More Foibles with Powers of Appointment

Does strict compliance still control? And, how do state inheritance taxes factor in?

If compound interest is the eighth wonder of the world, perhaps the power of appointment can be counted as the ninth.

Now, that may be hyperbole, but the power of appointment is a misunderstood yet highly flexible method of estate planning with irrevocable trusts. And, regardless of your feelings on them, they are here to stay. In a world where significant wealth transfers will be made to irrevocable dynasty trusts over the next couple of decades, the ability to properly examine and exercise powers of appointment will be paramount.

Traditionally, the biggest headache with powers of appointment has been distinguishing between general and limited powers of appointment for federal tax law purposes. However, powers of appointment are a creature of state property law. And, unfortunately, state law is not universal. In the past, I have highlighted some of the ways in which powers of appointment can have unanticipated effects for purposes of federal tax, and state law property rights.

But, what happens when state taxes kick in? For the handful of states that still have death or inheritance taxes, does the federal tax law treatment of a power of appointment (particularly a general power of appointment) differ from state death tax treatment? To see one such divergence, today I am going to take a trip up I-76 from Denver to examine our neighbors to the northeast - Nebraska.

In re Estate of Nelson, 571 N.W.2d 269 (Neb. 1997)

This case involved a common estate planning structure - the split of the estate of the first spouse to die into a credit shelter trust (which uses the estate tax exclusion of the first spouse to die), with the excess going to the spouse in a qualifying trust form. Among other requirements, the qualifying trust form is exempt from estate tax (which would otherwise be payable by the estate of the first spouse to die) if the surviving spouse has a general power of appointment, or (alternatively) if a QTIP election is made.

The tax issue in this case popped up at the death of the surviving spouse. The estate of the surviving spouse paid Nebraska inheritance tax on the property subject to the surviving spouse’s general power of appointment, which is a result consistent with federal tax law (particularly IRC Section 2041). Generally, under federal tax law, the mere holding of a general power of appointment at the powerholder’s death causes the property subject to that power to be included in the powerholder’s gross estate (with a corresponding benefit being a step-up in income tax basis for appreciated, non-IRD assets).

But, the co-personal representatives of the surviving spouse’s estate in this case filed a claim for refund of the inheritance tax, claiming that it should not have applied to the property subject to the spouse’s general power of appointment.

Their reasoning stemmed from two provisions of Nebraska’s Revised Statutes.

The first, Section 77-2008.03, generally provides that the creation of a power of appointment is treated as a transfer by the donor for purposes of Nebraska’s inheritance tax. This statute does not distinguish between a general or limited power of appointment. Instead, it says if the power can only be exercised in favor of a limited class of beneficiaries, then those beneficiaries will be the deemed recipients of the donor’s transfer, but if there is no such limitation, the default treatment is that the donee is the deemed recipient.

Stated in more familiar terms, a general power of appointment is a transfer to the powerholder by the donor, whereas a limited power of appointment is a transfer to the permissible appointees by the donor.

However, the kicker is what happens at the death of the powerholder, which is addressed in companion Section 77-2008.04. This statute says that neither an exercise, nor a failure to exercise, any power of appointment will be treated as a transfer by the powerholder for Nebraska inheritance tax purposes. This runs contrary to federal tax law, which generally treats any exercise or nonexercise (including a lapse or release) of a general power of appointment as a transfer by the powerholder, subject to certain limitations.

Ultimately, the Nebraska Supreme Court agreed with the appellants’ analysis of these statutes, and held that the surviving spouse’s failure to exercise the general power of appointment was not subject to Nebraska’s inheritance tax. A refund was granted, and this divergence from federal tax law appears to have continued unchanged or untouched by Nebraska’s legislature since 1955 (when the inheritance tax was enacted).

In fact, it was this 1955 legislative history upon which the Court partially based its analysis. However, as a warning to state bar associations, one Justice (in a concurring opinion) criticized the cited “legislative” history as really having been a statement of a member of the Nebraska State Bar Association. Having witnessed some fairly egregious errors and oversights of other bar association committees, this is a criticism that I share.

Hornung v. Stockall (In re Robert E. McDowell Revocable Trust), 894 N.W.2d 810 (Neb. 2017)

In a twist of irony, 20 years later, this implied but not express distinction between a general and limited power of appointment was again taken up by the Nebraska Supreme Court. However, this time it was not in the context of inheritance tax, but instead the effectiveness of a purported exercise of the power of appointment. This opinion rejected some of the trends of other states and the Uniform Power of Appointment Act, while also drawing some interesting distinctions from these trends.

In short, this case involved a limited power of appointment that could be exercised in favor of the issue of the donor, the spouses of such issue, and charities. The powerholder was the surviving spouse of the donor, and attempted to exercise the limited power of appointment in favor of her revocable trust. The core issue was once sentence from the clause of the powerholder’s will, which stated that the appointed property would be “administered by the Trustee as part of the property of said… [revocable] Trust.”

The main beneficiaries of the powerholder’s revocable trust were the same as the permissible appointees under the limited power of appointment. However, as with many revocable trusts, there were provisions that essentially treated the revocable trust as an extension of the powerholder’s estate. These provisions allowed distributions to the estate, creditors, and creditors of the estate of the powerholder from the powerholder’s revocable trust. So, in essence, the problem was that these contingent beneficiaries could benefit from the appointed property since the powerhoolder added such property to the general assets of her revocable trust, without restriction.

The county court held that this was an ineffective exercise of the limited power of appointment. The trustee of the powerholder’s revocable trust (also a beneficiary) appealed, arguing in part that the doctrines of selective allocation and substantial compliance should be adopted by Nebraska.

However, the Court rejected both doctrines. As to selective allocation, the Court noted that it is a rule of construction to be applied when the instruments creating and/or exercising a power of appointment are unclear or ambiguous. In rejecting selective allocation, the Court upheld the county court’s express holding that neither the donor’s will nor the powerholder’s revocable trust were ambiguous. As to substantial compliance, the Court implied that this doctrine applies to formal (procedural) requirements imposed by the donor, but that the issue in this case was one of substantive requirements which do not fall into the purview of the doctrine.

Conclusion

In both cases, the powers of appointment were classified as “general” or “limited” by implication. But, it is important to note that these express labels often stem from federal tax law, and may not have significance at the state law level.

However, one must question whether the conclusions of state law could have significance at the federal level. For example, even though the McDowell case involved a limited power of appointment, the exercise of that power essentially converted it into a general power of appointment. Alternatively, could the beneficiaries or trustees in that case have argued for a step-up in basis (assuming that no additional federal estate tax would have been due)? Notably, IRC 2041 only converts a limited power of appointment into a general power upon exercise if the applicable perpetuities period is extended. Without a state law savings clause, perhaps that could have been the effect here - that the perpetuities period of the powerholder’s revocable trust would have replaced the perpetuities period of the donor’s trust.

But, as noted in the first case, this deemed “conversion” (if we can call it that) if not challenged would not have had any effect for state inheritance tax purposes. After all, the exercise or non-exercise of a power of appointment of any stripes was expressly exempted by statute as a transfer for purposes of Nebraska’s inheritance tax.

And while some states have adopted selective allocation and substantial compliance, these doctrines may have limitations as seen above. The refusal of the Nebraska Supreme Court to adopt them seemed to have more to do with their inapplicability to the facts of the case, and less to do with policy.

Ultimately, it is important to look through any power of appointment to determine which state’s laws apply to the exercise or non-exercise of that power. These laws may be based not on the situs of trust administration, but instead the domicile of the powerholder. Results may vary, and a drafting attorney who is exercising a power of appointment can find themselves in hot water if situations like this arise. Similarly, an attorney assuming that federal tax and state tax treatment of powers of appointment are similar may end up with egg on their face.