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 beneficiary, the provision likely gives the beneficiary a testamentary power of appointment. This permits the beneficiary, effective upon the beneficiary’s death, to redirect any remaining trust assets among individuals or charities of the beneficiary’s choice. When avoiding estate tax is a major concern, it makes sense to limit the power of appointment in a manner that restricts the beneficiary from using trust assets to pay off personal debts. This allows trust assets to pass to the successor beneficiaries free of estate tax, which is important for large estates. But the limited power of appointment also prevents the successor beneficiary from getting a step-up in income tax basis, which can increase capital gains tax upon sale of trust assets.
The current estate tax exemption, now dramatically higher than it was in 2017, eliminates the estate tax as a planning issue for all but the very wealthy. This means it makes more sense to refrain from using limited powers of appointment in inheritance trusts. Why? The reason is because the value of potentially avoiding estate tax is outweighed by the more likely benefit of reducing income tax.