Powers of Appointment are the secret ingredient to the major advantages of irrevocable trusts and the formula that makes them work, yet the code does not do a good job of quantifying them, so we will do it for them. This knowledge makes it easier to decode documents, or design them in the first place, but also to communicate the advantages to the client and beneficiaries.
When drafting a trust the attorney must match the desires of the client with the design of the internal revenue code. A proper alignment of these two issues enables the client to control their money in the manner that they wish after they are gone while achieving the tax protection and asset protection desired for their heirs. As one might imagine, if you give too much power or access to the funds, the IRS will say they belong to the beneficiary, thus losing the estate tax protection and asset protection. Fortunately, the internal revenue code gives us a “bright line” test to determine whether the beneficiary is the owner of the trust property or not; it is called a Power of Appointment.
As I organize the information in this section of the code, there are five powers of appointment and we will add the right to income to make six. Technically, powers of appointment are over the assets of the trust, not the income those assets produce. The right to the income does not make you the owner of the underlying asset. So in plain language, I will list and explain each of the five powers and the right to income and then we can look at them in the context of a trust. Keep in mind I am simplifying a very technical area, the attorney in drafting the document, will use much more technical language, the accountant determining the tax implications will read that language carefully, the trustee will read and interpret distribution decisions based on that language; it could not be more central to the operation of the trust in carrying out the intent of the client.
Here are the powers:
1. Lifetime General Power of Appointment – The ability for a beneficiary to take any or all of the assets of the trust at any time and for any reason. This makes an irrevocable trust work very much like a revocable trust; full control and no tax or asset protection benefits. Generally used only in Marital trusts.
2. Testamentary General Power of Appointment – The ability for a beneficiary to change the beneficiaries to whomever they choose. By itself, this power gives no access during life but may be combined with other powers. Whether the power is exercised or not, the assets are included in the power holder's estate. Also used primarily in Marital trusts.
3. Five by Five Power – The ability for the beneficiary to take the greater of $5000 or 5% of the trust each calendar year; a 5% version of the Lifetime General Power. Some access translates to 5% of the income being taxable to the beneficiary, and 5% being included in the power holder's estate.
4. Ascertainable Standard – The ability of the beneficiary to request any amount of the assets, subject to specific language, like “health, education, and support” or “to support their accustomed manner of living.” Because these distributions are subject to specific language or subject to the judgment of an independent or adverse person, this power is NOT a general power and thus creates no estate tax inclusion for the beneficiary.
5. Specified Class – The ability to alter the beneficiaries of the trust, yet only within a predefined class or group of beneficiaries, like “among the grantor’s descendants.” Since this power does not give unrestricted authority to change and the power holder cannot appoint to themselves, this is NOT a general power and thus creates no estate tax inclusion for the beneficiary.
6. Income – The ability to get all of the income automatically, or have access to the income for anything or for predefined reasons. Again, the right to the income does not make you the owner of the underlying asset, so this is NOT a general power and thus creates no estate tax inclusion for the beneficiary.
In general in considering the language in a trust, one should answer the question, “if I were to leave instructions on how I wanted this money to be used, what would I say?” That response, when matched up with the six powers above, should make it fairly clear which powers to include. Keep in mind, the greater the power given, the greater the inclusion in the estate. Powers 1 and 2 create 100% Estate inclusion and thus are best saved for marital trusts. Power 3 creates a nice balance of access without discretion, yet does cause some estate inclusion. Inclusion in the estate is not just a tax issue it can also eliminate creditor protection, which in our world of high estate tax exempt values is more important to most clients.
Non-marital trusts, that are trusts for other family members will generally include Powers 4 and 6 on a discretionary basis. Access to 100% of the money, but only if needed for some identified use such as “maintaining one’s accustomed manner of living” or “for support in reasonable comfort”. On the other hand the language may be much more restrictive for a Special Needs Trust or a Supplemental Needs Trust such as, “no distribution shall be made which would disqualify her from State or Federal Aid programs which are available to her” or “to pay for such supplemental support not provided by state or federal aid programs”. These examples are simplified to demonstrate the meaning of the language and the grantor’s ability to design it as they wish. With broad discretion over the use of both income and principal, we can create the greatest balance of access and availability to the beneficiaries without breaching the tax protection and asset protection features of the trust. Power 5 can likewise maintain this protection and yet still give the beneficiaries a say in the future of the trust to be flexible to family needs and wealth dynamics.
It should go without saying that recommending and working with experienced partners to help design and implement the language your clients desire in their trusts is paramount to help your clients achieve what they desire with their life savings and for the people most precious to them. An attorney to draft precise language to reflect their wishes, an accountant to accurately interpret the tax consequences, and a professional trustee to properly and independently exercise the discretion the client provides in the document for benefit of their heirs.
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