Traditional revocable living trusts provide that upon the death of the trust-maker, the assets of the trust are to be distributed outright and free of trust to the beneficiaries, provided that the beneficiaries are old enough to manage their inheritance. However, this popular method of estate planning overlooks a key planning opportunity: the ability to provide the beneficiaries with a significant degree of divorce protection and creditor protection. In order to provide such protections, the trust could instead be drafted to distribute each beneficiary’s share in a separate “beneficiary controlled trust.” The idea is to keep the inheritance in a trust that can be completely controlled by the beneficiary but can also feature divorce and creditor protection.
In order to give the beneficiaries complete control over their beneficiary controlled trusts, it is often advisable to give the beneficiary a testamentary “power of appointment.” Such a power of appointment allows the beneficiary to direct how the balance of the inheritance is to be distributed upon the beneficiary’s death. There are two categories of testamentary power of appointments: a “general” power of appointment and a “limited” power of appointment. The different categories of power of appointments have different tax consequences.
A “general” power of appointment allows the beneficiary to direct the remaining balance of the beneficiary controlled trust to anyone in the world, without limitation. This would include the beneficiary’s creditors and the beneficiary’s estate. If the trust provides a general power of appointment, the assets of the trust will be included in the beneficiary’s estate. This means that the inheritance might be subject to estate tax upon the beneficiary’s death if the value of the inheritance plus the value of the beneficiary’s own assets exceeds the beneficiary’s estate tax exemption. On the other hand, assets held in the trust will receive a “basis adjustment” (often referred to as a “step-up” in basis) for capital gains tax purposes upon the beneficiary’s death, which could eliminate capital gains tax for future heirs.
A “limited” power of appointment prevents the beneficiary from directing the remaining balance of the beneficiary controlled trust to the beneficiary’s creditors or to the beneficiary’s estate. If the trust provides a limited power of appointment, the assets of the trust will not be included in the beneficiary’s estate. This means that the inheritance will be exempt from estate tax upon the beneficiary’s death. On the other hand, assets held in the trust will not receive a “basis adjustment” upon the death of the beneficiary, which might lead to significant capital gains tax for future heirs.
As a result, the choice of whether to include a “general” power of appointment or a “limited” power of appointment is the choice of whether to subject the beneficiary’s estate to estate tax or capital gains tax.
Because beneficiary controlled trusts are designed to last the lifetime of the beneficiary and beyond, it can be challenging to determine whether the application of the estate tax or the capital gains tax would be preferred. It is almost impossible to know how the beneficiary’s estate will be affected by changing circumstances in the future (such as a change in the size of the estate and a change in the tax laws).
In order to navigate these issues and to give the beneficiaries as many options as possible, the best approach is to choose one type of power of appointment when drafting the trust but to also include “trust protector” provisions that allow the type of power of appointment to be changed after the death of the original trust-maker in order to delay the ultimate decision of which tax would be most beneficial until circumstances are clearer. A comprehensive trust that provides as many options as possible can be a valuable tool for families trying to navigate the complex tax rules that are in constant flux.
KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California 93950 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 upon any of the information presented in this article, you should consult a competent attorney who is licensed to practice law in your community.