Often disregarded and even more misunderstood, powers of appointment can be a pretty big deal. In this article, we will discuss various common types of powers of appointment and their operational impact on an estate plan.
Powers of appointment come in few shapes and sizes. First, you have lifetime power of appointment, and also testamentary power of appointment. As you can probably extrapolate from their descriptive names, a lifetime power of appointment gives an individual the right to determine the distribution of assets while they are alive, and a testamentary power of appointment gives an individual the ability to direct the distribution of assets at their death. In my legal career, I have generally focused on the testamentary variety of powers of appointment; as such, we will be discussing these exclusively herein. You can also have limited powers of appointment or general powers of appointment. Limited powers of appointment will typically limit the class of beneficiary recipients; while general powers of appointment leave the class of beneficial recipients open to anyone. For the purposes of this article, we will focus on the general types of powers of appointment.
A testamentary power of appointment can be given to your beneficiary in a will or a trustbased estate plan. Let’s examine an example of what this may look like in your documents. For the purposes of this example, let’s say I have a revocable living trust (“RLT”), and my business partner Michael A. Hendricks (“Mike”) is a beneficiary of that RLT. I have made the following provision for Mike in the RLT with regard to his share: “Michael A. Hendricks has the unlimited testamentary general power to appoint all or any portion of the principal and undistributed income remaining in his trust at his death among one or more persons or entities and the creditors of Michael A. Hendricks’s estate. Michael A. Hendricks has the exclusive right to exercise this general power of appointment.” This means that Mike has the ability to direct the distribution of the share I have provided to him in my RLT, through his own will or trust to whomever he wishes upon his death. So, if Mike wanted to make certain that our fellow attorney James Cooke, Jr. (“Jim”) received Mike’s share at Mike’s death, he would add a provision to his own will or trust that directs his share from my RLT to Jim upon both my and Mike’s deaths.
Well, that’s super boring (unless you are Jim). However, it is still important. You see, not only does the testamentary power of appointment provide a post-mortem planning pivot point (that’s a lot of “p’s”) so that course corrections can be made and/or coordination with other estate planning documents can be achieved; but it also is a HUGE tax benefit. Wait, wait, tell me more!
You see, by giving Mike a testamentary power of appointment I have forced his share of my RLT to become a part of his estate for federal estate tax purposes. Hold up, that doesn’t sound good. Well, if Mike’s gross estate value exceeded his federal estate tax exemption (“FET exemption”), it may not be great. However, with an FET exemption currently set at $15,000,000, it is usually not a problem for most people. And, by causing inclusion in Mike’s estate, it now gets a step-up on cost basis when it passes from Mike to Jim.
What in the wild world of sports is a step-up in cost basis, you ask? This is one of the few safe harbors left in the internal revenue code (“IRC”) for taxpayers. You see, IRC Section 1014 states that the basis of property you inherit from a decedent is generally set to the fair market value (“FMV”) of the property as valued on the decedent’s date of death. Here is an example: Joe purchases a house for $10 (this is Joe’s cost basis) in 1995. Joe sells that house for $40 in 2025. Joe has had a capital gain of $30 ($40 sales proceeds less $10 original cost basis = $30 capital gain). Now, instead of Joe selling the house in 2025; Joe dies in 2025 and his house is inherited by Lisa, who then immediately sells the house in 2025 for $40. Lisa has 0 capital gain. This is because when Lisa inherited the house from Joe in 2025, her basis became the FMV of the property at death (presumably $40). So, when Lisa turns around and sells the property, she has no taxable capital gain to worry about because $40 sales proceeds less $40 basis = $0 capital gain. This is immensely powerful and important to whomever inherits from a decedent.
Now, when I meet with people for the first time to discuss their estate plan, I’m often told by the client that they want to keep assets in their bloodline as an absolute priority. I get that, I really do. However, this can run afoul of tax planning. I explain to clients that there are some things in estate planning that may be mutually exclusive. Such as absolute bloodline distribution security and tax efficiency. Often those people that prioritize absolute bloodline distribution security are also adamant that they want to pay the least amount of taxes possible in their estate planning system. Well, I then have to let them down gently so that they can’t have both. If they want absolute bloodline distribution security, then they will almost always have sacrificed the step-up in cost basis explained immediately above.
So, what’s the functional middle ground? Internally at JGB, we call it GPOA/Per Stirpes for short. Using Mike as my example again, what that means is that I give Mike that testamentary power of appointment; however, I state in my RLT that to the extent that he does not exercise the testamentary power of appointment, the balance of his share will then be distributed per stirpes (Latin for by his bloodline) to his decedents. In my experience, more often than not, the “Mikes” of the world do not ever exercise their testamentary power of appointment (and usually don’t know they have it or understand it) and therefore their share ends up falling bloodline at the end of the day – WHILE still preserving the step-up in cost basis as it passes to the next beneficiary in-line. As you can guess, I am a big proponent of this method. It is a good balance between mutually exclusive priorities.
If you would like to discuss how powers of appointment work in your estate plan or if you just want to review your existing plan with your JGB attorney, give us a call. We’d love to see you for a document review appointment.