Trusts & Estates Section Webinar

ORANGE COUNTY BAR ASSOCIATION

TRUSTS & ESTATES SECTION WEBINAR

Powers of Appointment: Everything You Need to Know from the Planning and Litigation Perspectives

Wednesday, August 12, 2020

Powers of Appointment: Everything You Need to Know From the Planning and Litigation Perspectives Orange County Bar Association, Trusts & Estates Section August 12, 2020

Catherine M. Swafford, Esq. & Helen Cheng, Esq. Withers Bergman, LLP 101 W. Broadway, Suite 1000 San Diego, CA 92101 [email protected] [email protected]

Outline: 1. Powers of Appointment Generally 2. Tax and Planning Issues 3. Potential Litigation Issues

What is a power of appointment? • A power given to someone to dispose of property. • A power conferred by the owner of property upon another person to designate the persons who will receive the property.

What is the purpose of a power of appointment? • To provide for flexibility after the settlor is no longer able to make changes to his/her estate plan. • Situations evolve and the world is constantly changing. • Controlling distributions from the grave.

Probate Code v. Common Law • California Powers of Appointment Act - Probate Code §§ 600-695. • Probate Code § 600: except to the extent the common law rules governing powers of appointment are modified by statute, the common law as to powers of appointment remain the law of California. • Probate Code § 601: if the law existing at the time of the creation of a power of appointment and the law existing at the time of the release or exercise of the power of appointment or at the time of the assertion of a right given by this part differ, the law existing at the time of the release, exercise, or assertion of a right controls. “Nothing in this section makes invalid a power of appointment created before July 1, 1970, that was valid under the law in existence at the time it was created.”

Probate Code § 610 – Definitions • “Appointee” – person in whose favor a power of appointment is exercised • “Appointive Property” – property that is the subject of the power of appointment • “Creating Instrument” – the document creating the power of appointment • “Donor” – person who creates the power of appointment • “Permissible appointee” – person in whose favor a power of appointment can be exercised • “Powerholder” – person to whom a power of appointment is given • “Power of Appointment” – power that enables a powerholder acting in a nonfiduciary capacity to designate a recipient of an ownership interest in, or another power of appointment over, the appointment property.

Probate Code § 611 – General and Special Powers • General: a power of appointment is “general” only to the extent it is exercisable in favor of the powerholder, the powerholder’s estate, the powerholder’s creditors, or creditors of the powerholder’s estate, whether or not it is exercisable in favor of others. • Special: a power of appointment that is not “general” is “special.” • A power of appointment may be general as to some appointive property, or an interest in or a specific portion of appointive property, and special as to other appointive property.

Probate Code § 611 – General and Special Powers • Not a “General” Power of Appointment – a power to consume, invade, or appropriate property for the benefit of a person in discharge of the powerholder’s obligation of support that is limited by an ascertainable standard relating to the person’s health, education, support, or maintenance. • Not a “General” Power of Appointment – a power exercisable by the powerholder only in conjunction with a person having a substantial interest in the appointive property that is adverse to the exercise of the power in favor of the powerholder, the powerholder’s estate, the powerholder’s creditors, or creditors of the powerholder’s estate.

Probate Code § 650 – general power of appointment • The powerholder of a general power of appointment may make an appointment: • Of all of the appointive property at one time, or several partial appointments at different times, where the power is exercisable inter vivos. • Of present or future interests or both. • Subject to otherwise lawful restraints on the alienation of the appointed interest. • In trust. • Creating a new power of appointment. • The foregoing list is illustrative, not exclusive.

Probate Code § 651 – special power of appointment • Subject to the limitations imposed by the creating instrument, the powerholder of a special power may make any of the types of appointment permissible for the powerholder of a general power under § 650.

Probate Code § 652 – appointive share or amount in special powers • The powerholder of a special power of appointment may appoint the whole or any part of the appointive property to any one or more of the permissible appointees and exclude others. • However, if the donor specifies either a minimum or maximum share or amount to be appointed to one or more of the permissible appointees, the exercise of the power must conform to the specification. • There is case law concerning these requirements. See below.

Probate Code § 612 – testamentary powers; presently exercisable; not presently exercisable; postponed powers • A power of appointment is “testamentary” if it is exercisable only by a will. • A power of appointment is “presently exercisable” at the time in question to the extent that an irrevocable appointment can be made. • A power of appointment is “not presently exercisable” if it is “postponed.” A power of appointment is “postponed” in either of the following circumstances: • The creating instrument provides that the power may be exercised only after a specified act or event occurs or a specified condition is met, and the act or event has not occurred or the condition has not been met. • The creating instrument provides that an exercise of the power of appointment is revocable until a specified act or event occurs or a specified condition is met, and the act or event has not occurred or the condition has not been met.

Probate Code § 613 – imperative powers and discretionary powers • A power of appointment is “imperative” where the creating instrument manifests an intent that the permissible appointees be benefitted even if the powerholder fails to exercise the power. An imperative power can exist even though the powerholder has the privilege of selecting some and excluding others of the designated permissible appointees. • All other powers are “discretionary.” The powerholder of a discretionary power is privileged to exercise, or not exercise, the power as the powerholder chooses. • The only real distinction is that is the donee of a discretionary power fails to exercise it, the property passes to any designated takers in default or returns to the donor’s estate, whereas property subject to an imperative power is divided among the potential appointees.

Probate Code § § 620, 621 – donor’s capacity and requirements for creation A power of appointment is created only if all of the following are satisfied: 1. The donor has capacity to transfer the interest in property to which the power relates. 2. There is a creating instrument. 3. The creating instrument is valid under applicable law. 4. The creating instrument transfers the appointive property. (Exception: does not apply to the creation of a power of appointment by the exercise of a power of appointment.) 5. The terms of the creating instrument manifest the donor’s intent to create in a powerholder a power of appointment over the appointive property exercisable in favor of a permissible appointee.

Probate Code § § 625, 630 – powerholder’s capacity and scope of authority • Powerholder must have capacity to exercise the power of appointment. Unless the creating instrument provides otherwise, a powerholder who is a minor does not have capacity to exercise the power of appointment. • If the creating instrument specifies requirements as to the manner, time, and conditions of the exercise of a power of appointment, the power can be exercised only by complying with those requirements. • Unless expressly prohibited by the creating instrument, a power stated to be exercisable by an inter vivos instrument is also exercisable by a written will. • Powerholder must show requisite intent – see next slide.

Probate Code § 640 – powerholder’s intent • There must be a manifestation of the powerholder’s intent to exercise the power, which exists where: • The powerholder declares, in substance, that the powerholder exercises specific powers or all the powers the powerholder has. • The powerholder purports to transfer an interest in the appointive property that the powerholder would have no power to transfer except by virtue of the power. • The powerholder makes a disposition that, when considered with reference to the property owned and the circumstances existing at the time of the disposition, manifests the powerholder’s understanding that the powerholder was disposing of the appointive property. • The aforementioned circumstances are illustrative, not exclusive.

Probate Code § § 641, 642 – powerholder’s intent by execution of will • A general residuary clause in a will, or a will making general disposition of all the testator’s property, does not exercise a power of appointment unless specific reference is made to the power or there is some other indication of intent to exercise the power.

If you have a general power of appointment, the power, or the release or lapse of the power, may have gift or estate tax consequences.

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Tax Issues Relating to Powers of Appointment For federal gift and estate tax purposes, a general power of appointment is a power exercisable in favor of the power holder, his or her estate, his or her creditors, or the creditors of his or her estate; with the following caveats: • A power to consume, invade, or appropriate property for the benefit of the possessor which is limited by an ascertainable standard relating to the health, education, support, or maintenance of the possessor shall not be deemed a general power of appointment. • If powers are exercisable only in conjunction with the donor or a person having a substantial interest in the property subject to the power, adverse to the donee, they shall not cause a general power of appointment. The power may be exercisable during life, at death, or at either time. The powerholder needs only to have the power to appoint to any one of the four categories. London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Tax Issues Relating to Powers of Appointment

X creates a trust for B, granting B the testamentary power to appoint assets to B’s estate, B’s creditors, or the creditors of B’s estate.

X creates a trust for B, granting B the power to withdraw corpus for any reason.

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Tax Issues Relating to Powers of Appointment A power to consume, invade, or appropriate property for the benefit of the possessor which is limited by an ascertainable standard relating to the health, education, support, or maintenance of the possessor shall not be deemed a general power of appointment.

Treasury Regulations clarify that: • a power is limited by an ascertainable standard if the extent of the holder's duty to exercise and not to exercise the power is reasonably measurable in terms of his needs for health, education, or support (or any combination of them). • The words “support” and “maintenance” are synonymous and their meaning is not limited to the bare necessities of life. • Examples of powers which are limited by the requisite standard are powers exercisable for the holder's “support,” “support in reasonable comfort,” “maintenance in health and reasonable comfort,” “support in his accustomed manner of living,” “education, including college and professional education,” “health,” and “medical, dental, hospital and nursing expenses and expenses of invalidism.” • A power to use property for the comfort, welfare, or happiness of the holder of the power is not limited by the requisite standard. • In determining whether a power is limited by an ascertainable standard, it is immaterial whether the beneficiary is required to exhaust his other income before the power can be exercised.

Typically, the words “welfare,” “happiness,” “enjoyment,” and “comfort” will not be considered an ascertainable standard and thus create a general power of appointment. There have been numerous cases regarding when a power is limited to an ascertainable standard, and courts looks closely at the specific clauses and the total context. To avoid risk and litigation, best practices are to simply use the words listed in the Code: “health, education, support, or maintenance.”

X creates a trust for B, granting B the power to withdraw corpus for B’s health, education, maintenance and support [in his/her accustomed standard of living].

The beneficiary will generally be treated as holding the distribution powers of the trustee if the beneficiary has the right to serve as trustee. Additional risk if the beneficiary has the unrestricted right to remove the trustee and replace with a trustee that is related or subordinate within the meaning of Tax Code section 672(c). • “Related or subordinate” includes self, spouse, issue, siblings, certain employees

Trustee has power to make distributions to B for any reason.

Trustee has power to make distributions to B for health, education, maintenance and support.

Trustee has power to make distributions to B for health, education, maintenance and support [in his/her accustomed standard of living]. An independent trustee may make distributions for any reason.

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Tax Issues Relating to Powers of Appointment What happens if a beneficiary has powers that cause a general power of appointment? • Difficult to release without gift tax consequences. • Possible to reform the trust

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Tax Issues Relating to Powers of Appointment A limited power of appointment includes the power to appoint assets to a class of persons, or to any person other than the power holder, his or her estate, his or her creditors, or the creditors of his or her estate.

What if beneficiary has power to distribute to self and others?

Trustee has power to make distributions to B and B’s siblings.

Trustee has power to make distributions to B and B’s siblings for health, education, maintenance and support.

Trustee has power to make distributions to B and B’s siblings for health, education, maintenance and support [in his/her accustomed standard of living]. An independent trustee may make distributions for any reason.

B has the testamentary power to appoint assets to descendants and charitable institutions.

But don’t forget the GST Tax!

B has the testamentary power to appoint assets to descendants and charitable institutions. In addition, with respect only to the portion of the trust estate that is not exempt from the generation-skipping transfer tax under Tax Code section 2631 (other than by reason of this general power of appointment), B has the testamentary power to appoint such assets to the creditor’s of B’s estate.

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Tax Issues Relating to Powers of Appointment Final notes: • Consider the distribution standard (HEMS unless it will always be an independent trustee) • Consider the trustee provisions (unless there is a HEMS standard, should always have an independent trustee • Consider the testamentary appointment provisions (LPOA up to GST exemption, GPOA for remainder) • Consider possible gift tax issues

Probate Code § 631 – judicial relief from formalities specified in creating instrument: • Where an instrument does not satisfy the formal requirements of § 630, the court may excuse compliance with the formal requirements and determine that the exercise of the appointment was effective if both of the following requirements are satisfied: • The appointment approximates the manner of appointment prescribed by the donor. • The failure to satisfy the formal requirements does not defeat the accomplishment of a significant purpose of the donor.

Probate Code § 631 – judicial relief from formalities specified in creating instrument: • However, § 631 does not permit a court to excuse compliance with a specific reference requirement under § 632. • § 632 provides that if the creating instrument expressly directs that a power of appointment be exercised by an instrument that makes a specific reference to the power or to the instrument that created the power, the power can be exercised only by an instrument containing the required reference. • The purpose of § 632 is to ensure a conscious exercise by the donee. • It precludes the use of form wills with ‘blanket’ clauses exercising all powers of appointment. The use of ‘blanket’ clauses may result in passing property without knowledge of the tax consequences and may cause appointment to unintended beneficiaries. • This requirement is the subject of much litigation. See below.

Probate Code § 631 – judicial relief from formalities specified in creating instrument • § 631 does not reference § 633, which provides that if the creating instrument requires the donor’s consent to exercise the power of appointment, the power can only be exercised when the required consent is contained in the instrument or exercise or in a separate written instrument. Consent may be given before or after the exercise of the power. If person whose consent is required dies, no consent is required. If person whose consent is required becomes incapacitated, the person’s guardian or conservator may consent.

Probate Code § 635 – defective exercise of imperative power; remedy • Nothing in this chapter affects the power of a court of competent jurisdiction to remedy a defective exercise of an imperative power of appointment.

Probate Code § 670 – effect of failure to make effective appointment • An exercise of a power of appointment is not void solely because it is more extensive than authorized by the power, but is valid to the extent that the exercise was permissible under the terms of the power.

Probate Code § 671 – imperative powers • Unless the creating instrument or the powerholder manifests a contrary intent, where the powerholder dies without having exercised an imperative power of appointment in whole or in part, the persons designated as permissible appointees take equally of the property not appointed. • Where the imperative power of appointment has been exercised defectively, its proper execution may be adjudged in favor of the person intended to be benefitted by the defective exercise. • Where an imperative power of appointment has been created so that it confers on a person a right to have the power exercised in the person’s favor, the proper exercise of the power can be compelled in favor of the person, or the person’s assigns, creditors, guardian, or conservator.

Probate Code § 672 – discretionary powers; general powers • If the powerholder of a discretionary power of appointment fails to appoint the property, the property not appointed passes to the person named by the donor as taker in default or if none, reverts to the donor. • If the powerholder of a general power of appointment makes an ineffective appointment, an implied alternative appointment to the powerholder’s estate may be found if the powerholder has manifested an intent that the property be disposed of as property of the powerholder rather than as in default of appointment.

What types of issues come up in litigation? • Ineffective exercise because it was made in the incorrect type of instrument • Ineffective exercise because incorrect language was used • Ineffective exercise because it was beyond the scope of what was authorized • Ineffective exercise because it fails to cover all requisite persons/ property • Donee’s death raises questions about who gets donee’s share • Donor’s or donee’s lack of capacity

Procedural avenues to obtain a court order:

• Probate Code § 17200 Petition • Petition for instructions (Probate Code §§ 17200(b)(6), 9611) • Petition to ascertain beneficiaries and determine to whom property shall pass (Probate Code § 17200(b)(4)) • Petition for construction of trust (Probate Code § 17200(b)(1)) • Petition for reformation on the basis of mistake of law and fact • Civil Code §§ 1576, 1577, 1578 • Estate of Duke (2015) 61 Cal.4th 871

• Probate Code § 15403: if the continuance of the trust is necessary to carry out a material purpose of the trust, the trust cannot be modified or terminated unless the court, in its discretion, determines that the reason for doing so under the circumstances outweighs the interest in accomplishing a material purpose of the trust. Requires a petition for modification and consent by all beneficiaries. • Probate Code § 15404: Court approval of modification not required if all beneficiaries and the settlor consent to the modification. If any beneficiary does not consent, the court may modify the trust, with the settlor’s consent, if the interests of the beneficiaries who do not consent are not substantially impaired. • Probate Code § 15409: on a petition by a trustee or beneficiary, the Court may modify the trust if, owing to circumstances not known to the settlor and not anticipated by the settlor, the continuation of the trust under its terms would defeat or substantially impair the accomplishment of the purposes of the trust.

Procedural avenues to obtain a court order (cont’d): • Petition to determine persons entitled to distribution • Probate Code § 11700: At any time after letters are first issued to a general personal representative and before an order for final distribution is made, the personal representative, of any person claiming to be a beneficiary or otherwise entitled to distribution of a share of the estate, may file a petition for a court determination of the persons entitled to distribution of the decedent’s estate.

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Litigation Issues – Cont’d Case law examples: • Crook v. Contreras (2002) 95 Cal.App.4th 1194 • Petitioner asked the Court to interpret a trust amendment to be a codicil to decedent’s will exercising decedent’s power of appointment. • The title of an instrument is not controlling because the “true test of the character of an instrument is not the testator’s realization that it is a will, but his intention to create a revocable disposition of his property to accrue and take effect only upon his death and passing no present interest.” • “Although the 1998 documents were titled as trust amendments, they could potentially qualify as codicils if they met the legal requirements for wills and demonstrated [the decedent’s] intent to dispose of property upon her death.” • Section 631 “may excuse compliance with donor-imposed requirements that exceed the requirements imposed by law for the appointment instrument… [but] Section 631 cannot be used to excuse the failure to satisfy legal requirements.” • Trust amendment did not qualify as a codicil because it failed to satisfy the legal requirements of Probate Code section 6110 requiring two witnesses to sign the codicil.

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Litigation Issues – Cont’d Case law examples (cont’d): • Katie’s case - Crook v. Contreras Part 2 • After Crook, the Legislature changed the legal requirements to execute a will by providing an alternative mechanism to prove a will when it is not signed by two witnesses. • Effective January 1, 2009, Subdivision (c)(2) was added to § 6110: “If a will was not executed in compliance with paragraph (1), the will shall be treated as if it was executed in compliance with that paragraph if the proponent of the will establishes by clear and convincing evidence that, at the time the testator signed the will, the testator intended the will to constitute the testator’s will.” • Estate of Duke: “Although 6110 does not reduce the formalities of attestation, it reflects a judgment that the formalities should not be allowed to defeat the testator’s intent when clear and convincing evidence satisfies the evidentiary concerns underlying the formalities of the statute of wills.” “We should not allow stringent formalities to obscure the ultimate purpose of the statute of wills, which is to transfer an estate in accordance with the testator’s intent.” • We could satisfy Probate Code § 631(a)(1)-(2), and Probate Code §6110.

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Litigation Issues – Cont’d Case law examples (cont’d): • Estate of Eimers (2020) 49 Cal.App.5th 97 • Original trust states: “Upon the death of any child, any share held in trust for the child’s benefit… shall be distributed to or for the benefit of such one or more persons or entities, and on such terms and conditions, either outright or in trust, as said child may provide and appoint by will specifically referring to and exercising this power of appointment…” • Holographic will stated: “To Charles J. Saletta and Caryn Saletta I hereby leave my shares of the Norbert Theodore Eimers Family Trust…” • The Salettas filed a petition to amend and reform the will to clarify that the reference to the Eimers Family Trust referred to the decedent’s power of appointment. • Court cannot reform a will under Estate of Duke where the specific reference requirement under Probate Code § 632 must be, and is not, satisfied. • A specific reference to the trust instrument was not enough. The will must specifically reference the “power of appointment” as required by the trust instrument. • Probate Code § 631(b) does not permit a court to excuse compliance with a specific reference requirement under Section 632.

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Litigation Issues – Cont’d Case law examples (cont’d): • Estate of John O’Connor (2018) 26 Cal.App.5th 871 • Original trust states: “Upon the death of John N. O’Connor, the principal and undistributed net income of his trust shall be distributed to such of his issue, the issue of the Trustors, or the creditors of his estate, either outright or in trust, as he shall appoint by a will specifically referring to and exercising this general testamentary power of appointment.” • Will stated: “I exercise any Power of Appointment which I may have over that portion of the trust or trusts established by my parents for my benefit or any other trusts for which I have Power of Appointment I exercise in favor of my brother [sic]” • Other brother and sister argued the exercise of the power of appointment was invalid because the will’s language referring to “any Power of Appointment which I may have” was only a general reference. • This language satisfies the specific reference requirement of Probate Code section 632. John was not required to reference the original trust instrument. He was only required to reference the power of appointment. The reference to his parents and the trust shows that this was not a ‘blanket’ or form clause. • “To constitute a sufficiently ‘specific reference’ to the power, a donee’s exercise must not merely state that he or she exercises all or any powers of appointment that he or she owns, but contain enough detail such that it is reasonable to conclude from the words used alone that he or she made an intentional and deliberate, not inadvertent, exercise of the particular power or powers of appointment granted to him or her by the donor.”

London l Cambridge l Geneva l Milan l Padua l Sydney l Hong Kong l Singapore l Tokyo New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco l British Virgin Islands Litigation Issues – Cont’d Case law examples (cont’d): • Sefton v. Sefton (2015) 236 Cal.App.4th 159 (Sefton II) • Interpreting Sefton I and Estate of Sloan (1935) 7 Cal.App.2d 319 • Grandfather’s 1955 will gave father a power of appointment whereby the trust estate shall be distributed to father’s then living issue as father shall appoint in his will, and in default of appointment, to father’s then living issue by right of representation. • Father’s will exercised the power of appointment by giving the trust property to 2 of his 3 kids. Excluded kid challenged the power of appointment. • The power granted father a nonexclusive power of appointment, i.e., the power of appointment to permissible objects but not the power to exclude any permissible objects from receiving a substantial distribution of the appointive property. • The common law controlled the outcome here. • The power of appointment failed, and the 3 kids took in default of appointment. • Probate Code § 652 changed the common law rule favoring nonexclusive powers of appointment. Section 652 states that the powerholder may appoint to any one or more of the permissible appointees and exclude others.

Case law examples (cont’d): • Tubbs v. Berkowitz (2020) 47 Cal.App.5th 548 • Surviving spouse trustee did not breach his fiduciary duties to the contingent remainder beneficiaries by exercising a power of appointment in the marital trust in favor of himself. • A person’s status as trustee with fiduciary duties does not limit their separate ability to exercise a power of appointment. The powerholder acts in a nonfiduciary capacity.

Questions?

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