A Primer for Elder Law Attorneys on Avoiding the Inadvertent Creation of General Powers of Appointment in Durable Powers of Attorney and Trusts
As Presented at the 2000 Elder Law Institute in Colorado Springs, Colorado
(A) Definition of general power of appointment
The inadvertent creation of a general power of appointment can create tax problems for the powerholder. A general power of appointment, which is the broadest possible form of a power of appointment, is defined as a power that is exercisable in favor of the holder, his/her estate, his/her creditors, or the creditors of his/her estate. A general power of appointment would permit a holder to use the assets for his/her own benefit, and is treated as if the powerholder owned the property outright. Unfortunately, under Internal Revenue Code section 2041, the powerholder will have the entire property subject to the power included in his/her gross estate for federal estate tax purposes. Although the regulations under section 2041 generally discuss trusts, nothing therein eliminates the possibility that section 2041 could be applied to gift-giving powers in durable powers of attorney, although no Tax Court or appellate division case has reached that holding.
(1) Only in conjunction with power’s creator
One exception to general power of appointment treatment is a power exercisable only in conjunction with the creator of the power. Because the principal of a durable power of attorney could revoke it, it is possible that any durable power of attorney could fall within this exception, thereby eliminating the problem of the agent being deemed to possess a general power of appointment.
(2) Only in conjunction with substantial adverse interest
A second such exception is a power exercisable only in conjunction with a person who has a substantial adverse interest in the property.
(3) Limited by ascertainable standard
A third such exception which will not be included in the powerholder’s gross estate if properly drafted is a power which is limited by an ascertainable standard relating to health, education, support or maintenance of the powerholder. Such a power must be limited to the extent that the holder’s duty to exercise or not to exercise the power is reasonably measurable in terms of the holder’s needs for health, education, support or maintenance. In particular, the regulations state that a power of appointment is limited by an ascertainable standard if, it is exercisable for the powerholder’s (1) support; (2) support in reasonable comfort; (3) maintenance in health and reasonable comfort; (4) support in his/her accustomed manner of living; (5) education, including college and professional education; (6) health; (7) medical, dental, hospital and nursing expenses and expenses of invalidism. Cases have consistently held that clauses exercisable for the “comfort, welfare, or happiness” of the powerholder is not limited by the requisite ascertainable standard, as well as a power to an “accustomed standard of living” or “to continue an accustomed mode of living.” See Revenue Ruling 77-60, 1977-1 CB 282. In determining whether a power is limited by an ascertainable standard, the regulations state that it is immaterial whether the beneficiary is required to exhaust his/her other income before the power can be exercised. What is not clear in the regulations and case law, however, is the extent to which the powerholder must invade his/her assets first.
(C) Examples of common powers at risk of being deemed general powers of appointment
(1) 5 x 5 withdrawal power
A power often given to the surviving spouse to withdraw annually the greater of 5% of a trust or $5,000.00 (a 5 x 5 power) is includable in the surviving spouse’s estate as a general power of appointment, and therefore should not be routinely given in a credit shelter trust. For example, consider a husband and wife who each had $675,000.00 in each of their own names; if he had died on 2/1/00 leaving behind a $675,000.00 credit shelter trust and then she died on 12/1/00, there would have been no federal estate tax. If he had given her a 5 x 5 power exercisable at any time over his trust, however, 5% of it would be includable in her gross estate, and the resulting estate tax would have been $12,487.50. If the flexibility of allowing the surviving spouse to have a 5 x 5 power on such a trust is desired, perhaps its exercise should be limited to a particular time (perhaps a particular day of the year or month) to minimize the possibility of its inclusion in the survivor’s estate.
(2) Discharge of legal obligation
A power exercisable for the purpose of discharging a legal obligation of a decedent or for his/her pecuniary benefit is considered a general power of appointment. Thus, a Trustee should generally not be given the power to use funds to discharge a legal obligation of support, especially for minor children. See Section 2041(a)(2) and Reg. 20.2041-1(c)(1). This problem can be alleviated by use of an ascertainable standard.
(3) UTMA/UGMA accounts
Since the Custodian of a UTMA or UGMA account has broad powers which are not deemed to be limited by an ascertainable standard, the assets in such accounts can be includable in the federal gross estate of a parent Custodian. See Estate of Jack Chrysler, 44 T.C. 55 (1965) and Estate of Harry Prudowsky, 55 T.C. 890 (1971).
Resigning as custodian can be deemed to be the release of a general power of appointment, so a parent custodian must survive the resignation by more than three (3) years or else Section 2035 could be deemed to apply and render the account includable in the parent’s federal gross estate.
(4) Trustee removal/replacement powers
The IRS generally takes the position that an unfettered right to remove or replace a Trustee is tantamount to having the power to put in place a Trustee who will do the powerholder’s bidding, including making distributions to the powerholder. Thus, Revenue Ruling 95-58, 1995-2 CB 191 should be considered whenever a Trustee removal or replacement power is being drafted. The power to appoint a Trustee who or which is related or subordinate to the powerholder, as those terms are defined in Section 672(c), should be avoided. That Revenue Ruling served as a revision to Revenue Ruling 79-353, which has held that if the donor possessed the power to remove and replace trustees, the donor was deemed to possess all of the discretionary powers of the trustee.
(5) Reciprocal trust theory
The IRS attempts to uncross transfers to unveil their economic substance. Annual exclusion gifts by a taxpayer to a brother’s three children accompanied by annual exclusion gifts from the brother to the taxpayer’s children have been uncrossed, with all of the gifts being deemed made by the parent to the children. See Schultz, 493 F.2d 1225 (CA-4, 1974). Similarly, in Estate of Bischoff, 69 T.C. 32 (1977), trusts established by two grandparents and reported as completed gifts, each of which trusts appointed the other to be Trustee of a discretionary trust for their grandchildren, have been uncrossed. Further, trusts created by partners for each other’s children in order to maximize their use of Crummey powers have met a similar fate. See Rev. Rul. 85-24, 1985-1 CB 329.
Of concern to many elder law attorneys should be the decision in PLR 9235025, whereby the decedent was deemed to have a general power of appointment over his share of a trust established by their father. The decedent and his brother were co-Trustees of each other’s trust share, and the IRS concluded that the power that each of them had was not limited by an ascertainable standard, even though under state law neither of them could contribute in a decision to distribute corpus to himself. The IRS inferred from the reciprocal nature of the control that they had over each other’s trust share that the powers would be exercised on a reciprocal basis, so that each of them could ensure that he received whatever he wanted.
State case law may help prevent the inadvertent creation of a general power of appointment, including via the reciprocal trust theory. For example, in Dana v. Gring, 374 Mass. 109, 371 N.E.2d 755 (1977), a trust permitted the Trustees to distribute trust corpus as they “deem necessary or desirable for the purpose of contributing to the reasonable welfare and happiness” of the settlor’s daughter, who was a co-Trustee. The court considered whether or not the daughter possessed a power of appointment by virtue of her being a Trustee, and whether that power was limited by an ascertainable standard. The court held that the Trustees’ power of distribution was fiduciary in nature and was necessarily limited by a fiduciary obligation to safeguard the corpus for the remainderman. The court reasoned that under Massachusetts law the daughter, as Trustee, could not have participated in the Trustee’s decisions as to the amount that could have been distributed for her own benefit and did not therefore possess a general power of appointment.
(6) Gift-giving powers in durable powers of attorney
As a general rule, the power to take something and use it as though it were yours is what the estate taxation of a GPA is all about, and that’s precisely what exists if an agent under a durable power of attorney has the unfettered power to make gifts. In the trust context, a GPA could result in estate tax inclusion in both the principal’s estate and the powerholder’s estate in an irrevocable income-only trust where the grantor reserves a SPA and grants a GPA to someone else whose death precedes the grantor’s death. The same result could occur in the DPOA context.
(a) Principal right to revoke deemed consent to gift
One argument regularly advanced against the proposition that a GPA exists is that the continuing right to revoke the DPOA operates as the implied consent of the principal to the gift, thereby falling under an exception under IRC 2041. Nothing in the Code or Regulations seems to minimize my uneasiness; the closest point in the Regulations to this discussion is that a GPA does not exist if exercisable only with “the consent or joinder of the creator of the power.” Having looked up these words in Black’s Law Dictionary, I do not feel this situation meets the consent or joinder definitions.
In support of this argument, there are tax cases where the agent makes gifts on the principal’s deathbed and the checks are cashed after the principal’s death. For example, in Estate of Sarah H. Newman v. Commissioner, 111 T.C. 81, the court concluded that the funds were includable in the principal’s federal gross estate because the principal could have stopped payment on the checks. The IRS and the court may have concluded that the principal’s consent is necessary to complete the gift made by the agent.
Unfortunately, those cases do not address what happens if the agent dies first. The fact that the principal’s assets could be gone before the DPOA is revoked, and could be removed due to fear of an imminent revocation, is where I have the biggest problem with this issue: instead of helping the principal, the agent could be helping the agent (to the principal’s assets).
(b) Fiduciary duties of agent to principal under common law
The strongest argument against classifying the agent’s gift giving power as a power of appointment is to assert the common law principles of the principal-agent relationship. Whatever action the agent takes would then be deemed the action of the principal and not that of the agent. Local law (i.e., the common law) would then apply, resulting in the principal, and not the agent, being deemed in possession of the property right, with the agent only being deemed an instrument of the principal. Under this analysis, the conclusion that the agent possesses a property right independent of the property right of the principal would be to ignore the common law relationship of principal and agent. Unfortunately, in my view, the power or action of the agent under this analysis appears to be safeguarded merely by the label placed on the relationship, which is a form over substance analysis often rejected by the IRS.
In support of this argument is that there is case law in which agents who misused their power to enrich themselves with the assets of the principal had to repay the principal. Under common law, the agent has fiduciary duties, and an agent who misuses the power by making unwanted gifts must repay the principal. The agent cannot possibly abuse the relationship, however, if the agent has the unrestricted power to take everything.
The bigger issue not covered by the common law, then, involves an agent who is not misusing the power, but merely using a broad self-dealing power given to the agent. It strikes me that a self-dealing power to make a gift to yourself without notice or knowledge of the person who originally gave you that power is not a common law principal-agency relationship. The notion of agency, as I see it, is that you are acting FOR the principal; the power to take is acting for yourself. In Black’s Law Dictionary, Fifth Edition, under Principal, subheading Law of Agency, it says: “The term “principal” describes one who has permitted or directed another (i.e. agent or servant) to act FOR HIS BENEFIT AND SUBJECT TO HIS DIRECTION AND CONTROL (emphasis added). If all fiduciary duties are stripped in the document, it is hard to imagine that the principal could have a successful cause of action against an agent who takes everything.
A comparable example exists with the estate taxation of limited partnerships. Where a person gives away limited partnership interests but remains a general partner with broad management powers over the partnership, there is no estate tax inclusion under IRC 2036 because the fiduciary duty of the general partner to the limited partners restricts the management powers. If, on the other hand, the partnership agreement releases the general from liability so that the fiduciary duty cannot be enforced, there would be estate tax inclusion.
(c) Possible need for preventative drafting
There is a point where intellectual analysis should be overridden by a gut instinct or common sense, and the downside should be an important consideration. My “tax common sense” says this is not something to intellectually rationalize away, especially where the IRS once came out of the blue with a ruling that trustee removal powers constituted GPAs, as discussed earlier. A similar ruling regarding DPOAs could end up forcing estate planning and elder law attorneys to reexamine every file where a DPOA had been drafted for a client.
In “Gift-Giving by an Agent Under a Durable Power of Attorney” Estate Planning, Vol. 26, No. 8 (October 1999), the editorial board decided that the practice note accompanying the article should be: “Draft a durable power of attorney carefully to ensure that potentially disadvantageous tax consequences will not result from the powers granted to the Agent.” Whether or not the author of the article was correct in his analysis and conclusion, the article quite possibly has been read by many federal estate tax auditors, so it makes great sense to draft a DPOA that eliminates the agent’s downside risk, instead of running the risk of having to go to Tax Court or beyond at great expense.
Assume for a moment the worst case scenario: that BB gave CC a DPOA with the unlimited ability to make gifts to CC without notice to BB, and that CC dies and the IRS requires inclusion of all of BB assets in CC’s gross estate for federal estate tax purposes. If the estate taxes are apportioned, BB would owe what would have been an avoidable estate tax, and may have a claim against the draftsperson. If CC’s will had the typical boilerplate provision requiring that estate taxes would be paid from CC’s estate, would CC’s estate have a malpractice action against the draftsperson based on a third-party beneficiary claim or negligent interference with the right to inherit? Would lack of privity be a defense? Would it matter if the draftsperson gave a warning to BB? Must the warning also have gone to CC?
With respect to DPOAs that are presently being drafted, a narrow, tailored gifting power should be drafted. It may be advisable to limit the power by an ascertainable standard, or to require the consent of an adverse party before the gift-giving power can be exercised or, if there is no such adverse party, to have a “special agent” appointed to make gifts to the family but not to himself/herself. Where there is probably no cause of action from an appointed agent that is not represented by the draftsperson, the main concern should be not having the spouse of the principal (whom the draftsperson is often also representing) end up with a general power of appointment.