IRC 2514: Gift Tax Rules for Powers of Appointment

A power of appointment is a right granted in a document, like a will or trust, giving a person the ability to designate who will receive certain assets. This authority is a component of estate planning that allows for flexibility in asset distribution. The tax consequences of these powers are governed by Internal Revenue Code (IRC) Section 2514, which details the gift tax implications. Understanding these rules is necessary for anyone who holds such a power, known as the “powerholder,” or is involved in administering a trust or estate.

Defining Powers of Appointment

A power of appointment is the authority given to a person, the powerholder, to direct the distribution of property they do not own. The primary distinction in the tax treatment of these powers hinges on whether they are classified as “general” or “special.” This classification determines if the assets subject to the power are considered part of the powerholder’s assets for tax purposes.

A General Power of Appointment (GPA) provides the holder with broad control over the property. A power is considered general if the holder can appoint the property to themselves, their estate, their creditors, or the creditors of their estate. For instance, if a trust gives a beneficiary the right to withdraw all or part of the trust’s assets for any reason, that beneficiary holds a GPA over those assets.

In contrast, a Special Power of Appointment (LPA) restricts who can receive the property. The holder of an LPA cannot appoint the property to themselves, their estate, or their creditors. For example, a trust might grant a child the power to distribute trust assets among their own descendants, which is an LPA and does not trigger gift or estate tax for the powerholder.

Taxable Lifetime Transfers

The holder of a General Power of Appointment (GPA) can trigger a taxable gift in three ways during their lifetime. These actions are considered transfers of property by the powerholder, even though they do not legally own the assets.

Exercise

When the holder of a GPA exercises the power in favor of someone else, it is a taxable gift. For example, if a beneficiary has the right to withdraw funds from a trust and directs the trustee to distribute $100,000 to their sibling, the beneficiary has exercised their GPA. This is treated as if the powerholder withdrew the money and then personally gifted it, with the value of the gift being the full amount transferred.

Release

A release of a GPA is also a taxable event. A release occurs when the powerholder voluntarily and formally gives up their right to exercise the power. If an individual holds a GPA over a trust’s assets and signs a legal document permanently relinquishing that power, they have released it. This relinquishment is treated as a transfer of the property, and the value of the gift is the value of the property subject to the power at that time.

Lapse

A lapse occurs when a powerholder fails to exercise their right within a specified time, causing the power to expire. A common example is a “Crummey” power, which gives a beneficiary the right to withdraw contributions to a trust for a limited period, often 30 days. If the beneficiary does not exercise this right and the power lapses, it is considered a release of the power. This lapse can be a taxable gift from the powerholder to the other trust beneficiaries.

Exceptions That Avoid Gift Tax

While the exercise, release, or lapse of a General Power of Appointment (GPA) can trigger gift tax, certain exceptions prevent this outcome. These exceptions allow beneficiaries access to funds for specific needs without adverse tax consequences.

The Ascertainable Standard

A power is not treated as a GPA if its exercise is limited by an “ascertainable standard.” The tax code specifies that if the holder can only use the property for their health, education, maintenance, or support (HEMS), the power is not a GPA. This standard must be reasonably measurable, as vague terms like “comfort,” “welfare,” or “happiness” do not qualify. If a trustee-beneficiary can distribute funds for their own medical bills, this power is restricted by HEMS and is not a GPA, avoiding gift tax.

The “5 and 5” Power

The most common exception, known as the “5 and 5” power, relates to the lapse of a power. The lapse of a GPA is only a taxable gift to the extent that the value of the lapsed property exceeds the greater of $5,000 or 5% of the assets from which the power could have been satisfied. For example, a beneficiary has the right to withdraw $20,000 from a $500,000 trust. The beneficiary does not exercise the right, and it lapses. The “5 and 5” limit is the greater of $5,000 or 5% of the trust ($25,000). Since the lapsed $20,000 is less than the $25,000 limit, no taxable gift occurred. If the withdrawal right was for $30,000, the lapse would create a taxable gift of $5,000 ($30,000 – $25,000).

Inclusion in the Gross Estate

The tax implications of a General Power of Appointment (GPA) extend to the powerholder’s estate. If an individual dies possessing a GPA, the property’s value is included in their gross estate for federal estate tax purposes under IRC Section 2041.

This inclusion occurs regardless of whether the powerholder exercises the power in their will; its mere existence at death is sufficient. For example, if a person dies holding a GPA over a $1 million trust, that $1 million is added to their gross estate. This happens even if their will does not mention the power.

Reporting Requirements for Taxable Events

When the exercise, release, or lapse of a General Power of Appointment (GPA) results in a taxable gift, it must be reported to the IRS. The powerholder is considered the donor and is responsible for this filing.

The required form is IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. This form is used to report all taxable gifts made during a calendar year. The value of the property transferred via the GPA is listed on the form to determine if a gift tax liability exists.

Form 709 must be filed for the year the taxable event occurred, with a deadline of April 15 of the following year. Failing to file when required can lead to penalties and interest.