May 30, 2019

A Proper Lesson on an Improper Exercise of a Power of Appointment

The Nebraska Supreme Court recently considered the validity of the exercise of a limited testamentary power of appointment in favor of the power holder’s own revocable trust, ultimately finding the exercise to be ineffective and void.  In re Robert L. McDowell Revocable Trust, the Court’s holding serves as a cautionary tale to trustees who are required to act on purported exercises and underscores the importance of careful drafting.

David C. Valente
A Proper Lesson on an Improper Exercise of a Power of Appointment

A Proper Lesson on an Improper Exercise of a Power of Appointment

In a recent case handed down by the Nebraska Supreme Court (the “Court”), In re Robert L. McDowell Revocable Trust,[1] the Court considered the validity of the exercise of a limited testamentary power of appointment in favor of the powerholder’s own revocable trust, ultimately finding the exercise to be ineffective and void. In addition to providing a thoughtful lesson on powers of appointment, the Court’s holding serves as a cautionary tale to trustees who are required to act on purported exercises and underscores the importance of careful draftsmanship.

Robert and Betty Dowell, husband and wife, executed revocable trusts in 2001. Robert predeceased Betty, to whom he granted a limited testamentary power of appointment over assets remaining in a subtrust established upon his death (the “Power”).  Permissible appointees included one or more of Robert’s descendants, the spouses of any descendants and tax-exempt organizations. To the extent any remaining assets were not effectively appointed by Betty through a last will, the remainder would be divided equally among Robert and Betty’s two surviving daughters, Jane O. Hornung (“Jane”) and Sandra K. Stockall (“Sandra”).

Through a last will executed subsequent to Robert’s death, Betty exercised the Power, or so she thought. Betty attempted to exercise the Power in favor of her own revocable trust, the terms of which excluded Jane as a beneficiary.  Upon Betty’s death, the trustee of Robert’s subtrust, acting in compliance with the Power, distributed all of its assets to Betty’s trust.  Jane filed suit in county court requesting instructions and declaration of beneficiaries’ rights pursuant to Robert’s trust. Jane alleged the exercise of the Power was invalid and as a result, the remaining assets in Robert’s subtrust should have been divided equally between her and Sandra. Sandra counterclaimed, requesting the court to enter an order validating Betty’s exercise and approving the distribution to Betty’s trust. The court found that Betty’s exercise was invalid because it exceeded the scope of the limited Power insofar as it commingled Robert’s subtrust’s assets with Betty’s trust’s assets, potentially benefiting Betty, her estate and its creditors – none of which were permissible appointees of the Power. Sandra appealed, and the Court granted her petition to bypass the Nebraska Court of Appeals.

In its opinion, the Court espoused the cardinal principal of the construction of powers of appointment, namely that the donor’s intention is controlling.  The Court found that in the clear and unambiguous terms of the Power Robert granted to Betty, he limited the class of appointees.  Betty purported to exercise such Power in favor of the trustee of her own revocable trust, to be held and administered as part of its property. The Court acknowledged that the remainder beneficiaries of Betty’s trust were Sandra and several of Robert’s grandchildren, all of whom were permissible appointees of the Power. To this end, Sandra argued that because the subject property would ultimately pass to individuals who were permissible appointees, the Power should be given effect. Meanwhile, Jane argued that an appointment to Betty’s trust – an impermissible appointee – rendered the appointment ineffective, regardless of whether the underlying beneficiaries of Betty’s trust were permissible appointees of the Power.

As the Court had not previously decided the issue, it looked to the decisions of other jurisdictions for guidance. Ultimately, the Court found the coup de grâce was the absence of express language segregating the powerholder’s own trust’s assets -- which were subject to the powerholder’s creditors and the creditors of her estate – from the appointive property. Had the terms of Betty’s trust expressly provided that the appointive assets were not to be comingled with other assets held by (or pouring into) Betty’s own trust, Betty’s exercise would have been valid, rather than being ineffective on account of benefiting non-objects of the Power.

The Court included a fascinating discussion of the doctrines of selective allocation and substantial compliance, but concluded that neither saves the invalidity of Betty’s exercise. Selective allocation is recognized by Restatement (Third) of Property, which provides, “If the donee of a power of appointment exercises the power in a document that also disposes of owned property, the owned and appointive property are deemed to be allocated in the manner that best carries out the donee’s intent.”[2] The Court notes that Massachusetts, Pennsylvania and New York (but not Nebraska) have recognized the doctrine, but that the Court could not find any reported case applying the doctrine in the past forty years.

The Court was not persuaded by Sandra’s argument that the exercise should be deemed valid because it would have ultimately benefited individuals who were permissible appointees, i.e., Robert’s descendants, nor was it persuaded by the observation that Betty’s own estate has sufficient assets to cover her debts and expenses, and thus the appointive assets would not have in fact benefitted Betty’s creditors, Betty’s estate or its creditors.

Meanwhile, the trustee of Robert’s subtrust had distributed the subtrust’s property to Betty’s trust pursuant to Betty’s exercise of the Power. The lower court had found that the trustee of Robert’s trust had acted reasonably and in good faith, but the Court concluded this decision to be plain error on account on the ineffectiveness of the exercise.  As a result, the trustee of Robert’s trust was found to have committed a breach of trust.

The Court’s own research suggested that legislatures in numerous states recognize selective allocation through their adoption of some or all of the Uniform Powers of Appointment Act. However, the Court’s decision should serve as a reminder to all estate planning attorneys to consider including language, in a powerholder’s trust intended to receive appointive assets, that segregates such trust’s assets from the appointive assets. Alternatively, the powerholder might consider appointing assets in favor of an irrevocable trust for the benefit of permissible appointees, to avoid altogether an assertion that the exercise might potentially benefit the powerholder, her creditors, her estate or its creditors. The Court’s decision should also serve as a reminder to trustees to closely examine the terms of any purported exercise to ensure its method of prescribed execution was followed strictly.

 

[1] In re Robert L. McDowell Revocable Trust, 296 Neb. 565 (2017).

[2] Restatement (Third) of Property: Wills and other Donative Transfers § 19.19 (2011)