the three benefits set forth above. The holder has maximum flexibility unless the terms of the power of appointment state otherwise.

But, on occasion, powers of appointment may expressly state that donees have to receive certain forms of benefits and/or that certain donees cannot be excluded. In order for this to happen, the power of appointment usually has to expressly spell out these terms. In other words, there is rarely if ever a presumption that a power of appointment is non-exclusionary.

In addition, powers of appointment do not have to be exercised with respect to all trust property. For example, a power of appointment over an entire trust can be applied to just the trust’s income, or principal, or a portion thereof. This is often called a partial exercise of a power of appointment. In the event of a partial exercise, the takers in default would receive the trust property that was not subject to the partial exercise of the power.

Types of Powers of Appointment

There are two sub-categories of powers of appointment, which fit together into four permutations we will describe below.

The first sub-category breaks down powers of appointment by when they can be exercised by a holder. If a holder can exercise a power of appointment during life, it is known as a lifetime power of appointment. If a holder can only exercise a power of appointment after death, usually through a will or revocable trust, it is known as a testamentary power of appointment.

Both lifetime and testamentary powers can be further broken down into two types in the second sub-category, based on whether the holder can personally benefit from the power of appointment. Generally, if a holder can benefit without certain strings being attached, the power is classified as a general power of appointment. But, if a holder cannot personally benefit or if certain strings are attached, the power is usually called a limited power of appointment or special power of appointment. Sometimes under state law, powers under which a holder cannot personally benefit are also called nongeneral powers of appointment.

The determination of a holder’s personal benefit invokes certain tax law definitions, usually found in IRC Sections 2041 (for testamentary powers of appointment) or 2514 (for lifetime powers of appointment). In either case, a power of appointment will be presumed to be a general power of appointment if any of four “forbidden parties” are included in the donees of the power of appointment. These four forbidden parties are:

1.      The holder (usually just for a lifetime power of appointment);
2.      The holder’s estate;
3.      One or more of the holder’s creditors, or
4.      One or more of the creditors of the holder’s estate.

Nonetheless, even if one of these four forbidden parties is present as a donee, this presumption of a general power of appointment may be overcome if either of these conditions or “strings” exists:

1. Any benefit to the holder is limited by an ascertainable, objective standard such as health, education, maintenance, support, and welfare (note that subjective terms like “comfort” and “satisfaction” usually would not meet this standard); or
2. The holder’s exercise of the power of appointment in favor of a forbidden party is subject to the approval of an adverse party, which usually is defined to be someone who would be hurt by the holder’s exercise of the power of appointment – often a taker in default, or sometimes another donee.

As noted above, a holder’s exercise of a power of appointment is usually not subject to fiduciary duties. But, the presence or absence of fiduciary duties is not a limiting factor that would otherwise prevent a power with one of the four “forbidden parties” as a donee from being a general power of appointment. This often rears its ugly head in a situation where an individual is both a trustee and beneficiary of a trust, which can be deemed to be a general power of appointment for tax or creditor purposes regardless of the presence of an express, nonfiduciary power of appointment in the trust. In such a case, state law and/or the trust may limit the trustee/beneficiary’s distribution powers to an ascertainable standard. This attaches a string to avoid the unintentional creation of a general power of appointment.

These two subcategories of powers of appointment can be combined, to create four common types of powers of appointment seen in trusts:

1.      Lifetime limited powers of appointment;
2.      Lifetime general powers of appointment (also often called powers of withdrawal);
3.      Testamentary limited powers of appointment; and
4.      Testamentary general powers of appointment.

Scope and Purpose of Powers of Appointment

Powers of appointment are often used to create flexibility within trusts, especially trusts that last for the lifetime of the holder of the power. For example, such trusts may have remainder beneficiaries who stand to receive per stirpes shares of the trust outright, or in another form of trust, at the primary beneficiary’s death. By granting the primary lifetime trust beneficiary a power of appointment, this beneficiary can have the flexibility to change the remainder distribution scheme of their trust. This can include a change from per stirpes division to provide unequal or exclusionary shares, a change from outright distributions to distributions in trust (or vice versa), or even a change of the terms or trustee of a trust (including the creation of a supplemental needs trust) that might continue for one or more remainder beneficiaries.

Powers of appointment might also be used to create certain tax effects. By granting an individual a testamentary or lifetime general power of appointment, you can cause them to become the deemed tax owner of trust property for gift, estate, and generation-skipping transfer tax purposes regardless of whether or not the power is exercised. This can allow for the use of a donor’s gift tax annual exclusion, a beneficiary’s gift and estate tax applicable exclusion, or a beneficiary’s or donor’s GST tax exemption. Further, a beneficiary with a lifetime general power of appointment may also be treated as the deemed income tax owner of trust property under the grantor trust rules (particularly IRC Section 678(a)), which can create favorable income tax treatment if the settlor themselves is not treated as the deemed income tax owner of the same trust property in accordance with IRC Section 678(b).

Of course, the opposite also holds true and powers of appointment are not always favorable. Traditionally, for example, a beneficiary spouse might be given a power of appointment over a marital trust and/or credit shelter trust (each of which will be discussed soon in this series of articles). In a second marriage or blended family scenario where the donor of the power of appointment does not want the remainder beneficiaries of these trusts to be disinherited, a spousal power of appointment may not be appropriate at all or may only be appropriate if it is nonexclusionary with respect to the remainder beneficiaries as donees.

Likewise, a spousal general power of appointment can frustrate the tax purposes of these trusts by, for example, wasting both spouse’s estate tax exclusions on credit shelter trust assets or disqualifying the marital trust for the QTIP or reverse QTIP elections. A spousal limited or general power of appointment over a credit shelter trust could also disqualify a disclaimer by the spouse to the bypass trust. For this reason, trust instruments with a spousal disclaimer often create a separate “disclaimer trust” or, alternatively, create an express carve-out under which the disclaiming spouse cannot exercise a power of appointment in the credit shelter trust over disclaimed assets.

Limits on Powers of Appointment

Generally, people who are not among the class or legal definitions of donees or appointees of a power of appointment are called impermissible donees or impermissible appointees. If an impermissible appointee stands to benefit from a holder’s exercise of a power of appointment, then states are divided on what might happen. In some states, the exercise of the power of appointment is treated as being invalid. But, in other states (including those that have adopted the Uniform Power of Appointment Act), equitable doctrines such as selective allocation and substantial compliance may “save” the exercise of a power of appointment. The laws of the state of domicile of the holder of the power of appointment often control this outcome.

As I discussed in this article and this article, one common situation where this might arise is where a limited power of appointment is exercised in favor of a holder’s revocable trust. Often, the terms of a revocable trust or state law allow the estate or creditors of the holder (as settlor) to benefit from the revocable trust to the extent the probate estate is not sufficient. Recall that the holder’s estate and creditors are “forbidden parties” under a limited power of appointment and thus become impermissible appointees.

The outcome is that the bare exercise of the power of appointment in favor of the revocable trust itself may be invalid, since impermissible appointees under the revocable trust can benefit from the appointed property. Alternatively, in states where the selective allocation doctrine has been adopted, principles of equity may dictate that the exercise of the power of appointment is valid so long as the holder’s other property (in their estate or revocable trust) is sufficient to pay creditor claims. The same outcome might result where charities are beneficiaries of a revocable trust, but not permissible appointees of a power of appointment. Often, this issue can be avoided by exercising a power of appointment in favor of specific subtrusts of a revocable trust.

Likewise, the terms of a testamentary power of appointment may require the holder to exercise it under their will, duly admitted to probate, by specifically referring to the power of appointment and expressing an intent to exercise it. What happens, for example, if the will is not submitted to probate, the power of appointment is exercised in a revocable trust, or the holder does not expressly refer to the location of the power of appointment in the trust instrument that created it? In some states, the exercise of the power of appointment might be invalid because the holder did not strictly comply with the donor’s requirements. But, in other states, the equitable doctrine of substantial compliance might save the exercise of the power of appointment by treating the donor’s requirements as having been sufficiently met to determine the holder’s intent to exercise that exact power of appointment.

Fiduciary Versus Nonfiduciary Duties

While more of an advanced topic, as I alluded to above it is possible that the holder’s exercise of a power of appointment could be subject to fiduciary duties if they are also acting as trustee at the time of exercise. Gray Edmondson wrote a great article highlighting some cases on this issue, and he and I also discussed the outcomes in this interview. I bring this up to caution you that, while express powers of appointment are often presumed to be nonfiduciary powers of appointment, the facts and circumstances could convert them to fiduciary powers of appointment.

And, as I noted above, some schools of law and thought classify a trustee’s fiduciary distribution powers as powers of appointment. This will have special significance, for example, when we discuss decanting of trusts.

Conclusion

Powers of appointment are extremely valuable, and can be considered ubiquitous in modern trusts. But, modern trust analysis requires accurate classification of powers of appointment according to the four main types described above. It also requires accurate identification of the donees or appointees of the power of appointment, along with any donor-imposed conditions for the exercise of a power of appointment.

And, while we have not yet discussed the rule against perpetuities and GST tax exemption, it is important to be sensitive to these issues when exercising a power of appointment for reasons to later be analyzed.

With the wealth wave, a significant amount of wealth will be transferred into lifetime or dynasty trusts for the next generation(s). Estate and tax planning for these generations will require in-depth knowledge of powers of appointment. Most AI and drafting software cannot sufficiently analyze or exercise powers of appointment. So, the more of a guru you can become on this subject, the more effective you will be even in the face of rapid technological advancement.

[1] Powers of appointment can exist outside of trusts, but this is not as common.