Increase in Federal Estate Tax Exemption Affects Testamentary Powers of Appointment

Summary:  Increase in federal estate tax exemption affects testamentary powers of appointment.

If your estate plan includes an inheritance protection trust for a child or other non‑spouse beneficiary, that trust likely gives the beneficiary a testamentary power of appointment.  This power allows the beneficiary, at their death, to decide who should receive any remaining trust assets.  When estate tax exposure was a common concern, this power had to be drafted as a limited power—meaning the beneficiary could redirect assets only among a defined group of people and never to themselves or their creditors.  A limited power of appointment keeps the trust assets out of the beneficiary’s taxable estate and preserves strong asset protection from creditors and ex‑spouses. For many years, that combination was the gold standard.

But a limited power of appointment has a trade‑off.  Because the trust assets are not included in the beneficiary’s estate, those assets do not receive a step‑up in income tax basis at the beneficiary’s death.  This can lead to significant capital gains tax exposure when the next generation eventually sells the inherited assets.
 
Today, the landscape has changed.  With the federal estate tax exemption now at $15 million per person, estate tax is no longer a realistic concern for the vast majority of families. As a result, the planning priority has shifted.  Instead of focusing on avoiding estate tax, most families benefit far more from ensuring that trust assets receive a step‑up in income tax basis to reduce future capital gains tax.
 
This is where a new drafting technique—called a testamentary formula general power of appointment—comes to the rescue.  Modern trust design allows the trust to include a formula provision that automatically gives the beneficiary a general power of appointment, but only to the extent that exercising that power will not create or increase federal estate tax.  The beneficiary does not need to take any action during life.  At the beneficiary’s death, the formula activates only for highly appreciated assets, causing those assets to be included in the beneficiary’s estate and therefore eligible for a step‑up in income tax basis.  Only the highly appreciated assets subject to the formula receive this temporary tax treatment.  All other trust assets remain fully asset protected.

For most people, the optimal structure is to include both:

• a testamentary limited power of appointment (for asset protection and family flexibility), and
• a testamentary formula general power of appointment (to secure a basis step‑up without creating estate tax).

This combined approach preserves the protective features families value while also reducing the capital gains tax burden for the next generation.