One of my favorite cartoons growing up was He-Man. Mimicking the title character when he transforms from Prince Adam into a supernatural figure, I’d pull a toy sword from the back of my OshKosh B’Gosh overalls and proclaim, “I have the power!” Though less dramatic, in the context of Estate Planning, beneficiaries might feel the same way when they learn about the options afforded to them in a Power of Appointment.
As it is becoming more common to leave inheritances “in trust” rather than directly to the beneficiary in order to minimize the estate tax and to provide a degree of creditor and divorce protection, Powers of Appointment are becoming increasingly important. When an inheritance is given to a beneficiary in trust, the question becomes where does the unused balance of the trust share, if any, go when the beneficiary dies? The trust maker can control where this unused balance goes. However, the trust maker can also give the beneficiary a Power of Appointment to direct where the balance goes, overriding the default “remainder beneficiary” named by the trust maker.
The Power of Appointment can be “wide open,” where the beneficiary is allowed to name anyone in the world to receive the remainder of the trust assets, or can be very “narrow,” limiting the possible remainder beneficiaries to certain persons or classes of individuals (i.e., descendants of the trust maker). In the context of a Beneficiary Controlled Trust, where the trust maker does not want to limit the beneficiary’s control over the trust share, a “wide open” Power of Appointment makes sense. However, in the context of a Bypass Trust for the benefit of a surviving spouse, a “narrow” Power of Appointment might be the best option to give the surviving spouse flexibility but still prevent the spouse from leaving trust assets to the tennis instructor or the belly dancer at the expense of the children.
The method for exercising a Power of Appointment is significant. Many old fashioned trusts state that a Power of Appointment must be exercised by a valid will. The problem with this procedure is that it requires a probate, even if all of the assets are in the trust. The better method is to allow a Power of Appointment to be exercised by trust or separate writing in order to create less administration when settling the estate.
Many beneficiaries might not know that they have a Power of Appointment and thus never exercise their right. This is why I always ask my Estate Planning clients if they have received an “in-trust” inheritance. If so, it is important to determine whether they have a Power of Appointment, whether they want to exercise it, and how to exercise it.