General Power of Appointment Can Neutralize Estate Tax

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A general power of appointment is power of appointment that is exercisable in favor of the donee, the donee’s creditors, or the creditors of the donee’s estate. Under IRC § 2042, the value of property over which the donee possesses a general power of appointment at death is included in the donee’s estate.

In situations where spouses have vastly unequal estates, the prudent use of a general power of appointment can avoid wasting the $3.5 million applicable exclusion amount, and in so doing, save more than $1.5 million in estate taxes.

To illustrate, assume one spouse has an estate worth $7 million, and the other spouse has an estate worth only $0.05 million. If poorer spouse dies first, virtually the entire applicable exclusion amount of the poorer spouse will be wasted. Upon the death of richer spouse, that spouse’s estate may be subject to significant estate taxes, since only $3.5 can currently be shielded from estate tax.

The traditional solution to this problem has been to “equalize” estates before the death of either spouse. If richer spouse were to transfer $3.5 million to poorer spouse either by outright gift or by lifetime QTIP trust under IRC §2523(f),  the estate tax problem would be solved, since regardless of which spouse died first, the applicable exclusion amount would be sufficient to avoid the imposition of estate taxes. However, richer spouse may be reluctant or unwilling to make such a large lifetime transfer to poorer spouse. Thus, exposure to a large estate tax liability could be eventuate.

Another solution involves the use of a testamentary general power of appointment. Employing this technique, richer spouse grants to poorer spouse a testamentary general power of appointment over so much of richer spouse’s estate as is equal to poorer spouse’s unused applicable exclusion amount. In the example, richer spouse would grant to poorer spouse a testamentary general power of appointment equal to $3.45 million (i.e., $3.5 million applicable exclusion amount less $0.05 million estate of poorer spouse). The testamentary general power of appointment would be conferred upon poorer spouse by virtue of a revocable testamentary trust executed by richer spouse during his lifetime. Being revocable in nature, the power could be revoked by richer spouse at any time before the death of poorer spouse.

Note that if richer spouse were to die first, the problem requiring the use of the general power of appointment will not arise: Richer spouse could simply leave to poorer spouse an amount equal to $3.5 million — either outright or in a QTIP trust. Richer spouse would still have available his own $3.5 million exemption, and upon the eventual death of poorer spouse, that spouse’s estate will have been augmented so that it can utilize that spouse’s own $3.5 million exemption.

However, if poorer spouse dies first, the general power of appointment conferred upon her will result in her estate being increased by an amount equal to the difference between the applicable exclusion amount and her estate, so that the poorer spouse’s entire $3.5 million exemption amount would be utilized. The general power of appointment exercised by poorer spouse at death could even fund a credit shelter trust which would benefit richer spouse during his lifetime.

By utilizing this technique, the estates of both spouses have been equalized, and richer spouse has not been required to part with dominion or control over any assets until the death of poorer spouse. Moreover, even at the death of poorer spouse, at which time richer spouse will be divested of dominion and control by reason of the testamentary exercise of the power of appointment by poorer spouse, richer spouse may still continue to benefit from the assets, since those assets could fund a credit shelter trust benefiting richer spouse during his lifetime.

[Note: Although the credit shelter trust may be drafted to liberally provide distributions to richer spouse during his lifetime, it may not go so far as to give richer spouse an unrestricted right to appoint trust assets to himself or others (i.e., an general power of appointment), as this could cause the trust assets to be included in the estate of richer spouse upon his death by virtue of IRC § 2036.]

If properly structured, this technique would thus achieve the following favorable tax results:

¶   No taxable event would occur during the lifetime of either spouse, since the inter vivos revocable trust granting the testamentary general power of appointment is not a completed gift, since it is revocable;

¶  At poorer spouse’s death, richer spouse makes a completed gift to poorer spouse (qualifying for the unlimited marital deduction) of that portion of richer spouse’s property which is subject to the general power of appointment;

¶  The extent of richer spouse’s property that is subject to the general power of appointment is included in the poorer spouse’s gross estate;

¶   Poorer spouse is treated as the transferor of all assets which fund the credit shelter trust, established for the benefit of richer spouse during his lifetime;

¶    Richer spouse (i) may be named both the beneficiary and trustee of the credit shelter trust, provided the power to make distributions to himself is limited by an ascertainable standard and (ii) may even possess a special power of appointment over the trust property, without the property being included in his estate at his death;

¶  The credit shelter trust may be exempt from generation skipping tax through allocation of poorer spouse’s GST exemption; and

¶  Assets transferred to the credit shelter trust will be asset protected, despite the fact that richer spouse will continue to benefit from the trust.

The IRS, in four published rulings, has approved the technique and tax result outlined herein. See PLRs 200604028, 200403094, 200210051, and 200101021.

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