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Kathleen Ford Bay, Esq.
Lippincott Phelan Veidt PLLC, Austin, TX
Under §2041(a)(2),1 the gross estate includes all property over which the decedent at the time of death had a general power of appointment created after October 21, 1942. (Also, if decedent has at any time exercised or released such a power of appointment in a way that would result in its inclusion under §2035 to §2038, that property is in the gross estate.) Section 2041(b)(1) provides that the term general power of appointment means property which the decedent could have appointed to himself, his creditors, his estate, or creditors of his estate. Reg. §20.2041-1(c)(1)(a) provides that a power of appointment is not a general power of appointment when exercisable only in favor of one or more designated persons or classes other than the decedent or his creditors, or the decedent's estate or the creditors of his estate.
When interpreting powers of appointment in state court proceedings, it is important to remember the fundamental rule that even if a lower state court (that is, not the highest court in the state) enters an order that determines property rights (for example, in a construction proceeding), that state order does not bind the IRS. The U.S. Supreme Court has ruled that the government looks first to see if the state's highest court has made any decision both in the case at hand and also in any other relevant case. If not, the government puts itself in the position of the highest court and, based on state law and court decisions, decides if the order should be followed. If the decision is "no", then the IRS is not bound and will decide the tax effects under federal law only.2
In PLR 201427008, the beneficiary had a power to appoint trust property, on his death, in his will, outright or in trust among his mother's issue, and the power of appointment did not expressly prohibit distributions to the beneficiary, his estate, his creditors, or the creditors of his estate. If the trust property is not appointed, then under the terms of the trust agreement, the trust property would be distributed to the beneficiary's issue who are living at his death, in equal shares per stirpes; if none, to his mother's issue living at the time of his death, in equal shares per stirpes. If there are no issue of his mother, then to his mother, if living, and if not, then to the living issue of beneficiary's uncle (his mother's brother), in equal shares per stirpes. If none of the above, to the then living issue of the settlor (beneficiary's grandfather and father of his mother and uncle), in equal shares per stirpes, and, if none, charity. Finally, if trust property was not effectively disposed pursuant to the foregoing provisions, the trustee is to transfer trust property to those persons who would be entitled under the applicable intestacy laws to inherit the personal property of settlor if he had died intestate and unmarried immediately following the death of the beneficiary.
The beneficiary's counsel must have concluded that there was a significant risk that the IRS position would be that the power was a general power of appointment and, therefore, upon the death of the beneficiary, the trust property would be included in the gross estate of the beneficiary at his death. First, the beneficiary went to a state court and had the trust construed as including the prohibitions on appointment. Second, the beneficiary requested the following rulings: (1) the testamentary power of appointment over trust property does not constitute a general power of appointment within the meaning of §2041(b)(1); and (2) the existence, exercise, failure to fully exercise, or partial or complete release of the power to appoint will not cause the value of trust property to be included in the holder's gross estate under §2041(a).
To address the perceived ambiguity a declaratory judgment action was filed, all necessary parties notified and none objected (the Attorney General was not required to be notified under the state law), and the charity consented to the relief requested, and a guardian ad litem was appointed to represent "minor and unborn and unascertained interests." The state court entered an order that the testamentary power of appointment could not be exercised in favor of the beneficiary, his creditors, his estate, or the creditors of his estate. In reaching its conclusion, the state court relied in part upon the settlor's intention that the trust not be subject to estate tax at the grandson's death.
Armed with the court order, a private letter ruling request was filed.
The IRS ruled that the state court order was binding on the IRS because the state court order was consistent with applicable state law as it would be applied by the highest court of that state. Accordingly, the IRS ruled that the testamentary power granted to the beneficiary was not a "general power of appointment" and thus the trust property would not be included in the gross estate of the beneficiary at his death.
The costs to the beneficiary for going to state court and then requesting a private letter ruling must have been quite high. If the language in the trust had simply contained a prohibition on the beneficiary ever being able to exercise the power of appointment to himself, his creditors, his estate, and the creditors of his estate, these costs could have been avoided. As practitioners review trusts, especially older trusts, if the prohibition language does not appear, practitioners should consider whether incurring the costs of a current construction proceeding (and potentially a later letter ruling) would be appropriate on the facts and if not, at least consider memorializing its absence and also drafting a narrative that sets forth the settlor's intent and, if the settlor is still alive, have him swear to an affidavit to that effect (and if the attorney who drafted the document is still alive, get a similar affidavit as to intent), so that, in the future, there is a decision by the client(s) to go to court to construe the trust document, the narratives and sworn statements are available for background.
For more information, in the Tax Management Portfolios, see Cline, 825 T.M., Powers of Appointment — Estate, Gift and Income Tax Considerations, and in Tax Practice Series, see ¶6230, Powers of Appointment — Section 2041.
1 Unless otherwise specified, all "Section" or "§" references refer to the Internal Revenue Code of 1986, as amended, and the regulations thereunder.
2SeeCommissioner v. Estate of Bosch, 387 U.S. 456 (1967).
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