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Exercise a limited power of appointment, make a gift

This is a little bit of inside baseball for the pointy-headed trust aficionados among you. We draft tons of trusts. Domestic trusts. Foreign trusts. Revocable and irrevocable. There is plenty of stuff in a trust that is non-obvious, both in the trust language and the tax implications of what you do after the trust is written. Here’s one instance where you can create an accidentally taxable gift when you’re not intending to.

Limited powers of appointments are provisions in a trust that give someone other than the trustee a power to take trust property and give it to someone.

For example, Dad sets up a trust for the benefit of Daughter. The money is in the trust for Daughter, but if she wants she can exercise this limited power of appointment and cause the trust to give the money to someone else instead.

Why do this? Flexibility. What Dad decides to do in 2009 might be not so useful in 2045 — economic or family circumstances might have made this trust obsolete. Daughter has the ability to decant the money out of the trust and into the hands of humans — or into a new trust — by using the limited power of appointment.

We here out on the wild and desolate prairies of Pasadena like limited powers of appointment. They can be exceedingly useful.

But they also create tax problem. Gift tax problems. For Daughter.

• If the trust says “mandatory distributions of income to Daughter for life” and Daughter exercises this limited power appointment and decants some of the principal out of the trust, the IRS says that is a taxable gift.

• If the trust gives the trustee total discretion in whether to distribute money to the power holder (or not), it ain’t so clear whether exercising the limited power of appointment during her lifetime will create a taxable gift by Daughter. A couple of Private Letter Rulings say “yes, taxable gift” [PLR 8535020, PLR 9419007] while an example in the Regulations says “No, not a taxable gift under a certain set of facts according to Section 2514” but the example is completely silent as to the general principles of Section 2511. Regs. Section 25.2514-3(e), Example 2.

Moral of the story? (1) Drafting a trust isn’t a boilerplate game; and (2) exercising a limited power of appointment should be done only with eyes wide open.