It is often a good idea to build flexibility into a trust in order to allow it to adapt to changing circumstances or tax laws. Adding powers of appointment to your trust can help accomplish this goal.
In the context of a trust, a power of appointment is a power to re-direct the trust’s property in a way that may be different from the disposition otherwise provided for in the trust. The holder of a power of appointment is not required to exercise the power. If the power is not exercised, the trust property will be administered as otherwise provided for in the trust.
Powers of appointment are often a good compromise between control and flexibility. For example, you may wish to provide your spouse with the flexibility to redirect the trust’s assets among your children based on their future needs (flexibility), but also lock in your children as the only individuals that may benefit from your trust (control). Powers of appointment can provide an opportunity for the power holder to adapt to changing circumstances even if the trust is irrevocable by its terms or due to the death of the trust’s creator. The value of flexibility is even clearer for trusts that are likely to last for multiple generations.
A power of appointment can be broad or limited. A general (or broad) power of appointment can be exercised in favor of anyone. A limited (or special) power of appointment can be exercised only in favor of a certain class of beneficiaries such as children or issue and may not be exercised in favor of the power holder, his or her creditors, his or her estate, or the creditors of his or her estate.
Giving powers of appointment to trust beneficiaries can have important tax consequences. Generally speaking, giving a trust beneficiary a general power of appointment exercisable in favor of anyone will cause the property subject to that power to be included in the beneficiary’s estate for estate and gift tax purposes. This is true even if the beneficiary does not exercise the general power of appointment. This is generally not true if the beneficiary is given a special or limited power of appointment.
Note that the different tax consequences that result from giving a general versus a limited power of appointment can provide tax planning opportunities. For instance, giving a trust beneficiary a limited power of appointment can help keep the property subject to the power out of the beneficiary’s estate for estate tax purposes. On the other hand, granting a general power of appointment to a trust beneficiary can cause property subject to the power to be included in the beneficiary’s taxable estate for estate tax purposes but provide income tax advantages by allowing for a step-up in the cost basis of those assets upon the beneficiary’s death.
Powers of appointment are an effective way to build flexibility into your estate plan. While they can be powerful tools, consideration should also be given to their tax consequences as you consider how they fit into your overall estate plan.