Issues with Revocable Trusts: Powers of Appointment, Life Insurance, and More

Care must be taken not just in drafting, but also in exercising, powers of appointment, especially when dealing with revocable trusts or life insurance

Powers of appointment are a useful tool for any estate plan, as they create flexibility over transfers (typically in trust) which would otherwise be irrevocable or permanent. 

However, powers of appointment do not come without pitfalls.  There are many issues, even outside of the scope of this article, which must be addressed when drafting and exercising powers of appointment, such as:

·         How the power of appointment may be exercised;

·         To whom the power of appointment may be exercised;

·         What assets are subject to the power of appointment; and

·         The tax effect(s) of granting or exercising the power of appointment. 

It is within these categories of issues that we can find some unique errors, as evidenced in past cases, that often fly under the radar. 

As a preview to the issues in this article, the following is a video introduction (article continues below video):

Exercising Power of Appointment to a Revocable Trust

Many powers of appointment are set up to be special, or limited, powers of appointment.  The reason for doing so is to avoid estate tax issues for the holder of that power, as any property that is subject to a general power of appointment (regardless of whether or not that power is exercised) is subject to estate tax at the holder’s death under IRC Section 2041. 

In order to avoid creating a general power of appointment, the holder must not be able to exercise the power in favor of the four magic parties – themselves, their estate, their creditors, or the creditors of their estate.  If any of the four magic parties are present, the holder can avoid having a general power of appointment if their power is restricted by any of the four magic standards – health, education, maintenance, and/or support.  A requirement of the consent of an adverse party can also prevent a holder from having a general power of appointment. 

Most form estate planning documents address these points to avoid the unintentional creation of a general power of appointment.  There is often an express clause forbidding the four magic parties from benefitting from the power of appointment itself.  In addition, if a holder is both a beneficiary and trustee of the same trust, distributions are often restricted to the four magic standards. 

But, the exercise of a power of appointment in a way that might benefit any of the four magic parties can have drastic consequences.  A classic example would be an exercise of a special, or limited, power of appointment in favor of the holder’s revocable trust. 

This was the situation encountered in the McDowell case from the Supreme Court of Nebraska.  In this case, a surviving spouse had a limited power of appointment over testamentary trusts created at the deceased spouse’s death.  The surviving spouse’s will exercised these powers solely in favor of a revocable trust established by the deceased spouse. 

There was a problem, however.  The power of appointment could only be exercised in favor of the deceased spouse’s issue (and their spouses), as well as charities.  The surviving spouse’s revocable trust, however, had a variety of beneficiaries including creditors of the surviving spouse’s estate.  This was not unique, as most revocable trusts allow for distributions to a deceased settlor’s probate estate for payment of estate creditors. 

The existence of this one magic party (creditors of the estate), however, caused the exercise of the power of appointment to be ineffective.  Why?  Because creditors of the estate were not within the permitted appointees – issue of the deceased spouse, spouses of such issue, and charities. 

As a result, the lower court reversed the exercise of the power of appointment, and the Nebraska Supreme Court affirmed.  So, instead of going to the surviving spouse’s revocable trust, the property in question was distributed to the remainder beneficiaries of the testamentary trusts established by the deceased spouse.  And, even worse, the court applied the remedies for breach of trust to require the trustee of the deceased spouse’s trusts to reacquire the property from the surviving spouse’s trust and beneficiaries. 

So, what could have been done differently?  In the case of the Reisman Estate, the Michigan Court of Appeals reached a different result in the same situation.  A power of appointment could not be exercised in favor of creditors of the estate, but the surviving spouse once again exercised (in a will) this power in favor of the surviving spouse’s revocable trust.  But, the clause of the will which exercised this power expressly stated that the property subject to the power would not be treated as an asset of the probate estate. 

The addition of this language to the will prevented any of the four magic parties under the surviving spouse’s revocable trust from benefitting from the trust assets.  So, the exercise of the power of appointment was successful. 

It is important to note that some states may treat this issue differently.  Traditionally, there were strict compliance requirements for the exercise of powers of appointment, with no room for equitable relief.  However, the Uniform Power of Appointment Act (adopted in some states), along with laws in a handful of other states, create two remedies – selective allocation and substantial compliance – which would prevent the result in McDowell. 

One must, however, question what happens from a tax perspective in these cases. 

Estate Tax Issues

These exercises of powers of appointment take what is, in effect, a limited power of appointment and convert it into a general power of appointment.  The IRS has, in the past, taken the position in the Bosch case that it is not bound by state court decisions regarding property rights unless these decisions are issued by the highest court in the state. 

Even if the exercise of a power of appointment is invalidated at the state level, the IRS could still determine that there is a general power of appointment at the federal level.  The key difference is how a power of appointment is defined.  Many states expressly state that powers of appointment are non-fiduciary powers.  However, federal tax law treats all fiduciary and non-fiduciary powers as powers of appointment.  Thus, for example, a trustee’s distribution powers could be treated as powers of appointment for federal tax law purposes. 

The stakes here are high.  If the IRS determines that there was a general power of appointment, or exercise of a general power of appointment, the trust assets could be subject to estate tax at the death of the holder of that power of appointment.   The IRS could also determine that there was a tax event for purposes of the generation-skipping transfer (GST) tax, such as a taxable termination, taxable distribution, and/or a resetting of a prior allocation of GST exemption.  There may be a hidden benefit, however, in the form of a step-up in basis for trust assets subject to the (deemed) general power of appointment. 

While the IRS has not rendered a binding opinion or ruling on the issues above with revocable trusts, the door is open for it to do so.  For example, in the Smith case, a deceased spouse’s trust named the surviving spouse’s revocable trust as a remainder beneficiary, without giving the surviving spouse an express power of appointment.  Nonetheless, the IRS deemed there to be a general power of appointment by virtue of the surviving spouse’s power to revoke the trust named as remainder beneficiary. 

As a result, the assets of the deceased spouse’s trust were included in the surviving spouse’s gross estate for estate tax purposes.  Even worse, the IRS had previously held that the surviving spouse’s right to revoke was not a “general power of appointment” at the deceased spouse’s death, thus denying the estate tax marital deduction to the estate of the deceased spouse. 

Powers of appointment can also be an issue with life insurance. 

Life Insurance in Trust

Separate from powers of appointment, IRC 2042 includes the death benefit of life insurance in the insured’s gross estate if the insured has any “incidents of ownership” in the policy at death.  This does not mean that the insured is the owner of the policy on paper, although this is enough to trigger IRC 2042.  Instead, it means that any ability to exercise control over the policy, its benefits, or its beneficiaries is enough to subject the death benefit to estate tax.  Even worse, any transfer or relinquishment of any incident of ownership for less than full and adequate consideration within 3 years of the insured’s death is ignored under IRC 2035. 

For this reason, it is common for an insured to create an irrevocable life insurance trust (ILIT), which serves as both owner and beneficiary of life insurance.  For policies purchased by the ILIT, or gifted to the ILIT more than 3 years prior to the insured’s death, this can prevent the policy death benefit from being subject to estate tax. 

Care must be taken, however, to prevent the insured from having any right, power, or interest under the ILIT which could be deemed by the IRS to be an incident of ownership.  For this reason, the insured generally should not be a beneficiary or trustee of the ILIT, nor should the insured have any power of appointment (limited or general) over the ILIT. 

But, depending on the remainder beneficiaries of the ILIT, there could still be deemed incidents of ownership.  Take, for example, a situation where a revocable trust is the remainder beneficiary of the ILIT.  If the insured has the right to revoke or amend this remainder beneficiary trust, then the guidance and principles above could also cause estate tax issues for life insurance even if the right to amend or revoke does not rise to the level of a general power of appointment. 

There is, however, one fluke out there in the form of the Margrave case.  In this situation, one spouse had (during her life) purchased a life insurance policy insuring the other spouse.  The insured spouse’s revocable trust was named as beneficiary, but the non-insured spouse remained the owner.  If you think, however, that you see where this is going, you are wrong.  The Tax Court determined, and the 8th Circuit confirmed, that there were no incidents of ownership retained by the insured spouse at death.  Why?  Because the insured spouse’s revocable trust had a mere expectancy, which was ultimately controlled by the non-insured spouse’s power (as owner) to change the beneficiary designation. 

The hidden difference here was order of death.  Since the insured spouse died first, there was no issue.  However, in the Smith case cited above, the Margrave case was distinguished on the basis that Smith was litigated at the death of the second – and not the first – spouse to die. 

(One issue not addressed in Margrave is that the non-insured spouse, as owner, may have made a taxable gift of the policy death benefit to the beneficiaries of the insured spouse’s revocable trust). 

Regardless, it is important not to get cute.  The insured under an ILIT should avoid having, or exercising, any power that could be interpreted as an incident of ownership. 

Conclusion

Powers of appointment require brain power, both in the drafting phase and the exercise phase.  Special care must be taken to avoid a general power of appointment, or an incident of ownership over life insurance, whether by drafting or by exercise.  But, there is a hidden benefit – it may be easier than you think to find a general power of appointment when examining trusts for which a decedent was a beneficiary, trustee, or individual with the power to remove and replace trustees.  This could create opportunities for income tax savings, by creating an argument for a step-up in basis that would accompany such general power of appointment. 

This article is provided for educational purposes only, and does not substitute for legal or tax advice.