By Daniel B. Evans | Copyright © 1987, 1997-2024 Daniel B. Evans. All rights reserved. | Not legal advice.
[This article was originally published by the Real Property, Probate and Trust Law Section of the American Bar Association in Probate and Property, Vol. 1, No. 6, p. 54 (November/December 1987). An additional sample trust provision has been provided following the article, to reflect the author’s current practices, but no additional research has been done to update or confirm any the legal authorities or legal principles. D.B.E. 7/13/97]
While the Tax Reform Act of 1986 eliminated many of the income tax advantages of gifts in trust and gifts for the benefit of minors, there are still estate tax advantages for gifts qualifying for the $10,000 annual gift tax exclusion. Once the unified credit is exhausted, the marginal federal estate tax rate is at least 37% (ignoring the state death tax credit), so each $10,000 gift represents a potential estate tax saving of at least $3,700. For families concerned with the new generation- skipping tax, enacted as part of the Tax Reform Act of 1986, the $10,000 annual gift tax exclusion also represents a way to avoid generation-skipping tax.
If the donee of a gift is immature or under a disability (whether legal or in the opinion of the donor), it may be desirable to have the gift in trust. If generation-skipping is a goal, it may be essential to have the gift in trust. There are, however, only three ways for a gift in trust to be considered a “present interest” which will qualify for the annual gift tax exclusion under Section 2503(b) of the Internal Revenue Code (the “Code”): (1) a trust for a beneficiary under the age of twenty-one can be structured to qualify under Section 2503(c) of the Code; (2) if the beneficiary is entitled to all of the income of the trust, the present actuarial value of the income interest is considered a present interest qualifying for the annual exclusion; and, finally, (3) the power of a beneficiary (or group of beneficiaries) to withdraw from the trust immediately after the contribution to the trust converts the gift to a present interest even though the power later lapses. This third technique, usually referred to as a “Crummey” power because of the 9th Circuit opinion which upheld the effectiveness of the technique even where the beneficiaries are minors, is usually desirable because, unlike the other techniques, it places no restrictions upon the dispositive provisions of the trust after the lapse of the right of withdrawal. See Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).
Drafting Objectives
In drafting Crummey powers, there are three general goals:
- To provide that all taxable gifts to the trust will qualify for the annual gift tax exclusion to the greatest extent possible.
- To avoid, if possible, a taxable gift by the beneficiaries of the trust upon the lapse of the Crummey powers.
- To limit the powers of the beneficiaries to the greatest extent possible consistent with the two preceding objectives.
The third consideration is not a legal one, but demonstrates that these are not powers which anyone expects to be exercised. We are not drafting dispositive provisions, but merely carrying out a technical exercise to achieve certain tax results. Nevertheless, in drafting trust provisions to carry out these objectives, there are several specific issues which should be addressed.
Amount Subject to Withdrawal
The amount which may be withdrawn by a beneficiary is obviously limited to the annual gift tax exclusion, and is also obviously limited to the actual amount of the gift. Therefore, the amount to be withdrawn is either the annual gift tax exclusion or the actual amount of the gift, whichever is less.
If more than one beneficiary (such as all children of the grantor) are given the power to withdraw, the actual amount of the gift should be divided among the beneficiaries living at the time of the gift.
The reference to the annual gift tax exclusion must be coordinated with the timing of the lapse of the power. If the rights of withdrawal do not lapse until the end of the year, it is sufficient to state that the total amount which may be withdrawn during the year may not exceed the annual gift tax exclusion. If, as is commonly done, each right of withdrawal lapses thirty or sixty days after the gift, the right of withdrawal should be limited to (a) the annual gift tax exclusion, reduced by (b) all other rights of withdrawal previously arising or existing during that calendar year, so that rights which have lapsed (or are about to lapse) will be taken into account. The examples at the end of this article include both types of provisions.
It is also advisable to define what types of events or transactions create a right of withdrawal. For example, a reference to “contributions to the trust” may not be sufficient if employer-provided group term life insurance is transferred to an irrevocable life insurance trust, as the IRS has held that the payment of the life insurance premiums by the employer results in a taxable gift by the employee. Rev. Rul. 76-490, 1976-2 C.B. 300. To cover this and other possible situations, the right of withdrawal should be defined so that any event which would otherwise be a taxable gift for federal gift tax purposes can be covered by the Crummey power and qualify for the annual exclusion.
Another definitional problem relates to the potential election of a married donor to split gifts under Section 2513 of the Code. If the donor and his spouse elect to split the gift to the trust, there should be two annual exclusions for each beneficiary, instead of only one. However, the election under Section 2513 is not made until the gift tax return is filed, which may be many months after the gift has been made. The determination of the amount which may be withdrawn cannot qualify as a present interest if it must wait until the gift tax return is filed, so the trust instrument should include a presumption that all gifts by a married donor are to be split with his spouse unless the donor directs otherwise at the time of the gift.
Lapse of Powers
If it is worth your time to plan to avoid taxable gifts by the grantor of the trust, it must also be worthwhile to take steps to avoid taxable gifts by the beneficiary or beneficiaries of the trust. While the beneficiaries are presumably of a younger generation, and so less likely to be the immediate subject of a federal estate tax return, it is nevertheless presumed, or at least hoped, that they will grow up to be clients with estate planning problems, and preferably not problems of your making.
Since the lapse of a power to withdraw may be a taxable gift by reason of Section 2514(e) of the Code, and the $10,000 annual exclusion (or $20,000 exclusion in the case of a married grantor) exceeds the $5,000 (or 5% of the trust principal) per year exception under Section 2514(e), there may be a taxable gift by the beneficiary if the power to withdraw simply lapses after thirty or sixty days. There are basically three ways to deal with this problem:
1. The simplest solution is to limit annual gifts to the trust to $5,000, at least until a fund of more than $100,000 is accumulated through gifts using the unified credit or through incredibly shrewd investments. However, since a major goal is to use the client’s $10,000 annual exclusion, this is not very satisfactory.
2. If the trust has only one beneficiary, and that beneficiary is given at least a special testamentary power of appointment, the lapse of the power to withdraw is not a taxable gift by reason of a regulatory definition of what is meant by a “taxable gift.” Under Treas. Reg. § 25.2511-2(b), a gift by a grantor to a trust for his own benefit, of which he is the only beneficiary during his lifetime and the principal and undistributed income of which is subject to a special testamentary power exercisable in favor of his issue at his death, is not a taxable gift because the donor has not parted with “dominion and control.” Therefore, as long as there is only one beneficiary of the trust (which is often the case), and as long as the grantor is willing to give the beneficiary at least a special testamentary power of appointment, the power to withdraw $10,000 or $20,000 can lapse in thirty or sixty days without any taxable gift by the beneficiary.
Of course, each lapse in excess of $5,000 or 5% of the trust principal (whichever is greater) will be considered a transfer for purposes of Section 2036, and so most (if not all) of the trust will be included in the beneficiary’s taxable estate for purposes of the federal estate tax. However, this kind of trust is often a temporary trust for the benefit of a minor or immature beneficiary, and not for generation-skipping purposes, and so this aspect may not be a practical concern.
3. The third solution, which is suitable for generation-skipping trusts or trusts with more than one beneficiary (such as an irrevocable life insurance trust), is to allow the powers to “hang” and only lapse at the rate of $5,000 per year, even though contributions to the trust are made at the rate of $10,000 per year. The essence of the “hanging” Crummey power is that the power lapses only as quickly as is possible within the $5,000 or 5% limitation of Section 2514(e), and not necessarily within thirty or sixty days. In fact, it is usually simpler for the powers to lapse at the same time each year, although this creates an interesting drafting problem.
The most common drafting approach to lapses is to provide that unexercised rights of withdrawal lapse by $5,000 at the end of each year, on December 31. The problem is that the IRS has ruled that a beneficiary must have a reasonable opportunity to exercise the power, which is usually interpreted as a period of at least thirty days. See Rev. Rul. 81-7, 1981-1 C.B. 474. You cannot, therefore, have a gift towards the end of December (when gifts often seem to occur) and still have the power lapse in whole or in part on December 31. Some people try to avoid this result by allowing at least thirty days to exercise the power to withdraw, so that the power to withdraw a gift made in December would not lapse until sometime during the following month of January. There is nothing in the definition of the annual exclusion to prohibit this result, as the IRS itself has ruled in Rev. Rul. 83-108, 1983-2 C.B. 167. However, you will then have two lapses in the same year, since the December gift will lapse in the following year and any right of withdrawal which carries forward to the following year, or which is attributable to a gift made in January through November of the following year, will also lapse in that year, and so violate the $5,000 or 5% limitation.
A solution to this dilemma is to provide that the powers to withdraw all gifts made during a calendar year lapse, in whole or in part, on January 31 of the following year. This means that a beneficiary will always have at least thirty days to exercise a power to withdraw, and there can be only one $5,000 (or 5%) lapse in any one year. As pointed out above, the fact that a power to withdraw may be exercisable in a year following the year in which the gift was made does not in any way invalidate the annual exclusion, and there is nothing in the definition of the $5,000 or 5% limitation of Section 2514(e) or its regulations to indicate that the lapse must occur on December 31. This is, therefore, a simple and workable approach. The only significant disadvantage is that a power may be exercisable for as long as thirteen months before it lapses (from January 1 until January 31 of the following year), instead of only thirty days. However, if the power is going to lapse by only $5,000 each year, at least half of each year’s annual exclusion will “hang” for more than one year in either event. Once you have accepted the hanging powers, therefore, the use of January 31 as the date for lapses of powers is a relatively small additional compromise.
The examples at the end of this article show two different approaches to the lapse of the powers to withdraw. In the first case it is assumed that the beneficiary is a child of the grantor and the sole beneficiary of the trust and that the child has at least a special testamentary power of appointment over the principal remaining at death, so that the lapse of the full annual exclusion in a single calendar year does not result in a taxable gift. In the second example, it is assumed that there are multiple beneficiaries and that the powers lapse by only $5,000 on each January 31.
Minor Beneficiaries
The holding in the Crummey decision was that a right of withdrawal given to a minor beneficiary qualified for the annual exclusion, even though no guardian was appointed for the minor, as long as there was no impediment to the appointment of the guardian. The IRS acquiesced in this result in Rev. Rul. 73-405, 1973-2 C.B. 321. Although some practitioners have suggested that a petition be filed in court for the appointment of a guardian of a minor, there does not seem to be any need for this procedure under the Crummey decision and the Revenue Ruling. However, you should provide that any notices to beneficiaries of their right to withdraw be given to the natural guardian of a minor beneficiary (or the natural guardian other than the grantor), so that it will be clear that the natural guardians will have an opportunity to get a court appointed guardian for the minor if that is necessary to exercise the power to withdraw.
You should also check local law to find out if it is possible for the grantor, as part of the trust instrument, to appoint a guardian of a minor’s estate. It may also be possible that the natural guardian can receive small amounts (such as $5,000 or $10,000) on behalf of a minor, so that the natural guardian could be authorized to exercise the power to withdraw. However, the grantor as natural guardian should not have the power to exercise a power to withdraw, as that could create various gift or estate tax problems. For example, if the trust held a life insurance policy on the grantor, the power to withdraw might be considered to be an incident of ownership of the policy within the meaning of Section 2042. Also, if the power of the grantor to withdraw makes the gift incomplete for federal gift tax purposes until the power lapses, which might not occur until the following year, the annual exclusion will be lost.
Be careful not to inject into the document any impediment to the exercise of the power to withdraw. You should not, for example, restrict the exercise of the power to a court appointed guardian of the estate, in case local law would allow a natural guardian (or even the minor himself) to exercise the power under certain circumstances. It does seem appropriate, however, to require that any distribution be made only to a proper guardian of the estate of a minor.
Satisfaction of Withdrawals
While it is always assumed that the power to withdraw will not be exercised, there are a couple of provisions which may be necessary or appropriate regarding distributions in satisfaction of an exercised power.
The IRS has ruled that where the gift to the trust is the payment by an employer of the grantor of the premium on a life insurance policy held by the trust, a right to withdraw may qualify the indirect gift by the employee for the annual exclusion as long as the trustee has the power to satisfy the withdrawal rights using the policy or any other property held in the trust. PLR 8006109 and 8021058. It therefore seems to be not only permissible, but also advisable, to provide that the right to withdraw may be satisfied by any property held in the trust.
It would also seem to be advisable to provide that, while the rights of withdrawal remain unexercised, and have not yet lapsed, the trustees should not make any other distributions from the trust to any other beneficiary (for example, under any discretionary authority) if the distributions would deplete the trust funds below the amount necessary to satisfy the unexercised rights of withdrawal.
Income Tax Consequences
Some very interesting articles have been written about the possible income tax consequences of Crummey powers.
First, it cannot be denied that until it lapses a Crummey power is an unrestricted power to withdraw the principal of the trust, and so the holder of a Crummey power must be considered the owner of that portion of the trust principal and taxable on the income of that portion under Section 678 of the Code. See Rev. Rul. 67-241, 1967-2 C.B. 225.
Unfortunately, many writers have gone on to suggest that the lapse of a Crummey power also makes the beneficiary the “grantor” of the trust within the meaning of Sections 671 through 677 of the Code, so that the trust remains a grantor trust for federal income tax purposes. The problem with this position is that there is no Code section, Regulation, Revenue Ruling, or case decision holding that the lapse of a power to withdraw, previously exercisable by someone other than the original grantor of the trust, makes the beneficiary of the trust a “grantor” of the trust. The IRS did reach this conclusion, without citation of any authority, in one private letter ruling but, as the IRS likes to remind us, a private letter ruling is no authority at all. See PLR 8142061.
More importantly, there is no income tax provision comparable to the definition of “release” in Section 2514(e), and so no statutory support for the conclusion that the lapse of a power to withdraw should be considered a release of a power or transfer for income tax purposes. In fact, if income tax principles are comparable to gift tax principles, the lack of any provision in Sections 671 through 677 comparable to Section 2514(e) should indicate that the lapse of a power to withdraw is not a transfer for income tax purposes.
If there is an income tax problem caused by the lapse of Crummey powers, the problem is a fundamental one and not susceptible to any drafting solution. Fortunately, however, the problem still seems academic and, in light of the lack of any authoritative interpretation, our clients are not obligated to treat a trust as a grantor trust for federal income tax purposes after the lapse of Crummey powers.
Conclusion
Crummey powers remain a practical, efficient way of making gifts in trust which qualify for the annual gift tax exclusion. Care should be taken, however, to make sure that there is no impediment to the qualification for the annual exclusion, and that the lapse of the powers to withdraw does not have any adverse gift tax consequences for the beneficiaries of the trust.
Crummey Provisions for One Beneficiary
Following the initial transfer to the trustees, and following each additional transfer to the trustees, the following provisions shall apply:
1. My child, _________________, shall have the right to withdraw, upon the child’s written request, property having a value not exceeding the value of the transferred property. However, the value of the distribution which may be made with respect to property transferred by a donor shall not exceed the excess, if any, if (a) the maximum annual federal gift tax exclusion under Section 2503(b) of the Internal Revenue Code in force at the time of the transfer over (b) the total value of all rights of withdrawal previously exercisable with respect to transfers of that same donor in that calendar year.
2. The rights of withdrawal shall not be cumulative. No right of withdrawal may be exercised after the death of the child or more than thirty days after the date of the transfer.
3. The trustees shall give prompt written notice to the child of each transfer of property to the trustees, and any requested distribution shall be made promptly upon receipt of the written request. While the child is less than eighteen years of age, a copy of the notice of the transfer shall be given to the guardian of the child, and any distribution resulting from the exercise of a right of withdrawal shall be made to the guardian of the child’s estate.
4. If a right of withdrawal is exercised, the trustees may satisfy the right of withdrawal in cash or any other property then held in trust.
5. For the purpose of this paragraph, any amount which is considered to be a gift received by the trustees for federal gift tax purposes shall be considered a transfer subject to this paragraph, and the “donor” of a transfer to the trustees shall be the person considered to be the donor for federal gift tax purposes. Unless a donor directs in writing to the contrary at the time of a transfer to the trustees, it shall be presumed that the donor and the donor’s spouse will consent to have the gift considered as made one half by each of them in accordance with Section 2513 of the Internal Revenue Code.
Crummey Provisions for Multiple Beneficiaries (“Hanging Powers”)
Following the initial transfer to the trustees, and following each additional transfer to the trustees, the following provisions shall apply:
1. My spouse, _______________, and each of my children living at the time of the transfer shall have the right to withdraw, upon his or her written request, property having a value not exceeding (a) the value of the transferred property, divided by (b) the number of beneficiaries eligible to request a distribution with respect to the transferred property. However, the total value of the distributions which may be made to a beneficiary with respect to property transferred by one donor in a single calendar year shall not exceed the maximum annual federal gift tax exclusion under Section 2503(b) of the Internal Revenue Code in effect at the time of the transfer.
2. The rights of withdrawal shall be cumulative. However, no right of withdrawal may be exercised after the death of the beneficiary, and, on January 31 of each year, the total amount which may be withdrawn by each beneficiary with respect to all preceding calendar years shall be reduced by the sum of $5,000.00 or five percent of the value of the trust principal on that January 31, whichever is the greater amount.
3. The trustees shall give prompt written notice to my spouse and each of my children of each transfer of property to the trustees, and any requested distribution shall be made promptly upon receipt of the written request of the beneficiary. If any beneficiary is less than eighteen years of age, a copy of the notice of the transfer shall be given to the guardian of the beneficiary, and any distribution resulting from the exercise of a right of withdrawal shall be made to the guardian of the beneficiary’s estate.
4. If a right of withdrawal is exercised, the trustees may satisfy the right of withdrawal in cash or any other property then held in trust.
5. The trustees shall not make any distribution under any other provision of this agreement if, as a result of the distribution, there would be insufficient assets to satisfy all of the rights of withdrawal then exercisable.
6. For the purpose of this paragraph, any amount which is considered to be a gift received by the trustees for federal gift tax purposes shall be considered a transfer subject to this paragraph, and the “donor” of a transfer to the trustee shall be the person considered to be the donor for federal gift tax purposes. Unless a donor directs in writing to the contrary at the time of a transfer to the trustees, it shall be presumed that the donor and the donor’s spouse will consent to have the gift considered as made one half by each of them in accordance with Section 2513 of the Internal Revenue Code.
[Note: The following example was not part of the original article, but has been added to reflect a current practice of the author. D.B.E. 7/13/97]
Crummey Provisions for Multiple Beneficiaries (“Hanging Powers”)
And Preference for Distributions to Spouse
Following the initial transfer to the trustees, and following each additional transfer to the trustees, the following provisions shall apply:
1. My spouse, _______________, shall have the right to withdraw property having a value not exceeding the value of the transferred property. To the extent that the value of the transferred property exceeds the limitation in the following subparagraph 2, each of my children shall have the right to withdraw property having a value not exceeding an equal share of that excess.
2. The total of the amounts which a beneficiary may have the right to withdraw with respect to property transferred by one donor in a single calendar year shall not exceed the maximum annual federal gift tax exclusion under Section 2503(b) of the Internal Revenue Code in effect at the time of the transfer.
[Paragraphs 3, 4, 5, 6, and 7 are the same as paragraphs 2, 3, 4, 5, and 6 in the original example above.]
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