Five by Five Powers Versus Crummey Withdrawal Rights: A Comparison

Bringing clarity to two overlapping, and often confusing, concepts

Five by five powers, and Crummey withdrawal rights, are somewhat similar concepts that operate off the same tax principles. However, they are not the same. I recently explained the complicated GST tax differences in this article, but I thought a return to basics would be helpful as well. So, in this article, I will examine the main differences between these two powers from a gift and estate tax perspective - along with how they interact. For now, I will table the differences from an income tax, and creditor protection, perspective.

Five by Five Powers

Five by five powers are powers of withdrawal granted to a beneficiary of an irrevocable trust. These powers allow a beneficiary the choice to receive trust distributions without going through a trustee, which may require substantiation of need. Most often, these powers are granted to a spouse - usually over a credit shelter trust or its inter vivos equivalent, the spousal lifetime access trust (SLAT).

Distributions, however, are limited to the greater of $5,000, or 5% of the value of the trust, per year, for reasons I will explain below.

Crummey Rights

Unlike five by five powers, which can be granted for convenience, Crummey withdrawal rights often have little function beyond qualifying trust transfers for the gift tax annual exclusion (as explained below).

These types of powers are not granted on a year-by-year basis (subject to structuring of lapse outcomes as I will explain), but instead are designed to only apply in a year in which property is transferred to an irrevocable trust. When there is a contribution to a trust, a beneficiary with a Crummey withdrawal right has a temporary window of time (sometimes 30-60 days, but in all cases no later than December 31 of the year in which the contribution occurs) to take out the lesser of (1) their proportionate share of the trust contribution, or (2) the total gift tax annual exclusion(s) (currently $17,000 per donee per year, increasing to $18,000 in 2024) available to the donors who make or are deemed to make the contribution.

(I use the term donors, and not settlors or grantors, because it may be the case that an individual who is not a settlor of the trust is deemed to make a transfer to the trust for gift tax purposes. Such might be the case if, for example, a spouse who is settlor contributes community property to a trust or a gift-splitting election is made. In either case, the non-contributing spouse may be treated as a donor of one-half of the gift to the trust without becoming a settlor.)

Generally, the gift tax annual exclusion (set forth in IRC Section 2503(b)) does not apply to a gift of a “future interest” in property. While there is much more depth to this analysis, the general outcome is that most transfers in trust will be treated as indirect gifts of future interests to the trust beneficiaries. This means that trust transfers generally cannot qualify for the gift tax annual exclusion except with respect to any beneficiary who has the immediate present right to enjoy or beneficially use the transferred property.

So, the Crummey right (as first condoned by the Ninth Circuit in Crummey v. Commissioner in 1968) is a way to manufacture a “present interest” in the case of a transfer that is usually intended to be anything but.

Differences with Respect to Donors

As I will discuss below, most of the similarities between these two types of withdrawal rights arise when we consider the transfer tax treatment of a beneficiary holding these rights. But, there is often confusion regarding the tax consequences to the donor of the trust themselves.

In either case, the donor’s mere transfer to the trust shifts the transfer tax ownership of the transferred property to the trust beneficiary, at least in part, or to the trust itself. In the case of the Crummey power, it is the mere existence of this power (and the related notification procedure, which is a subject for another time) that determines the donor’s gift tax effect - whether it is a gift qualifying for the gift tax annual exclusion, or whether it is instead a taxable gift (which is subject to gift tax if and when the donor uses up their entire lifetime gift tax applicable credit). It doesn’t matter whether the beneficiary actually exercises the power.

In other words, we can consider the property subject to both types of withdrawal powers to be an “after-tax” transfer with respect to the donor.

But, I would be remiss if I did not mention that Crummey rights can only exist for inter vivos transfers from a donor. They do not apply for transfers as a result of a donor’s death, as these types of transfers are subject to estate tax (which only applies once, hence no “annual exclusion”).

There can also be issues where a beneficiary has multiple Crummey powers in the same year, from the same donor or donors. In such a case, the earliest-in-time typically controls when determining whether a beneficiary’s cumulative calendar-year Crummey powers can indeed qualify for the gift tax annual exclusion.

Five by five powers, on the other hand, are relatively neutral when we look at the transfer tax (and even income tax) effect on the donor. This type of withdrawal right can apply regardless of whether the donor is living, and while income tax is not the main focus of this article, this type of withdrawal right may not shift income tax ownership of trust property during the donor’s life under IRC Section 678(b) if the donor retains a grantor trust power over the transferred property.

Instead, as we will find out, the common thread between a five by five power and a Crummey power will be the shifting of transfer tax ownership to a trust beneficiary.

Powers of Withdrawal: Gift and Estate Tax Treatment

Both a five by five power, and a Crummey power, are treated as lifetime general powers of appointment. This type of power has an interesting outcome for gift and estate tax purposes.

On the estate tax side, if you hold a general power of appointment at death, then the property over which you could have exercised that power of appointment will be included in your gross estate for estate tax purposes. The outcome is that the property gets a step-up (or step-down) in income tax basis, and that the property potentially becomes subject to estate tax if your taxable estate and lifetime adjusted taxable gifts exceed your estate tax applicable exclusion. And, under IRC 2207, your executor could potentially recover (from the property subject to that power at your death) the incremental increase in your estate tax attributable to the general power of appointment.

In essence, the death of a holder of a general power of appointment results in a lapse of the general power of appointment. For estate tax purposes, this does not change the estate tax inclusion. But, for gift tax purposes, the exercise, lapse, or release of a lifetime general power of appointment can be treated as a transfer subject to gift tax.

In the case of an exercise of the five by five power or Crummey withdrawal right, there is no gift tax to the beneficiary holding that power. Why? Because there cannot be a gift tax for a transfer to yourself, which is essentially what the exercise of such a power constitutes.

But, keep in mind that your time to exercise the withdrawal right in either case is time-restricted. What happens when the deadline passes? In the case of either type of withdrawal right, as noted above, the expiration of this deadline can also be a lapse of a lifetime general power of appointment which is subject to gift tax. In such a case, the fundamental outcome is that the failure to exercise the withdrawal right enhances the pool of assets available to all other trust beneficiaries, creating an indirect gift from the beneficiary holding the power to the other trust beneficiaries (and, in part, to themselves). And, in the case of a Crummey power, this lapse does not create new Crummey powers for other trust beneficiaries - it is instead a gift of a future interest, meaning that the beneficiary holding the lapsed power who is deemed to make the gift cannot claim a gift tax annual exclusion.

There is, however, a unique exclusion which can apply to the beneficiary here. That exclusion is found in IRC Section 2514(e), which states that (on a per-year basis) no deemed gift occurs on the lapse of a lifetime general power of appointment to the extent the lapse is limited to the greater of (1) $5,000, or (2) 5% of the assets (by value) which were subject to the lapsed withdrawal right. But, any portion of the lapsed right exceeding this threshold does get the gift tax treatment alluded to above. And, unlike the annual exclusion, the $5,000 lapse exclusion is not indexed for inflation.

It is worth noting, as well, that for income tax purposes, a power of withdrawal can cause the beneficiary holding that power to be the deemed income tax owner of the property over which the withdrawal right could have been exercised for the year under IRC Section 678(a). However, as mentioned above, 678(b) clarifies that this only applies if the grantor of the trust themselves is not treated as the deemed income tax owner of that property. I bring this up to mention that a release of a lifetime general power of appointment may not allow one to shed this deemed income tax treatment, but a lapse might (due to the reference to a “release or modification” of the power only under IRC Section 678(a)(2) - a subject for another time).

Differences in Scope for the Powers

The existence of the $5,000/5% lapse exclusion explains the nomenclature of the “five by five” power, as such a power is designed to only exist and lapse to the extent of this exclusion on a calendar-year basis. However, a Crummey right as mentioned above has a different scope of property (by value) to which it is subject. This mismatch creates a lot of angst when we consider the lapse exclusion. It also creates a difference of scope between the two powers when we compare the two bounds of the “greater of” $5,000 or 5%.

With a five by five power, it typically applies to an entire trust. As a result, it is typical that the higher of these two bounds - 5% - will apply to both the amount which can be withdrawn, and the amount that is deemed to lapse at the end of the year. The lower bound - $5,000 - would only kick in if the value of the trust is $100,000 or less.

But, with a Crummey power, the amount which can be withdrawn will be limited by the available gift tax annual exclusions - $17,000 or $34,000 ($18,000 or $36,000 in 2024), or if less the beneficiary’s proportionate share of the contribution to the trust. Because the higher bound of 5% only kicks in where more than $100,000 can be withdrawn, it is typical that the lapsed amount of a Crummey right that is exempt from gift tax is only $5,000 (since 5% of $17,000 or $34,000 is, in either case, less than $5,000).

Put simply, the Crummey right will usually use the $5,000 lapse exclusion lower bound while the five by five power will usually use the 5% lapse exclusion higher bound. The only exception may be where multiple donors each create Crummey powers for the year for the same beneficiary, such that the cumulative annual exclusions exceed $100,000.

In the case of the five by five power, this means the withdrawal right and the lapsed amount will be equal, resulting in no deemed gift. But, in the case of the Crummey power, this means the lapsed amount ($5,000) may be less than the amount which could have been withdrawn (up to the gift tax annual exclusion). This creates a deemed gift of up to $12,000 or $29,000 (2023 annual exclusion(s) net of $5,000) from the beneficiary holding the lapsed Crummey power to the other trust beneficiaries. (Technically, this deemed gift amount would always be less than $12,000 or $29,000 since the lapse would be, in part, an indirect gift from the beneficiary to themselves which as established above is not subject to gift tax).

Structuring of Lapses for Gift Tax Purposes

How do we avoid a scenario where the beneficiary holding the lapsed Crummey power is forced to use lifetime gift tax applicable credit to offset gift tax on this deemed gift, since (as noted above) this is a future interest not qualifying for the gift tax annual exclusion?

There are a couple of approaches that are fairly common.

One approach is known as “hanging powers.” With hanging powers, the excess portion of the Crummey right over the $5,000 per-year lapse limitation continues on into the next year instead of expiring. So, the excess $12,000 or $29,000 (using 2023 exclusion numbers) could be withdrawn by the beneficiary any time during the next calendar year. Recall that an actual exercise of this power to withdraw does not create a taxable gift from the beneficiary to themselves. But, the next year, another $5,000 lapse limitation could apply on December 31, further shrinking the withdrawal right to up to $7,000 or $24,000. This would continue on until the withdrawal right is absorbed by the $5,000 per-year lapse limitations.

This works OK if there is a one-time contribution. But, where annual contributions are contemplated, this structure can become unwieldy. At some point, the cumulative withdrawal right may even exceed $100,000, allowing the higher lapse exclusion bound of 5% to apply until the aggregate withdrawals again drop below $100,000. This also creates a creeping estate tax issue, in that the beneficiary has an ever-increasing cumulative withdrawal right that is subject to gross estate inclusion.

So, as an alternative (with an added GST tax benefit explained in my prior article), the other common approach is to isolate all unlapsed Crummey withdrawal rights in a separate sub-trust for which the beneficiary holding the current and lapsed power(s) is the sole lifetime beneficiary. This would be coupled with a testamentary limited power of appointment over the sub-trust. Why a testamentary power of appointment? Because this power keeps each lapse from being treated as a completed gift to the remainder beneficiaries of the trust under Treas. Reg. 25.2511-2(b), while also possibly granting more creditor protection (depending on the state) than a general power of appointment. The trade-off, however, is that the entire sub-trust - including growth in contributed assets - would be included in the beneficiary’s gross estate.

Interaction

Since both Crummey withdrawal rights, and five by five withdrawal rights, operate off the same gift tax principle, it is easy to confuse the two. In particular, the lapse of a Crummey right is often mistakenly referred to as a five by five power. Similarly, a spousal withdrawal right limited to $5,000 (for GST tax purposes, as discussed in my prior article) may mistakenly be referred to as a five by five power. But, as noted above, the two powers are functionally different.

I would be remiss, however, if I did not raise an alarm bell when both are present for the same beneficiary. Why? An individual beneficiary only gets one set of lapses under IRC 2514(e) per calendar year. Remember above where I noted that multiple Crummey rights for the same beneficiary each year must be considered in order of time? Likewise, any existing five by five withdrawal rights must also be considered.

This does not mean, however, that the existence of a five by five power means that a beneficiary cannot be granted a Crummey withdrawal right. Instead, it means that no amount of that Crummey power can lapse unless a beneficiary exercises, in full or in part, their five by five power for the year.

In the grand hierarchy, Section 2514(e) lapses usually apply in order of time. But, a new five by five power will, in most cases, be created on January 1 of each calendar year regardless of whether the prior year’s power was exercised or lapsed. This means existing five by five powers should, in most cases, be deemed granted before any Crummey powers.

But, they may lapse after Crummey powers. If so, this can create odd outcomes for powers that do not all lapse at the same time. Five by five powers usually are not drafted to have a lapsed amount in excess of the $5,000/5% limitation. This could create a deemed gift from the holder of a five by five power, to other trust beneficiaries, upon lapse. Or does it? Keep in mind that the very next day after the lapse of the old five by five power, a new one is created. Technically, this new power could extend to a portion of the (now-lapsed) old power. Even though there are no “hanging” powers per se, could a well-drafted power pick up this excess to make sure there is no indirect gift?

Conclusion

If you remember nothing else, my key takeaway for you is to consider all lifetime powers of withdrawal when planning for annual exclusion gifts - including existing five by five powers. Where the same beneficiary holds, or may hold, both types of powers, the outcome usually means that the Crummey withdrawal right may remain hanging or may accrete to a Section 2632(c) trust. Alternatively, if five by five powers lapse later in the year, it could gum up the works. In effect, five by five powers rely on the existence of one five by five lapse - thus creating a wash each year. Intervening Crummey rights are often not addressed in the language granting five by five powers, or addressing their lapse.

Note, however, that this does not affect the grant of the annual exclusion. The five by five power itself will not affect the availability of an annual exclusion to the holder if the holder is also granted a Crummey power. Why? Because the five by five power usually extends to assets that have already been subject to gift or estate tax. But, a Crummey power will affect all other annual exclusion gifts for the year. Likewise, non-trust annual exclusion gifts occurring earlier in the year may limit the scope of subsequently-granted Crummey rights for the same year.

Ironically, where one holds five by five powers over multiple trusts (without intervening Crummey powers), this may not create an issue. Why? Because the December 31 lapse would likely apply to all trusts in the aggregate. So, for example, if one held a five by five power over a trust valued at $1,000,000 and another five by five power over a trust valued at $3,000,000, this would functionally be the same as having one five by five power over a $4,000,000 trust. So long as the trusts over which five by five powers are held exceed, in the aggregate, $100,000, the higher 5% lapse limitation should allow aggregation.

This raises the question - why can’t we aggregate lapses of Crummey withdrawal rights in this calculation? The reason, as noted above, is timing. One can only aggregate lapses occurring on the same day. For this reason, if a beneficiary is going to have both a Crummey right and a five by five power, it may be beneficial to add that the beneficiary’s Crummey power will lapse no earlier than December 31. (This can create a GST tax tension - but that is a subject for another time.)

Practically, where might one look for these types of situations? For one, a spousal beneficiary under a SLAT (and sometimes an ILIT) may hold both types of powers - especially in cases where there is an attempt to create non-reciprocal SLATs or ILITs. You may also see five by five powers in existing credit shelter trusts, especially in blended family situations where there is a concern about remainder beneficiaries questioning discretionary distributions to a spousal beneficiary.

There is, however, an added wrinkle that I will save for another article - the question of whether a guaranteed distribution, such as an annuity or unitrust, could fall into the classification of potential lapses. Stay tuned for more on the interaction of state law distribution rights, and trustee’s powers, on this equation.