Lapse Limitations of Crummey Powers: Some Common Errors
What does IRC Section 2514(e) actually say?
Table of Contents
Background
While this topic has been touched upon in some of my prior coverage on Crummey powers, there is one recurring issue I continue to see pop up. Sometimes, it is found within a trust itself, while other times it may be spotted in a Crummey notice and/or the gift tax return.
That issue? The amount by which a Crummey power lapses.
To recap prior articles, a Crummey power is a presently-exercisable general power of appointment. IRC Section 2514(b) generally provides that the exercise, or release, of a presently-exercisable general power of appointment will be treated as a transfer by the person holding the power (as opposed to the grantor as the creator of the power). While the exercise of a Crummey power itself usually will not be subject to gift tax (since it is technically a transfer from the powerholder to themselves, which is not a gift for gift tax purposes), an affirmative release of such a power can be a transfer since it creates an indirect gift to other trust beneficiaries. This does not prevent a qualified disclaimer, but the possibility of a qualified disclaimer is not usually drafted for in Crummey powers to begin with (and in the worst case may result in a loss of the grantor’s gift tax annual exclusion).
What if the powerholder simply sits on their hands and does nothing? Most Crummey powers have a limited shelf life – commonly 15 to 60 days, or if earlier the end of a calendar year (although these are just examples). When this shelf life expires, the powerholder can no longer exercise the Crummey power. This outcome is known as a lapse of the presently-exercisable general power of appointment, which has its own unique gift tax treatment under IRC Section 2514(e) and Treas. Reg. 25.2514-3(c).
For tax purposes, IRC Section 2514(e) treats a lapse of a presently-exercisable general power of appointment the same as a release. In other words, the powerholder upon lapse is treated as if they made a transfer of property. This can result in a gift to the other trust beneficiaries, since the elimination of the ability to withdraw increases the pool of trust principal available to all trust beneficiaries. How much, however, is this gift?
Before diving in, I think it is helpful to again point out that this gift tax outcome applies to the powerholder who will typically be a trust beneficiary. Whether or not the power is exercised, released, or lapses generally does not affect the grantor making the contribution to a trust that is subject to a Crummey power. The grantor still gets their annual exclusion (assuming all other requirements for a present interest are satisfied), and still has to allocate GST exemption to a power not complying with IRC Section 2642(c).
Deciphering IRC Section 2514(e)
Unlike a release, the lapse comes with a one-time exclusion against this deemed gift by the powerholder that is available exclusively to the powerholder once per calendar year for all such lapses. Instead of paraphrasing the finer points of the exclusion, we should start with the actual Code provision as its interpretation is not always clear to practitioners:
(e) Lapse of power
The lapse of a power of appointment created after October 21, 1942, during the life of the individual possessing the power shall be considered a release of such power. The rule of the preceding sentence shall apply with respect to the lapse of powers during any calendar year only to the extent that the property which could have been appointed by exercise of such lapsed powers exceeds in value the greater of the following amounts:
(1)
$5,000, or
(2)
5 percent of the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied.
There are two phrases that often create consternation herein.
The first is that the lapse is noted to apply only to the property that could have been appointed by the exercise of the lapsed power. In other words, no more can lapse than could have been withdrawn. So, if a beneficiary had a right to withdraw the annual exclusion ($19,000 for 2025), it stands to reason that that the lapsed amount cannot exceed $19,000.
But the second source of consternation – that is often misinterpreted – is found in the 5% lapse limitation. For purposes of determining whether this 5% is greater than the $5,000 limitation in the 2514(e) lapse limitation calculation, the 5% is applied to “the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied.”
Which raises a question. Does this mean we take into account 5% of the amount that could have been withdrawn - $19,000 – in our example above? Or, since the $19,000 is an addition to the principal of the trust, does it mean that the “assets out of which” the Crummey power could have been exercised include the entire principal of the trust as it is then constituted at the time of the lapse?
Surprisingly many drafters, trustees, and gift tax preparers go with the latter interpretation. If this was accurate, it would allow us to use 5% of the entire trust principal and not just the amount that could have been withdrawn. The outcome would be that the entire power could possibly lapse, since in theory we could aggregate all other contributions subject to Crummey powers (and other principal of the trust, including assets gifted using the grantor’s applicable credit and/or sold to the trust) to calculate this 5% lapse limitation.
The example in Treasury Regulation Section 25.2514-3(c)(4) doesn’t appear to do us any favors on first read. This example provides:
For example, if an individual has a noncumulative right to withdraw $10,000 a year from the principal of a trust fund, the failure to exercise this right of withdrawal in a particular year will not constitute a gift if the fund at the end of the year equals or exceeds $200,000. If, however, at the end of the particular year the fund should be worth only $100,000, the failure to exercise the power will be considered a gift to the extent of $5,000, the excess of $10,000 over 5 percent of a fund of $100,000. Where the failure to exercise a power, such as a right of withdrawal, occurs in more than a single year, the value of the taxable transfer will be determined separately for each year.
This example implies that the entire principal of the trust is taken into account in determining a lapse. There is a nuance, however, in that the withdrawal right described in the example is not a Crummey power. While I have rehashed this difference in several prior articles, there is a difference between a Crummey power – which is a one-time withdrawal right when there is a contribution by a grantor – and a five-by-five power, which grants an annual withdrawal right over the principal.
Only an annual withdrawal right gets to use the entire trust principal for purposes of calculating the 5% lapse limitation of IRC Section 2514(e)(2). Crummey powers do not get this benefit, which makes sense when we consider the basic math (that you cannot lapse more than you could have withdrawn to begin with). Yet, the 5% lapse limitation for a five-by-five (annual) power continues to get misapplied for Crummey powers. And lest you think I am wrong, don’t take my word for it – the Service has confirmed the more limited interpretation.
Rev. Rul. 85-88
In Revenue Ruling 85-88, the issue at play was whether multiple withdrawal rights in multiple trusts could be aggregated for purposes calculating the annual $5,000/5% lapse limitations. This Ruling set forth two fact patterns, each of which involved a trust granting a Crummey power by which a beneficiary could withdraw up to $5,000 from each contribution made to each trust. To be clear, this was a Crummey power, and not an annual five-by-five withdrawal power.
Generally, the Ruling concluded that a beneficiary is only entitled to one $5,000/5% lapse each year. But, the most telling conclusion of the Service was:
The 5 percent test is based on the value of the assets subject to the power at the time of the lapse of the power.
In other words, we apply the 5% to the value of the portion of principal that was actually subject to the power – again holding true to the maxim that we cannot lapse more than we can withdraw by value. This amount is usually limited to the immediate contribution by the donor that generated the Crummey power, along with any prior year powers that have carried over (if they are accounted for in the lapse structure).
As support for this conclusion, the Service notes:
Permitting separate 5-and-5 exemptions for multiple trusts would elevate form over substance by providing more favorable treatment where a transfer to a trust is restructured as multiple transfers to separate trusts.
While the impetus for this conclusion was the attempted aggregation of multiple withdrawal powers created in a calendar year, the outcome remains the same – there is only one lapse limitation permitted across all such powers for the powerholder. In such a situation, the Service goes on to (somewhat confusingly) note, “the 5 percent test would be applied by aggregating the maximum amount in each trust subject to C's withdrawal powers with respect to such trust on the date of lapse of such powers during the calendar year.”
Of course, this still does not give us a clear answer. What if a powerholder had 6 separate Crummey powers of $19,000 each, created (and lapsing) at several times during the calendar year? Would the first lapse exhaust the $5,000 limitation, with no consideration then being given to the other 5 powers? Or, when the 6th power lapsed, could we look backwards and argue that 5% of these aggregate contributions (6 x $19,000, or $114,000, times 5% = $5,700) is our lapse amount? Arguably the second result could be used since the Ruling refers to the lapse of such “powers” in a calendar year for aggregation purposes, especially if the contributions are all to the same trust. But, the Service also noted that they do not want people end-running this outcome where multiple trusts are involved – perhaps just for the simple multiplication of $5,000, but also perhaps for aggregation of withdrawal rights for the 5% test.
This still leaves us then with a huge gulf between the possibility of using the $5,000 lapse limitation when compared to the 5% lapse limitation. And, it is not clear how this would get allocated across all of the Crummey powers, even if in a single trust. Using the same example as above, would $5,000 lapse in the first withdrawal right with the additional $700 from the 5% test solely applying to the sixth withdrawal right? Or, would the additional $700 get allocated proportionately across withdrawal right numbers 2-6? (Arguably it couldn’t apply to the first if we go chronologically since the first would have absorbed the lower $5,000 limitation.)
Unfortunately, there’s no clear answer to this complex question. There is, however, a very clear answer to the issue of whether the 5% test applies to the withdrawable amount or the entire trust principal where a Crummey power is involved – with the former being expressly mandated by the Service.
Amount of Gift on Lapse
The Ruling concluded that the excess $5,000 would be treated in part as a gift to the remainder beneficiary, “less the value of [the powerholder’s] retained interest in that amount.” This implies that the powerholder’s actuarial interest in the principal and income of the trust could be subtracted in determining the amount of the gift.
Before considering this valuation question, note that practically all Crummey powers are drafted to prevent this completed gift of the amount in excess of the lapse limitation to the other trust beneficiaries as covered in prior articles. The approaches often include a hanging power (excess amount doesn’t lapse but continues as an open withdrawal right into the next calendar year, absorbing future $5,000/5% lapses), an incomplete gift power (powerholder’s retention of a testamentary power of appointment over the excess amount, preventing a completed transfer for gift tax purposes until death or release of the power), a 2642(c) power (unlapsed amount held in a separate share trust solely for the powerholder for life that will be included in the powerholder’s gross estate), or 2514(e) powers (withdrawal right limited to $5,000, and no more than 60 days).
If one of these restrictions on lapse does not apply, note that this Ruling predated the enactment of IRC Section 2702. This Code Section generally provides that a transferor’s retention of an interest in gifted property will be given a value of zero unless structured as an annuity or unitrust. Since the lapse of a Crummey power is treated as a release, and since a release of a presently-exercisable general power of appointment makes the powerholder the transferor for gift tax purposes, this zero value rule would likely apply. In other words, the powerholder’s retained interest will be given zero value when determining the gift tax amount of lapses in excess of the $5,000/5% limits.
Key Takeaways
Again, this seems like a fine nuance but it is a very important one when we compare (1) a lapse of 5% of the value that could have been withdrawn, versus (2) a lapse of 5% of the entire value of the trust principal itself as it is then constituted at the time of lapse. This distinction can be found not just in trusts, but also in gift tax returns and even in Crummey notices.
Importantly, it is a distinction that can lead to inadvertent gifts by Crummey beneficiaries if done wrong. It can also affect the GST-exempt status of a trust.
It is hard to claim that the right to withdraw an amount limited to the gift tax annual exclusion would somehow lead to a lapse that is greater than the amount that could have been withdrawn. While it is only the Service’s interpretation, Rev. Rul. 85-88 gives us a clear picture at least on this point. However, the issue of multiple Crummey powers lapsing in a given year is not quite as clear based on the text of the Ruling itself. In future articles, we will tackle this issue.