Powers of Part 2: Taxation of Powers of Appointment, 0918 COBJ, Vol. 47, No. 8 Pg. 56

• Author: GRIFFIN BRIDGERS, SUSAN L. BOOTHBY, AND LISA C. WILLCOX, J.
• Position: Vol. 47, 8 [Page 56]

47 Colo.Law. 56

Powers of Part 2: Taxation of Powers of Appointment

Vol. 47, No. 8 [Page 56]

The Colorado Lawyer

September, 2018

August, 2018

TRUST AND ESTATE LAW

GRIFFIN BRIDGERS, SUSAN L. BOOTHBY, AND LISA C. WILLCOX, J.

This is the second in a two-part series exploring the powerful benefits and complex issues confronting estate planning attorneys in using the power of appointment. Part 1 discussed Colorado law relating to powers of appointment. Part 2 addresses associated federal income and transfer tax issues.

Much of the uncertainty in drafting trusts in the first decade of this century centered on the changes made to the federal gift and estate tax laws. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) reduced transfer estate tax rates and increased the estate tax and generation-skipping tax exemption.¹ EGTRRA scheduled the repeal of the estate tax and generation-skipping tax for the year 2010, followed by a "sunset" of EGTRRA in 2011, in which the old regimes of the estate tax and generation-skipping tax would reappear.

The federal estate tax laws underwent yet another change in 2012 with the enactment of the American Taxpayer Relief Act of 2012.² That law increased the unified credit, now called the "applicable exclusion," to $5 million per person, indexed for inflation.^[3] As a result of the indexing, the applicable exclusion for the year 2017 was $5.49 million.⁴

Now, under the Tax Cuts and lobs Act, effective January 1, 2018, the estate tax and generation-skipping exemption has increased to $11.18 million in 2018.⁵ The Tax Cuts and lobs Act is due to sunset on December 31, 2025, returning the 2012 to 2017 exemption amounts, as indexed for inflation at that time.⁶ Although only a small number of decedents' estates will be affected by this most recent legislative change, the estate and gift transfer tax structure has been the subject of frequent changes by Congress in the past and will likely change again in the future. With the transfer tax⁷ exemption at $ 11.18 million, trust drafters will likely change their focus to making trusts more income tax efficient.

Much of the focus in tax planning is placed on the avoidance or deferral of transfer taxes b y the donor of property, with little consideration given to the tax consequences to the estate plan beneficiaries. However, contrary to Colorado property law, the grant of a power of appointment can, in some cases, cause the power holder to be treated as the owner of the assets over which the power can be exercised for income and transfer tax purposes. In such a case, an estate plan beneficiary may incur additional transfer tax liability. On the other hand, with today's generous estate tax applicable exclusion amount, such a result may be of no consequence to a beneficiary and, in some cases, may even create a tax benefit for beneficiaries as a group. This article looks at the specific powers of appointment that trigger such tax consequences.

Definition of General Power of Appointment

The definition of a general power of appointment is central to the analysis of transfer tax consequences surrounding powers of appointment.

For transfer tax purposes, a general power of appointment is defined in the Internal Revenue Code of 1986 (the Code) as a power that can be exercised in favor of any of the power holder, the power holder's creditors, the power holder's estate, or the creditors of a power holder's estate.⁸ There are three restrictions that will prevent such power from being categorized as general for transfer tax purposes if they are added to a power of appointment.

First, if the power holder's power to consume, invade, or appropriate property for his or her own benefit is limited by an ascertainable standard relating to the power holder's health, education, support, and maintenance, this power to withdraw will not be treated as a general power of appointment.⁹ The Colorado Uniform Act does not contain such a provision. The Uniform Power of Appointment Act (UPAA) contains a provision that treats a power subject to an ascertainable standard as non general for purposes of creditor claims against the power-holder,^[10] but as discussed in Part 1, Colorado has not yet enacted the creditor provisions of the UPAA.¹¹

Second, if the power of appointment can only be exercised with the consent of the donor creating the power, such power will not be treated as a general power of appointment.^[12]

Third, if the power of appointment can only be exercised with the consent of another person having a substantial adverse interest in the property over which the power can be exercised, such power will not be treated as a general power of appointment.¹³ This final restriction is similar to one found in the Colorado Uniform Act, which states that if a power holder may exercise a power of appointment only with the consent of an adverse party, the power is nongeneral.¹⁴ An adverse party is defined as a person with a substantial beneficial interest in property, which interest would be adversely affected if the power were exercisable in favor of the power holder, the power holder's estate, a creditor of the power holder, or a creditor of the power holder's estate.^[15]

The primary difference between the respective definitions of a general power of appointment between the Code and the Colorado Uniform Act is that the Code contains a plural reference to "creditors," while the Uniform Act uses the singular term "a creditor."^[16] Presumably, this difference would be of no consequence in determining whether a power of appointment is general for transfer tax purposes." Accordingly, a limitation of permissible appointees to a specific creditor or creditors of the power holder, or the power holder's estate, would then create a general power of appointment under both the Colorado Uniform Act and the Code. Such a limitation could be helpful, for example, in granting a general power of appointment to a power holder who might be prone to creditor issues.

Taxable Powers of Appointment in General

Sections 2514 and 2041 of the Code each define the circumstances under which a power of appointment can subject the power holder to gift or estate tax, respectively. For purposes of this analysis, this article focuses solely on powers of appointment created after October 21,1942.^[18] In general, these Code sections treat the power holder of a general power of appointment as the transferor, or owner, of the property over which the power can be, or could have been, exercised, in the following circumstances:

1. In general, the lapse or release of a general power of appointment, in full or in part, may cause the power holder to be treated as having made a transfer, for gift tax purposes, of the assets over which the power could have been exercised.¹⁹

2. If the power holder of a general power of appointment dies holding such power, or is treated as holding a previously exercised or released general power of appointment at the time of death under Code Sections 2035 to 2038, the assets over which such general power of appointment could have been exercised will be included, for estate tax purposes, in the gross estate of the power holder.²⁰

3. The application of the gift or estate tax to the exercise, release, or lapse of a general power of appointment by the power holder may cause such power holder to be treated as the transferor, for generation-skipping transfer tax purposes, of the assets over which such exercised, lapsed, or released power of appointment could have been exercised.^[21]

4. If a power holder has a general power of appointment that gives the power holder the present right to withdraw the income or principal of the trust, such power holder will be treated as the owner, for income tax purposes, of such assets.²²

5. A power holder of a general power of appointment who dies holding such power (for estate tax purposes), or who exercises such power effective at death, is treated as the transferor of the property subject to the power for purposes of Code Section 1014 (which allows the income tax basis of assets acquired from a decedent, by reason of his or her death, to be "stepped-up" to their fair market value at the date of the decedent's death).

In addition, the power holder of a nongeneral^[23]power of appointment may be treated as the transferor of the property, for gift and estate tax purposes, if the nongeneral power is exercised (during life or at death) in a manner that suspends or postpones, where permitted by the applicable state rule against perpetuities, t he vesting of such property.²⁴ This exception is commonly known as the Delaware tax trap.

It is helpful to examine the tax effects of a power of appointment highlighted through some examples of common situations that cause the power holder of a power of appointment to be exposed to transfer tax and/or income tax liability.

For purposes of these examples, assume that julie creates an irrevocable trust for her children and issue. In creating this trust, julie gives each living trust beneficiary a Crummey²⁵ power to withdraw the lesser of (1) the beneficiary's equal share of any amount contributed to the trust by julie in a given calendar year, or (2) the amount of the gift tax annual exclusion available for gifts by julie to the beneficiary in question. This power expires 30 days after the date of julie's contribution to the trust or, if sooner, on December 31 of the year of the contribution.

Gift Tax

For gift tax purposes, the exercise or release of a general power of appointment is treated as a transfer by the power holder when such exercise or release occurs during the power holder's life.²⁶ For this reason, it is important to consider the tax effects to the power...