Section 2041(b)(1) of the Internal Revenue Code defines a general power of appointment as “a power which is exercisable in favor of the decedent, his estate, his creditors, or the creditors of his estate.” Sometimes a testator or grantor intends to create a general power of appointment over property. Other times general powers of appointment are created accidentally. Because a general power of appointment is the functional equivalent of property ownership, an accidental power of appointment can be devastating from an estate tax point of view. In this article we cover two common cases where accidental powers of appointment might be created and ways to avoid doing so.
The first case deals with bypass trusts in which the surviving spouse is both beneficiary and trustee. The objective, of course, is to avoid the inclusion of the funds in the bypass trust in the estate of the second-to-die spouse. Bypass trusts constitute one of the most effective estate-tax freezes devised, but careless wording can cause the trust corpus to be taxed in the estate of the second-to-die spouse.
Section 2041(b)(1)(A) of the Code creates an important and useful exception to the general rule enunciated above. A power to consume, invade or appropriate trust income, corpus or both for the decedent’s benefit is not deemed a general power of appointment if it is “limited by an ascertainable standard relating to the health, education, support, or maintenance of the decedent.” Thus, when we create a bypass trust, we give the surviving spouse-trustee-beneficiary the power to receive income and invade corpus, but on for his or her health, education, support or maintenance-no more and no less.
Sometimes drafters get creative. The result is at best expensive litigation with the Internal Revenue Services (IRS) and at worst the inclusion of the bypass trust corpus in the estate of decedent surviving spouse. In a recent Tax Court case the “co-trustees were also given the right and power to invade the corpus of the trust and to use such part thereof and if necessary, all of it, for the necessary maintenances, education, health care, sustenance, welfare or other appropriate expenditures needed by [the surviving spouse] and the other beneficiaries of this trust taking into consideration the standard of living to which they are accustomed and any income available to them from other sources.”
The IRS challenged the wording as not limited by an ascertainable standard but rather creating a general power of appointment in the surviving spouse, included the trust corpus in her estate and billed her executor $716,000 for estate taxes due. The estate appealed to the Tax Court which ultimately sided with the executor. Our loyal readers will be spared the laborious thought processes of the judge who reached the common sense conclusion that the wording in the trust was close enough to the statutory wording to merit recognition as an ascertainable standard, especially when everyone involved knows bypass trusts are designed to exclude the corpus from the estate of the second-to-die spouse.
Of course, it would have been preferable if the drafter of the trust has limited himself or herself to the statutory language, without adornment. Such language is bullet-proof and gives the IRS, which is particularly hungry for revenue theses days, no reason to challenge trust language.
There is a second common situation arising in the context of bypass trusts. Treasury Regulation Section 20.2041 – 1(c)(1) states if a decedent has the power to make a distribution that satisfied a legal obligation of the decedent, the decedent is deemed to have a power of appointment to him or herself. Commonly, a bypass trust for the surviving spouse also included minor children as the beneficiaries of the trust. The problem arises because the surviving spouse-trustee has an obligation to support his or her minor children. It has been held, therefore, if the surviving spouse-trustee has the power to make distributions to his or her minor children, the corpus of the trust will be included in his or her estate.
In these cases, consequently, it is necessary to insert language prohibiting the trustee from distributing income or corpus if the distribution would serve to satisfy the trustee’s obligation to support. As can be readily seen this regulation is plain silly as all trustee-surviving spouse needs to do is make distributions to him or herself subject to an ascertainable standard and use the funds to support the minor children. Alternatively, and more complicatedly, an independent third-party trustee can be named just to make distributions to the minor children. Even though this regulation is impractical, however, it still needs to be complied with to avoid estate tax inclusion problems.
In sum, since discretion is the better part of valor, creativity should be stifled when drafting trust language. Boilerplate which has the approval of the Internal Revenue Code or Treasury regulations should be used when available.