Reader Questions: Crummey Versus 5x5 Powers
A subtle distinction, with far-reaching effects
Table of Contents
Intro and Reader Question
I will be testing out answers to reader questions on occasion. This may not be a regular feature, however. While I would love to host an “Ask Griff”-style article or video series, doing so verges too close to the delivery of legal or tax advice while also not always allowing for full knowledge or disclosure of (confidential) facts that can change the answer. (Which I don’t remind you of enough - this newsletter is intended for the education of wealth transfer professionals only, and not the general public, and in that vein is not intended to substitute for legal or tax advice.)
That being said, I received the following from a reader relating to a prior article on the accounting and valuation burdens placed on trustees by Crummey withdrawal rights:
In your recent paper, "The Added “Work” of Crummey Power Accounting." you wrote,
This 5% limit only applies to the amount of cash or property that could be withdrawn under the power of appointment itself, and not to the value of the entire trust. Why? Because the limit applies to a lapse of a presently-exercisable general power of appointment, and the power holder’s power only applies to current-year (and sometimes carried over, unlapsed prior years’) trust contributions.
Is this specifically due to a one time Crummy gift to the trust vs a right to withdraw from the trust corpus which lapses?
How does this reconcile with the example on page 7 of the attached Senate Report, on the creation of IRC Section 2514(e)? The example provided by the Senate Committee references the 5% to the value of the trust or fund and not the value of the lapsed power. Have there been rulings or changes in the law that make this Senate report obsolete?
Before diving in, the Senate Report being referenced here dealt with the enactment of the predecessor to 2514(e) - Section 811(f)(5) of the Internal Revenue Code of 1939.
In this Senate Report, we found the following example:
Which raises a good question. Why does the 5% lapse limitation apply to the entire trust corpus in this example, but only applies to the (cumulative) amount that can be withdrawn under a Crummey withdrawal right?
To answer this question, we must illustrate a subtle distinction between five by five powers, and Crummey withdrawal rights. I discussed some of these differences in this article from 2023, but let’s refresh some of the key points in the context of this discussion.
Differences in Powers
Let’s highlight a quick difference in definitions:
One-time withdrawal rights represent a one-time opportunity to withdraw one’s proportionate shares of contributions to a trust that are subject to gift tax with respect to the donor.
Annual withdrawal rights represent an annual right to withdraw a certain dollar amount, or percent of the value, of a trust.
While splitting hairs, the fine distinction here is between an annual withdrawal right and a one-time withdrawal right.
Before further elaborating, I find it helpful to note that a withdrawal right is not always the same as the right to receive discretionary or mandatory trust distributions. Such distributions are within the purview of the trustee. Even if the beneficiary is a trustee, such distribution powers will not always be treated as withdrawal rights for transfer tax or state law purposes. Why? Because at one extreme, a trustee’s discretionary distribution powers are often limited to an ascertainable standard by the trust’s terms or by state law which prevent them from being general powers of appointment (as we will discuss below). At the other extreme, mandatory trust distributions have to be made - typically on an annual or more frequent basis - leaving no tax knot to untie for an “undistributed” amount. The trustee has no discretion to hold back the mandatory distribution; instead the trustee might only have the discretion to fulfill the distribution in cash or with other trust assets (in-kind) or, as we will discuss below, to consider a total return unitrust.
Withdrawal rights, when compared to distribution rights, take the discretion out of the hands of a trustee and place it in the hands of a beneficiary or power holder. These powers can apply to trust income or principal (corpus). A power holder can choose whether or not to exercise their power to withdraw. But, as noted last time, this power to withdraw is usually not permanent. Why? Because the power to withdraw is typically treated as a presently-exercisable general power of appointment.
Holding a presently-exercisable general power of appointment can be bad, for several reasons:
If a power holder exercises the power, they will remove assets from the trust at the expense of other trust beneficiaries while introducing the tax and creditor protection risks of personally owning the assets removed from the trust.
If a power holder gets rid of the power, this is called a release which is treated as a gift of the assets that could have been withdrawn (by the power holder) to the other trust beneficiaries under IRC Section 2514.
If a power holder simply does nothing, and waits until the power expires, this is called a lapse which, under IRC Sections 2041 and 2514, is treated the same as a release.
If a power holder dies while holding such a power, the assets subject to the power will be included in their gross estate under IRC Section 2041.
If, after the lapse or release of a power, the power holder is still a beneficiary or trustee of the trust, the assets subject to the lapsed or released power may be treated as if they were transferred by the power holder for purposes of IRC Sections 671-677, 2036, 2038, or 2611.
For GST tax purposes, if the settlor of the trust is someone other than the power holder, the lapse or release of a presently-exercisable general power of appointment could cause the power holder to become the new transferor of the assets that were subject to the lapsed or released power for GST tax purposes. This may waste any prior allocation of GST exemption by the trust’s settlor.
IRC Section 2514(e) (and its predecessor, Section 811(f)(5)) were designed to relieve some of this tax uncertainty. This Code Section generally provides that a lapse (but not a release) of a presently-exercisable general power of appointment will not be a transfer tax event for purposes of gift, estate, or GST tax (with respect to the power holder) so long as the lapsed amount is limited to the greater of $5,000, or 5% of the trust assets “which could have been appointed by exercise of such lapsed powers.”
All withdrawal powers fit into this rubric. But, as noted by the reader’s question in the Senate Report example above, there is a question as to the scope of trust assets “which could have been appointed by exercise of such lapsed powers.” In the Senate Report, the entire trust corpus is taken into account when computing the 5% limitation. But, in a Crummey power, this seems to be limited to the amount which could have been withdrawn.
While brings us full circle back to the subtle distinction between a one-time withdrawal, or an annual or more frequent withdrawal. Cutting to the chase, here are our guidelines on the 5% lapse limitation:
Crummey withdrawal rights, as one-time withdrawals, limit the 5% lapse to the amount that could have been withdrawn (since they only apply to a finite contribution to the corpus of a trust).
Annual withdrawal rights, as automatically lapsing and renewing withdrawals, extend the 5% lapse to the entire corpus of the trust or subtrust to which they apply.
Which brings me to my final point. We often use the nomenclature of five by five powers to describe powers which use this IRC Section 2514(e) lapse limitation. But, not all annual withdrawal rights are five by five powers.
Five by Five Powers
In the example from the Senate Report above, a beneficiary has the right to withdraw $10,000 from a trust valued at $200,000 every year. If they reach the end of the year without exercising this power, it will lapse - thus invoking IRC Section 2514(e) to determine whether there is a taxable lapse of this presently-exercisable general power of appointment.
2514(e) provides that there is a nontaxable amount, starting at $5,000 but increasing to 5% of the assets subject to the power if greater than $5,000. In this case, 5% of $200,000 is $10,000, which just happens to be equal to the pecuniary amount which can be withdrawn each year. Thus, there is no taxable lapse if the beneficiary does not withdraw $10,000. But, if the beneficiary instead had the right to withdraw $15,000, this would exceed the 5% limitation when this $15,000 withdrawal right lapses. In such a case, the excess over the 5% lapse limitation ($10,000 based on the $200,000 trust value) would be a taxable lapse.
But, this is where valuation takes on added importance. Let’s say the trust goes down to $190,000 the next year. Now, 5% of this amount is just $9,500. When the $10,000 annual withdrawal right lapses, this 5% threshold is exceeded by $500. This means the beneficiary has now made a gift to the other trust beneficiaries of $500. Alternatively, if the beneficiary had died during the year before exercising the power, the entire $10,000 would have been included in their gross estate (since the lapse limitation applies only for gift tax purposes and corresponding GST tax purposes).
To avoid this outcome, many annual withdrawal rights are now drafted to avoid exceeding the IRC Section 2514(e) limits. In other words, instead of allowing a beneficiary to withdraw a finite pecuniary amount annually, they may have the right to withdraw the greater of $5,000, or 5% of the trust corpus/principal.
Many states also allow a trust providing for mandatory income distributions to be converted into a total return unitrust as well, so as to avoid a breach of a trustee’s duties of loyalty and impartiality between current income beneficiaries and remainder beneficiaries based on investment of the trust’s assets. To solve this problem, such trusts can be converted into trusts permitting a distribution of a fixed value of the corpus each year to the mandatory income beneficiary or beneficiaries. This percent, however, is usually capped at 5% - again in order to avoid a taxable lapse (if the current income beneficiary is also the trustee).
The five by five limitation covers all manner of sins when it comes to determining transfer tax ownership of a trust by a power holder. But, there is one aspect of these powers that often flies under the radar when it comes to withdrawal powers held by a spouse.
GST Tax Effects of Five by Five Powers
Typically, so long as the lapse of a withdrawal right (whether one-time, or annual) is limited to the $5,000/5% limitations of IRC Section 2514(e), Treas. Reg. 26.2651-1(a)(5), Example 5 provides that the power holder will not become the new transferor (for GST tax purposes). Any lapse in excess of these amounts will, however, cause the power holder to become the GST tax transferor of the excess amount over the 2514(e) limitations.
Five by five powers are often granted to spouses, typically in a credit shelter trust or in a SLAT (especially a SLAT designed to be non-reciprocal - a rabbit hole we will soon explore in a separate series of articles). But, there is usually a GST tax error found in these powers. How?
Many five by five powers have year-long application. In other words, the power holder (spouse or otherwise) has until December 31 to withdraw the greater of $5,000, or 5% of the trust corpus. (This 5% limitation usually applies to the value as of the close of the previous tax year following the typical unitrust language, which may be flawed in its application when we consider that the timing of the lapse considers the value of the trust as of December 31 in the year of lapse and not the prior year). Then, on January 1 (the next day), a brand new withdrawal right over the greater of $5,000 or 5% of the trust corpus is renewed and refreshed.
This invokes the estate tax inclusion period (ETIP) rules, which generally provide that none of the trust settlor’s GST exemption can be allocated (automatically or manually) to the trust so long as there is a 5% or greater probability that any trust corpus will be included in the gross estate of the settlor (as transferor for GST tax purposes), or their spouse. (We will call this separate 5% rule the 5% actuarial exception, and it is not applied the same way as the 5% lapse limitation.)
Treas. Reg. 26.2631-1(c)(2)(ii)(B) clarifies that a five by five power held by a spouse generally will not create an ETIP. But, in order to avoid an ETIP, the five by five power cannot last longer than 60 days. This means a spousal five by five power drafted to last all calendar year, with lapse on December 31 and renewal the next day (January 1) creates an ETIP unless the 5% actuarial exception is met (a highly-complex subject for another time). And, so long as the power continues to be refreshed, the ETIP never goes away and, consequentially, the settlor can never allocate any GST exemption - even to the 95% of the trust not subject to the five by five power (because, unless the 5% actuarial exception applies, the risk of inclusion of any portion of a trust in the gross estate of the transferor or transferor’s spouse creates an ETIP for the entire trust).
So, when drafting a spousal five by five power over a trust that is intended to be GST-exempt, it is a good idea to limit this power to 60 days instead of keeping it open the entire calendar year.
Income Tax and Five by Five Powers
We will discuss income tax effects of withdrawal rights - both one-time and annual withdrawals - in a separate series of articles. For now, however, a trust that is not a grantor trust with respect to the grantor themselves may be subject to IRC Sections 678(a)(1) and (a)(2) with respect to the power holder. This means, each year, 5% of the trust’s taxable income may be taxable to the power holder. It also means that, subject to interpretation and application of IRC Section 678(a)(2) to the lapse of the five by five power (this Code Sections speaks only to partial “release,” or “modification”), there may also be a creeping inclusion of an additional 5% per year of trust income in the gross income of the power holder.
Conclusion
While the difference between a one-time withdrawal right and an annual withdrawal right seems subtle, it creates significant transfer tax ripple effects when we consider the application and effect of IRC Section 2514(e) on the lapse of the power.
Remember, however, that 2514(e) only applies by its terms to a lapse of a power (while, ironically, treating this from a tax perspective as a “release” other than for the $5,000/5% limitations). Releasing withdrawal rights does not avail the power holder of the protections of this Code Section. For tax planning purposes, it can be extremely difficult to get rid of any presently-exercisable or even postponed general powers of appointment without also giving up one’s beneficial interest in a trust. Decanting or modification, as we will later discuss, may not be options.
Note also that this article does not discuss the full scope of withdrawal rights. Some trusts for the next generation, for example, give beneficiaries tiered withdrawal rights at certain ages (such as 1/3rd at age 25, one-half at age 30, and the rest at age 35). These rights often do not lapse until the beneficiary’s death, and at death there is no lapse exception - the entire trust may be subject to gross estate inclusion at that point.
So, if there is one lesson to be taken away from the last couple of articles, it is that withdrawal rights often create more headaches than they are worth. Before using them in a trust - whether as one-time withdrawal rights (such as Crummey rights), annual withdrawal rights (whether or not drafted to take advantage of the $5,000/5% limitations), or tiered withdrawal rights that never lapse, a holistic view of the burdens and obligations surrounding these rights is warranted.