When establishing a living trust, you essentially have two options for how your beneficiaries will inherit your assets. One option is to allow your beneficiaries to inherit outright and free of trust. This means that after your death, once your estate is settled, your assets will be distributed out of your trust and to your beneficiaries individually. The trust at that point will not have any assets left and will therefore be terminated. Your beneficiaries will own their share of your trust in their own names as if those assets belonged to them all along. I often use the analogy of toothpaste in a tube to describe outright distributions. Picture your trust as a tube of toothpaste. An outright distribution will “squeeze” out each beneficiary’s share, leaving an empty tube of toothpaste to discard.
The other option is to leave your assets in trust for the benefit of your beneficiaries with a third-party Trustee in charge to manage each beneficiary’s share of your trust. You might do this if you have minor beneficiaries who are too young to manage their inheritance. Sometimes beneficiaries are older adults but still lack the financial skills to appropriately manage finances. Another reason to create in-trust inheritances would be if your beneficiaries are on public benefits and the receipt of an inheritance would interfere with their eligibility for those benefits. Furthermore, in-trust inheritances can often provide a degree of creditor protection, divorce protection, or additional estate tax protection.
If you choose to leave an in-trust inheritance rather than an outright inheritance, the question becomes what happens if a beneficiary survives you but dies prior to completely spending his/her trust share? A comprehensive trust will include contingent beneficiaries under such circumstances. However, you might want to give your beneficiaries the power to override your default contingency provisions. This is known as a “testamentary power of appointment.” There are many different types of powers of appointment.
For tax purposes, there can be a “general” power of appointment or a “limited” power of appointment. A “general” power of appointment for tax purposes means that your beneficiary will be permitted to allocated the remaining balance of his/her trust share to the beneficiary, the beneficiary’s creditors, the beneficiary’s estate, or the creditors of the beneficiary’s estate. In contrast, a “limited” power of appointment does not allow the beneficiary the power to allocate the remaining balance of his/her trust share to these the beneficiary, the beneficiary’s creditors, the beneficiary’s estate, or creditors of the beneficiary’s estate.
Depending upon whether a beneficiary holds a “general” or a “limited” power of appointment can have significant consequences.
With regard to a “general” power of appointment for tax purposes, the assets in the trust are to be considered part of the beneficiary’s estate for estate tax purposes, the assets in the trust that are subject to capital gains tax receive a “step-up” in basis upon the death of the beneficiary, and real property in California that passes to the beneficiary’s children can qualify for the parent/child exclusion from property tax reassessment for purposes of Proposition 13.
With regard to a “limited” power of appointment for tax purposes, the assets in the trust not considered part of the beneficiary’s estate for estate tax purposes, the assets in the trust that are subject to capital gains tax do not receive a “step-up” upon the death of the beneficiary, and real property in California that passes to the beneficiary’s children would not qualify for the parent/child exclusion from property tax reassessment for purposes of Proposition 13 but might qualify for the more limited grandparent/grandchild exclusion from property tax reassessment for purposes of Proposition 13.
Beyond the differences between the “general” and “limited” powers of appointments for tax purposes, some powers of appointment might allow the beneficiary wide discretion in deciding to whom to allocate the remaining balance of his/her trust share. Other powers of appointment might limit the scope of permissible appointees to a specific class of permissible appointees such as descendants of the Trust-Maker or charities.
Your trust will often specify as to how a power of appointment can be exercised. Historically, powers of appointment had to be exercised through the beneficiary’s will. However, it is now more common for a Trust to allow the exercise of a power of appointment through the beneficiary’s trust or through a separate written instrument signed by the beneficiary.
KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California, and Kyle may be reached at 831-920-0205.
Disclaimer: This article is for general information only. Reading this article does not establish an attorney/client relationship. Before acting on any of the information presented in this article, you should consult an attorney who is licensed to practice law in your community.