When trust-based estate planning veers into the realm of the irrevocable, a power of appointment allows control over how property is ultimately distributed to beneficiaries. Learn how to wield this tool effectively.

Understanding Powers of Appointment

A Power of appointment in estate planning adds another layer of flexibility to irrevocable trusts by granting control over trust assets to the grantor, or to someone designated by the grantor, to ensure their wishes are honored. And depending on the type of power retained, there are significant tax benefits to consider regardless of whether the power is actually exercised.

Two Types of Powers of Appointment

Limited Power of Appointment:

This restricts the power holder to only distribute trust assets to a specific, limited group of people, such as the holder’s children, grandchildren or charities. Limited powers of appointment notably exclude the grantor of the trust as a permissible distributee, meaning they cannot regain control for themselves but rather are only permitted to control the ultimate destination of assets among a pre-selected group.

General Power of Appointment:

This grants the holder much broader control and does not limit the potential recipients of assets. A holder of a general power can distribute trust assets to anyone they choose, including themselves, their creditors, or even their pet’s trust fund! 

Depending on the desired flexibility and control, both Limited and General Powers of Appointment are eligible to be exercised either during the holder’s lifetime (“Lifetime Power of Appointment”) or at death through a Last Will and Testament (“Testamentary Power of Appointment”).

Benefits and Considerations: The Power of Powers

• Flexibility for Changing Circumstances: Life is unpredictable. A power of appointment allows changes to the unchangeable. Revocable trusts are easily revised by the grantor, when desired. Revisions to an irrevocable trust, however, are generally not possible. When the grantor of an irrevocable trust retains a power of appointment at the time the trust is created and funded, they effectively retain an ability to adjust the distribution plan when a family situation changes or their original wishes become outdated.
• Causing Inclusion in the Taxable Estate: Irrevocable trusts are oftentimes funded for the purpose of avoiding estate tax on certain assets at death. As long as the grantor of the trust has parted with control and gifted the assets to the trust, those assets are not later subject to estate taxation. The presence of a power of appointment could thwart this result and cause the trust to instead be included in the estate and subject to an estate tax.  
• In certain circumstances this is a blessing, as in the case with assets having a very low cost basis. When these highly appreciated assets are sold by beneficiaries after the grantor’s death, a capital gains tax is assessed on the amount between the fair market value and the low cost basis. However, assets that are included in the grantor’s taxable estate receive a “step-up” in cost basis to the fair market value at death, thereby minimizing or eliminating entirely any capital gains. By retaining even a limited power of appointment, a grantor of an irrevocable trust can provide their beneficiaries with top notch capital gains treatment while simultaneously reaping other benefits of a trust that is irrevocable, such as protection of assets from long-term care costs, creditors or divorce.
• Accounting for Future Needs: Grantors might want children to have the freedom to redirect assets they’ve inherited among a select group of chosen beneficiaries. A common approach to inheritance planning is to leave assets to children in trust. When the child dies, assets remaining in their trust pass by default to beneficiaries chosen in advance by the original grantor. Alternatively, the grantor could grant a limited power of appointment over the inherited assets thereby permitting the child to bypass the pre-chosen “next-in-line” beneficiaries in favor of others of their choosing.

It’s crucial to understand the different types of powers and their tax implications. Correctly used they can help achieve estate planning goals. Incorrect use can be a blow to the plan and the family. Consulting with an estate planning attorney is essential to ensure powers are used effectively to achieve the desired outcome.