Unexpected gift tax problems can arise in certain situations upon the lapse (nonexercise) of a Crummey power. In most cases, this problem will not occur or, if it does, it will be minor. But planners should be aware of it in cases where the value of a life insurance policy or subsequent premiums are large.
Specifically, the problem most frequently arises where premium outlays will exceed the greater of $5,000 a year or 5 percent of the trust’s assets in the year of the grantor’s contribution. The trap is set when the client, in an attempt to create a larger window through which the beneficiary can make withdrawals in order to take full advantage of the annual exclusion (including the annual exclusion of the client’s spouse where the client is married and splits the gift), opens that window too much. This may reduce the grantor’s gift tax problems, but increase those of the beneficiary.
Why might opening the window too much create a gift (and possibly estate) tax problem for the beneficiary? The problem stems from the fact that another term for an absolute demand or withdrawal or Crummey power is a general power of appointment (a power the beneficiary has to appoint trust funds to the beneficiary himself). By allowing that general power to lapse, the beneficiary who could have taken the cash, but didn’t, is making a taxable gift to anyone who has interests in the trust that are enlarged by the lapse.
Unfortunately, those donees will not receive their gifts immediately. That makes such gifts future interests and, therefore, the gifts are ineligible for the gift tax annual exclusion. This means the Crummey beneficiary who permits the withdrawal power to lapse would (absent the “five-or-five” de minimis rule) be required to file annual gift tax returns (no matter how small the gift) and may have to use part of his lifetime exemption or pay a gift tax.
In many cases, as a practical matter, the annual right of withdrawal for each Crummey powerholder will be limited to $5,000 each year. That presents a major problem in the large premium situation, i.e., those where the premium significantly exceeds the amount sheltered under the normal Crummey limits. A client who sets up a trust with four Crummey powerholders can safely contribute only $20,000 ($5,000 x 4 beneficiaries) a year before running into gift tax problems. Yet if the premium were $60,000 a year, the $40,000 annual difference would soon exhaust the client’s unified credit.
There are ways in which the irrevocable trust can be designed to avoid or minimize this problem, described below.
Limited Pay and Suspended Premium Types of Life Insurance
Limited pay life insurance can be useful. For instance, a ten-pay life contract would be complete in ten years. The amount saved in estate taxes would be considerable compared to the relatively small gift taxes paid during the ten-year period.
Suspended premium insurance is a variation on the first theme. However, while premiums may be projected to suspend at some point, they may not actually do so.
Increase the Number of Legitimate Powerholders
The use of multiple powerholders must be coupled inversely with the client’s desire not to have to litigate with the IRS and his fear that such powerholders will exercise their rights. There is no question that success with multiple powerholders requires giving them all legitimate and realistic rights to exercise their powers. There must be no implied or express agreement that they will not exercise their rights.
The problem can’t be solved by creating multiple trusts with multiple demand rights for the same beneficiary. Multiple demand powers held by the same beneficiary over the same or different trusts are aggregated to determine if the grantor has exceeded the $5,000 portion of the “five-or-five” limitation.
Add Testamentary Control
Here, the powerholder is given testamentary (by will only) control as a means of preventing a taxable gift when the power lapses. There are two different ways to utilize this approach, a general testamentary power of appointment and a special testamentary power of appointment.
Under the general testamentary power technique, each beneficiary is given a general (“name anyone you want to receive it”) testamentary power of appointment over his share of the trust. So each beneficiary can choose who will receive that share of the trust if he doesn’t live to get it. But that right to direct who will receive it can be exercised only at death and only by a specific written provision in his will referring to the general power in the trust. The trust will provide that if the beneficiary doesn’t properly exercise the power, the property will pass to the other beneficiaries in the trust. So if the beneficiary dies without diverting the property to someone other than the client-named remainder person in his will, not only will the property go to the party the client desired but it will pass at the time and in the manner desired.
Using this technique, a client can make gifts equal to the full annual exclusion amount and couple those gifts with equal withdrawal rights. So with five donees, the client could give up to $70,000 per year (in 2015, as indexed for inflation) rather than just $25,000. If the powerholder didn’t exercise the right to take the $14,000 in a given year, the lapse would not be considered a completed gift (i.e., it wouldn’t be subject to the gift tax) because the powerholder can, at any time, name someone other than the client-specified remainder person as the recipient of the property subject to the power.
There are, of course, costs and downsides to the general power of appointment approach: First, whether or not the powerholder chooses to allow the power to lapse without use, property subject to the power will be in his estate because the power is general. Second, this powerholder controlled ability to shift property rights equates, by definition, to a loss of control by the client.
The second variation on the testamentary Crummey power technique is to grant each beneficiary only a limited (special) power of appointment. Assume the trust provides separate shares for each beneficiary and, if the beneficiary dies, his share will pass to whomever he provides by will within a client-specified class such as the powerholder’s siblings (i.e., the beneficiary is given a special testamentary power of appointment to choose who will take the property if he does not exercise the Crummey power, but the powerholder’s choices are limited to parties or classes of individuals selected by the client-grantor). The class of limited takers can, in fact, be quite broad and include anyone other than the powerholder, his estate, his creditors, or the creditors of his estate.
Here again, the trust provides that, if the beneficiary fails to make a withdrawal within the specified time frame, his right to make an immediate withdrawal ends. The window closes. But the cash or other assets he could have taken are earmarked for his exclusive benefit. This avoids the gift tax problem since the cash subject to the power does not pass to anyone else until the beneficiary’s death. The lapse of the withdrawal power is therefore not a completed taxable transfer. The powerholder could, at any moment until death, name some new beneficiary or change the size of the interest going to the client-named beneficiaries. Of course, since the cash he could have taken is held in his name, there is an estate tax implication: The proportionate share of the principal of the trust attributable to the lapsed withdrawal powers will be includable in the Crummey holder’s estate if the beneficiary dies before the trust ends.
There are, of course, costs and downsides to the limited testamentary power of appointment approach: First, whether or not the powerholder chooses to allow the power to lapse without use, some portion of the property subject to the power will be in his estate if the powerholder dies before the trust ends. So, like the general testamentary power technique, the limited power in someone else’s hands in a separate trust means the client can’t fully use generation-skipping exclusions to shift wealth without the generation-skipping transfer tax. Second, this powerholder controlled ability to shift property rights equates, by definition, to a loss of control by the client. The Crummey holder has actual dispositive rights that may or may not mesh with the trust grantor’s dispositive objectives.
Use a Hanging Power
Some authorities claim that this alternative gives the client the best of all worlds by avoiding the gift tax problem upon the lapse of the power and allows full use of the maximum annual exclusion without creating estate tax or control problems. Is it possible to make maximum annual exclusion gifts and yet avoid inclusion of any portion of the lapsed power in the beneficiary’s estate while retaining control in the grantor-client?
The hanging power works like this: The holder is allowed to make a withdrawal each year equal to his share of the client’s contribution up to the maximum allowable annual exclusion ($14,000 in 2015). The right to that aliquot share is cumulative. So, to the extent no withdrawal (or less than the holder’s share is withdrawn) is made in a given year, the balance hangs over and can be used in a following year. Specifically, each year, assuming the power is not used, the right to take the greater of $5,000 or 5 percent of the trust’s principal lapses. But the right to take any amount over that amount continues. It carries over or hangs over to future years.
So if the client contributed $10,000 to the trust and there was only one powerholder, the right to take $5,000 would lapse in the first year but the right to withdraw the remaining $5,000 would continue. In later years, the right to take the first $5,000 (or 5 percent of trust corpus if greater) continues to lapse while a pot builds up of the excess amounts. By the second year, if no withdrawals were made, $10,000 worth of contributions would have lapsed but $10,000 worth of excess contributions ($5,000 from the first year and $5,000 from the second year) are now available as credits against future years. This pot of credits builds up until the client stops or slows down contributions. Figure 34.1 illustrates this concept. Note that, in the example, premiums are assumed to be suspended along with the need to make additional gifts to the trust after 2003. Also, the hanging power was extinguished in 2010.
The hanging power concept assumes that the major premium payments will be made in the early years and then suspend, while at a certain point the beneficiary’s right to make withdrawals (and therefore estate and gift tax liability) will be extinguished.
If the beneficiary dies while money is in the pot (i.e., while amounts remain available at the beneficiary’s demand), whatever is subject to that general power is includable in the powerholder’s estate. Once there is no longer any amount which can be taken, nothing should be includable. Note that in the early years of the policy the amount lapsing is $5000. However, as the cash value of the policy grows and once it exceeds $100,000, then the 5 percent amount kicks in, helping to extinguish the pot sooner and mitigate the risk of inclusion in a beneficiary’s estate.
The nontax problem here is one of control; while there are funds that can be taken, the client’s dispositive objectives are at risk. The hanging powerholder can legitimately and realistically take a sizable sum. So beneficiaries could frustrate the client’s intent by making withdrawals of large amounts. (Of course, minors could only exercise this right through the unlikely course of action of having a guardian appointed to exercise the right.) This should serve as a warning. Clients should be cautioned to carefully select powerholders mature enough to understand the client’s objectives and the potential consequences of their actions. Remember, also, that the client can always choose not to make future gifts to a beneficiary.
Yet a further problem is the IRS position on hanging powers. The IRS has equated a hanging power with the following language to a mere tax savings clause that is adverse to public policy and should be disregarded; an invalid subsequent condition that discourages enforcement of federal gift tax provisions.
The clause that triggered the negative IRS response to hanging powers read: “If upon the termination of any power of withdrawal, the person holding the power will be deemed to have made a taxable gift for federal gift tax purposes, then such power of withdrawal will not lapse but will continue to exist with respect to the amount that would have been a taxable gift and will terminate as soon as such termination will not result in a taxable gift.”
Many experts feel that the IRS is wrong in its position but suggest that a modification of the hanging power language will counter the IRS argument. They suggest avoiding any reference to the term taxable gifts or to a recharacterization of a gift as an incomplete gift if the IRS finds such a gift. The drafting attorney should clearly delineate the lapse formula including the timing and amount so that it can be shown that all the withdrawal rights could have been determined at the moment granted and the powerholder didn’t have to wait until a tax audit or court determination to ascertain his rights to take trust property.
It is suggested that the client contribute the full $15,000 (up to $30,000 per married couple, annual exclusion amounts as indexed for 2019) and give each powerholder the right to withdraw an amount equal to the “five-or-five” limits. This right will lapse each year thirty days after each year’s contribution has been made and that same amount will lapse each further year. This way, all gifts made by the powerholder are safe gifts in that they fall within the protected “five-or-five” limits. If there are excess gifts, the amount of the excess can’t exceed $25,000 ($30,000 maximum annual exclusion limit in 2019 for a married couple less $5,000 protected amount). Even after twenty years of premiums, this would be within the estate tax exemption limits. This relatively small use of the exemption would be a good investment since it would be leveraged many times over by the shifting of wealth through the use of estate tax-free life insurance.
Single Beneficiary Trusts
Providing separate trusts or separate trust shares may be the simplest way to overcome the “five-or-five” limits if the client is willing to give up flexibility and risk several disadvantages; the trustee will not be able to make discretionary trust distributions to persons other than the beneficiary since there will be only one beneficiary (or one trust with separate “sole benefit” shares for each beneficiary). Furthermore, all the income and principal must be payable to the estate of the beneficiary if he dies before the trust pays out all its principal and each beneficiary must be given a testamentary general power of appointment over his trust share. When a Crummey power lapses, no gift is made to someone else since there are no other beneficiaries. Since the lapse results in a transfer only to the sole beneficiary’s estate, there is no taxable gift. So a married parent splitting gifts and who has four children can fund a trust with separate shares for each of her four children, a total of $120,000 in 2019.
In addition to the loss of flexibility, other disadvantages include:
- the trust’s assets can’t be sprinkled or sprayed to the person who needs or deserves it the most or who is in the lowest tax bracket, since there is only one beneficiary;
- the property will pass as if owned by the beneficiary rather than the client, possibly to a person and in a manner that would be objectionable to the client;
- the property will be includable in the beneficiary’s estate, for tax, probate, and creditor purposes; and
- the property may be distributed (due to the untimely death of the beneficiary) prior to the date expected by the client.
Grant Withdrawal Rights to Secondary/Contingent Beneficiaries
This was the strategy used in the now well-known Cristofani case. Here, grandchildren who were contingent beneficiaries were given withdrawal rights in addition to those provided to the client’s children who were the primary beneficiaries of the trust. These grandchildren were entitled to principal and income only to the extent the prior level of beneficiaries (their parents) hadn’t exhausted trust assets.
The IRS found that this level of powerholders had, as beneficiaries, such a remote chance of actually receiving assets from the trust that there must have been some implied understanding between them and the grantor client that they would not make a withdrawal; why else would they not have exercised their power and taken some of the assets in the trust?
But the Tax Court disagreed with the IRS and focused on the central issue: Did the powerholders (no matter what level or how remote their chance of taking a share of the trust as a beneficiary) have the absolute legal right to make an unfettered withdrawal of property from the trust? The authors suggest, in spite of the court’s favorable conclusion, that conservative practitioners will limit Crummey rights to beneficiaries who have a realistic chance to receive something from the trust as beneficiaries rather than merely as powerholders.
Even this tack has its downsides and costs. The most obvious is that the IRS is right in one sense; with nothing to lose, what will stop a remote beneficiary from making a withdrawal? Aside from that, the right to make a withdrawal does carry estate tax inclusion if the powerholder dies while the window is open. Likewise, the lapse of a power will be considered a future interest gift and so there may be gift tax consequences.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM