by Peter B. Tiernan
Total discretionary inter vivos trusts1 provide a variety of benefits. For example, no one would deny the advantages that a sprinkle trust provides in taking care of the needs of multiple generations. Similarly, total discretionary trusts provide needed protection when an individual cannot hold onto money or has an addiction. The trustee in such a case could control what, if anything, is distributed. Adding a Crummey power to this type of trust produces certain consequences. The purpose of this article is to examine those consequences and how to deal with them.
The inclusion of Crummey powers in a trust converts transfers which otherwise would be future interest transfers into transfers of present interests. Only present interests qualify for the gift tax annual exclusion under I.R.C. §2503(b). Should Crummey powers be included in total discretionary trusts? Assuming the settlor’s primary purpose is to protect a beneficiary who cannot handle money or has an addiction, then giving a Crummey power to that beneficiary is clearly not the best approach. Likewise, if a beneficiary has a tax lien against him or her, the Florida Trust Code permits a creditor to reach what the power holder can withdraw.2 However, even in these two instances, gift tax savings can still be achieved by giving Crummey powers to the remainder beneficiaries of the trust.
Crummey powers might be particularly beneficial when the settlor is concerned about potential future creditors of the beneficiary, i.e., my son, the uninsured doctor. In such a case, Crummey powers could be provided to both the son and the remaindermen. This would provide gift tax savings since it would permit the maximum amount of gift tax exclusions during the time that the son has no creditors. But what should be done once a malpractice judgment is rendered?
In TAM 8901004, the IRS permitted a settlor of a trust to exclude persons holding powers of withdrawal from exercising those powers in connection with future contributions to the trust. This ability to exclude a future exercise of a Crummey power is something to consider in every total discretionary trust when the settlor’s purpose is to provide protection against possible future creditors. Under the Florida Trust Code, a creditor can reach the maximum amount that can be distributed to or for a power holder’s benefit. However, with this exclusion power, a settlor can protect the trust against the claims of any such future creditors.
GST and Gift Tax Considerations with Crummey Powers
There are GST issues with many total discretionary trusts. Consider, for example, a trust created for a child who has problems holding on to money or has creditor problems. With such a trust, the child’s children (the settlor’s grandchildren) will most likely be named as remainder beneficiaries. This is a classic generation-skipping scenario. However, since the child (a non-skip person) is a permissible current noncharitable recipient of income or corpus, he holds a Ch. 13 interest in the trust.3 If a non-skip person holds a Ch. 13 interest in the trust, then the trust is not a skip person.4 Therefore, there is no direct skip on any transfers made by the settlor to the trust. With such an arrangement there would normally be no GST consequences until the child’s death.5
The gift and GST consequences of including Crummey powers with total discretionary intervivos trusts are similar but not identical to the consequences when a Crummey power is included in the typical irrevocable inter vivos trust (i.e, a support type trust). Because of the significance of these consequences, however, a review of the applicable tax law is both warranted and beneficial.
Consequences for a Grandchild
What are the gift and GST consequences to a grandchild when he or she does what the settlor presumably wants and permits his or her Crummey power to lapse? These possible consequences depend upon whether the lapse of the grandchild’s Crummey power is treated as a release. Generally, a lapse of a Crummey power is treated as a release.6 This rule is subject to one important exception. A lapse of a general power of appointment (i.e., a Crummey power) is not treated as a release to the extent it does not exceed the greater of $5,000 or five percent of the value of the trust as of the date of the lapse (herein referred to as the safe harbor amount).7
There are two deemed consequences, for GST purposes, whenever the lapse of a Crummey power is treated as a release. First, there is a deemed distribution/transfer by the trust to the power holder.8 Absent such a deemed distribution/transfer, there can be no taxable distribution or taxable termination occurring. Second, if a lapse is treated as a release, there is a deemed transfer by the power holder to the extent the power holder is treated as making a completed transfer for purposes of Ch. 12.9 A deemed transfer is necessary for finding that the power holder is a transferor for GST purposes.
For example, assume 1) the settlor contributes $5,000 to a trust during the year; 2) the trust has current assets of $50,000 (after the contribution); 3) the grandchild has the right to withdraw the entire $5,000 contributed; and 4) the grandchild allows his or her withdrawal right to lapse.
The safe harbor amount in this example is $5,000 (the greater of $5,000 or $2,500 [five percent of $50,000]). The amount that has lapsed is within the safe harbor. It is, therefore, not treated as a release.10 Since there is no release, there is no deemed distribution of this amount from the trust to the grandchild (i.e., no distribution to a grandchild that could constitute either a taxable distribution or taxable termination). Further, there is no deemed transfer by the grandchild back to the trust (no transfer that could constitute a GST transfer by the grandchild). Similarly, because the lapse is within the safe harbor amount, there is no lapse of the grandchild’s power that is subject to gift tax.11
Compare the above to a power to withdraw amounts in excess of $5,000 or five percent of the trust. For example, 1) a settlor contributes $20,000 to a trust; 2) the trust (after the contribution) has assets of $65,000; 3) the grandchild has the current right to withdraw $13,000; 4) the grandchild allows the withdrawal right to lapse; 5) the grandchild has no hanging power, general, or limited testamentary power of appointment over the amount in excess of the five and five safe harbor; 6) no GST exemption has been allocated by the settlor to this contribution or to prior contributions; 7) the grandchild and his or her two siblings are the three remainder beneficiaries of the trust.
In this second example, the grandchild can withdraw an amount which is in excess of the greater of $5,000 or five percent of the trust corpus. Consequently, the grandchild’s power over this excess amount (i.e., $8,000) is a lapse, which is treated as a release.12 As to this excess amount, there is a deemed distribution from the trust to the grandchild.13 Further, the GST regulations provide that there is a deemed retransfer by the grandchild of this $8,000 excess amount back to the trust.14
Is this deemed transfer from the trust to the grandchild a taxable distribution or a taxable termination? In this respect, there is a termination of the grandchild’s Ch. 13 interest in this $8,000 and immediately after the distribution, no non-skip person has an interest in this $8,000. However, to be a taxable termination, there must also be no transfer subject to the federal estate or gift tax.15 In this instance, the deemed transfer by the grandchild back to the trust is subject to gift tax. Consequently, this deemed transfer to the grandchild will be treated as a taxable distribution.16
With a taxable distribution, it is the transferee who is responsible for paying any GST tax due.17 Therefore, 1) unless $20,000 (i.e., to cover the settlor’s entire contribution) of the settlor’s GST exemption is allocated to this contribution by the settler; and 2) unless $45,000 of the settlor’s GST tax exemption was allocated to all previous contributions to the trust, generation skipping taxes will be owed by the grandchild. To make matters even worse, all there is in this instance is a deemed distribution, there is no actual distribution to the grandchild from which he or she can pay the tax.
For GST purposes there is also a deemed retransfer by the grandchild back to the trust of this $8,000 amount. However, there are no GST consequences from such a deemed transfer in this instance since the beneficiaries of the trust (i.e., the grandchild’s parent and her siblings) are not skip persons in relation to the grandchild.
Regarding possible gift tax consequences, upon the lapse of the Crummey power, a grandchild has, for gift tax purposes, made a transfer to the taker in default of his or her power, in this case, a transfer back to the trust of the amount over the five and five safe harbor (i.e., $8,000). Regarding this $8,000 deemed transferred to the trust, the issue here is whether the grandchild has made a completed gift to the trust of this amount.
Whether there is a completed gift for gift tax purposes is dependent upon two factors: 1) whether the trust is considered to be a self-settled trust (as to the grandchild) and, if so; 2) whether creditors of the grandchild can pierce the trust for satisfaction of their claims. If both these factors are present, then there is case law that there is no completed gift (which could result in inclusion of substantial amounts of the trust in the grandchild’s gross estate upon his or her death under I.R.C. §2036).18 Clearly, under the new Florida Trust Code, creditors of a power holder can force the exercise of the power to satisfy their claims.19 Consequently, whether there is a completed gift hinges solely upon whether the trust is a self-settled trust as to the grandchild. If the trust is a self-settled trust as to the grandchild, then there is no completed gift — otherwise, there is.
Section 736.0505(2)(b) of the Florida Trust Code provides that after the lapse or release of a withdrawal power, a power holder is treated as the settlor of the trust (i.e., the trust is a self-settled trust) only to the extent that the value of the property subject to the power to withdraw at the time of the lapse or release exceeds the greater of the amounts specified in I.R.C. §2041(b)(2) or §2514(e) (the greater of five percent or $5,000), or I.R.C. §2503(b) ($13,000 currently). What this means is that whenever a child in any year has the right to withdraw an amount in excess of the greater of $13,000 (because $13,000 is more than $5,000) or five percent of the present value of the trust, then the trust would be treated as a self-settled trust for that year. Consequently, if the grandchild had the right to withdraw this excess amount, then there is no completed gift by the grandchild in that year. If, however, the amount which the grandchild can withdraw in any year is equal to or less than the amount set forth in F.S. §736.0505(2)(b), the grandchild would not be treated as the settlor of the trust in that year and there is a completed gift upon the lapse of the grandchild’s Crummey power.
Under the examples in this article, the grandchild does not have the right to withdraw an amount in excess of the amount set forth in F.S. §736.0505(2)(b). Therefore, there is a completed gift by that grandchild upon the lapse of his or her Crummey power.
The next question involves who are the donees of such a gift? Gifts to a trust are, for gift tax purposes (but not for GST purposes), gifts to the beneficiaries of the trust.20 Such a gift is divided among the current and future beneficiaries of the trust based on their respective beneficial interests in the trust. Under our facts, there can be no taxable gift to the child because all the child has is a discretionary interest (i.e., a mere expectancy) which has no ascertainable value that is enhanced by the retransfer. Consequently, the entire benefit of this retransfer inures to the remaindermen.
There can also be no gift to the power holder in this instance since an individual cannot make a gift to himself or herself. Consequently, the only individuals who could be donees of this gift are the remaindermen other than the grandchild. Assuming the power holder has two siblings who are also remainder beneficiaries of the trust, the grandchild has made gifts of the present value of two-thirds of the lapsed amount (i.e., the present value of two-thirds of $8,000) to the other remaindermen when the withdrawal right lapses. Such gifts are gifts of future interests and, as such, part of the grandchild’s lifetime gift tax exemption will have to be applied against these gifts.
Consequences for Child
What are the tax consequences to a child upon the lapse of his or her Crummey power? Assume the same fact pattern as the second example set forth above relating to a grandchild, except that the child is the sole holder of the Crummey power. Regarding the amount within the safe harbor in such a situation, there is no release and, therefore, no deemed transfer of property to the child. Likewise, there is no deemed retransfer back to the trust by the child.
As to any amount in excess of the safe harbor amount, however, there is both a deemed transfer from the trust to the child and a deemed retransfer back to the trust by the child.21 Under GST regulations, the child is deemed to be the new transferor of this excess amount. There is more than one transferor in this case and the portions of the trust attributable to the settlor and the child are treated as separate trusts for GST purposes.22
Regarding the GST consequences, as indicated previously regarding grandchildren, the lapse results in a deemed distribution to the child of $8,000 and also a deemed retransfer back to the trust by the child of this same $8,000.23 For GST purposes, however, regardless of whether the settlor’s GST exemption was allocated to the transfer, this deemed distribution to the child would not be treated as a taxable distribution to the child. This is because the child is a non-skip person in relation to the settlor. Further, the child’s deemed retransfer back to the trust would not be treated as a direct skip from the child to the trust. This is because the trust is not a skip person in relation to the child (assuming, of course, that the only beneficiaries of the trust are the child and his or her children [the settlor’s grandchildren], they would not be skip persons in relation to the child).
This article deals primarily with total discretionary trusts in which the settlor’s grandchildren are the ultimate beneficiaries (i.e., to my grandchildren who survive me). If what is involved is a dynasty trust, however, then there is one further wrinkle to consider. If the child’s grandchildren are future beneficiaries of the trust, then $8,000 of the child’s GST exemption (since the child, rather than the settlor, is considered under the regulations to be the transferor of this amount) must be allocated to the amount that is deemed to be transferred back to the trust by the child. Otherwise, any distributions to the child’s grandchildren from the trust will have GST consequences.
With reference to the gift tax consequences to the child, as indicated previously, gifts to a trust are, for gift tax purposes (but not for GST purposes), gifts to the beneficiaries of the trust.24 There is no gift to the child in this instance for two reasons. First, the child has no ascertainable interest that is enhanced by the deemed retransfer. Second, the child cannot make a gift to himself or herself. However, the child has made gifts to the remaindermen, on account of this deemed retransfer back to the trust. The amount of the gift to each remainderman should be the present value of one-third of the $8,000 deemed to be transferred. These gifts would be gifts of future interests and, therefore, part of the settlor’s $1,000,000 gift tax exclusion would have to be applied.
If the settlor of a total discretionary trust wants the trust to be fully exempt from GST consequences, he or she is going to have to allocate GST exemption equal to 100 percent of his or her contributions each year to the trust. That is the only option available to the settlor.
As indicated previously, there are significant GST and gift tax consequences to a child and a grandchild from the inclusion of Crummey powers in a total discretionary trust when a settlor wants to exclude the maximum amount for both gift and GST purposes. With respect to such tax consequences, there are various solutions, none of which are perfect. One approach would be to limit a child’s, grandchild’s, or a more remote descendant’s right of withdrawal each year in any trust that is not an I.R.C. §2642(c) trust to the greater of $5,000 or five percent of the trust corpus at the time of the withdrawal.25 Such an approach would avoid the above undesirable tax consequences to the individual holding a Crummey withdrawal power. However, such an approach does not permit the settlor to take maximum advantage of the annual gift tax exclusion. For that reason, most clients are not willing to settle for this safe but admittedly conservative approach.
Another approach is to grant the Crummey power holder a testamentary limited or general power of appointment over the amount in excess of the safe harbor amount.26 Such a power prevents the lapse of the power holder’s withdrawal right from being a completed gift (by the power holder).27 The problem with this technique is that even though it enables the settlor to take full advantage of his or her annual gift tax exclusion, it does so at the expense of the Crummey power holder. If the power holder has a general testamentary power of appointment over the excess amount, there will be inclusion of the excess amount in the power holder’s gross estate under I.R.C. §2041. If the power holder only has a limited testamentary power, the power holder is still deemed to be the transferor of the excess amount. Since the power holder is deemed to have made a transfer and retained a limited power of appointment over the amount transferred, there would be inclusion of the amount transferred in the power holder’s gross estate under §2038.28 Therefore, this technique is probably advisable only when the power holder’s gross estate is of such a small size that transfer taxes are not a serious concern.
A third approach is to use a hanging power for the excess. With this approach, the settlor should be able to derive the full benefit of the gift tax annual exclusion.29 The hanging power would limit the lapse of the power holder’s withdrawal right each year to the safe harbor amount. Any amount subject to withdrawal in excess of the five and five safe harbor amount would not lapse. The unlapsed amount is carried forward and will be subject to lapse only to the extent of available five and five safe harbor amounts in succeeding calendar years, until the entire hanging amount is fully lapsed (if that ever occurs).
A final option would be to use a cascading Crummey power. This is a technique that was developed by and is a service mark of Jonathan G. Blattmachr.30 Although this might be the best approach available for dealing with the gift and GST consequences, it is rather complex and requires substantial supervision, which could result in problems in implementing it.
Avoiding Getting Hung by a Hanging Power
One of the recommendations mentioned above is to use a hanging power. One aspect of hanging powers that is not always fully comprehended by settlors (and some attorneys) is a power holder’s right to withdraw unlapsed amounts from prior years.31 A power holder, during the withdrawal period, has the right to withdraw not only the amount that currently lapses, but also all amounts from previous withdrawal periods which have not yet fully lapsed (the amounts that are still hanging from prior years). This amount could be substantial and allowing the power holder to withdraw this amount might defeat the settlor’s purpose for creating the trust. The Crummey notice that is sent should advise the power holder of this right. Otherwise, the IRS, following the logic of Revenue Ruling 81-7, might argue that the failure to advise the power holder of the extent of his or her withdrawal right is grounds for disputing the legal effectiveness of the hanging power.32
There is another rather obscure trap lurking. Under the new Florida Trust Code, creditors can reach any amounts that a power holder can withdraw during the time that the power may be exercised.33 This should include amounts from prior years that have not yet fully lapsed. It’s bad enough when a child or grandchild exercises a Crummey power, thereby adversely affecting the settlor’s estate planning. The ultimate insult would be for a creditor to force the exercise of a beneficiary’s power so that he or she could attach said interest. Therefore, the settlor should be made fully aware of this possibility before inserting hanging powers for children or grandchildren who might have future creditor problems. Alternately, this might be an appropriate situation to include a trust protector to address this type of issue.
Automatic Allocation of GST Exemption
Do total discretionary inter vivos trusts that include Crummey powers qualify for automatic allocation of GST exemption? If so, is automatic allocation something that the settlor would want?
GST tax exemption is only automatically allocated to trusts that are GST trusts. A GST trust is any trust that could have a generation-skipping transfer with respect to the transferor. One of the six exceptions to a GST trust is a trust in which any portion would be included in the gross estate of a non-skip person (other than the transferor) if such person died immediately after a transfer to the trust. Do total discretionary trusts fit within this exception?
The regulations under I.R.C. §2632 state that a power of withdrawal of no more than the annual exclusion amount under I.R.C. §2503(b) held by a non-skip person (i.e., a child) will not cause the trust to be excluded from the definition of a GST trust (and, therefore, would result in an automatic allocation of GST exemption to the trust). Assuming that a trust limits Crummey powers for the settlor’s children (i.e., non-skip persons) to the §2503(b) amount, it might seem that there should be automatic allocation. Whether the automatic allocation rules apply, however, is a determination that must be made each year. If the trust limits a child’s right to withdraw to $13,000 each year with no hanging power, the trust would clearly qualify as a GST trust each year. Similarly, a trust that provides no Crummey powers to a child would also qualify. However, assume a child can withdraw the maximum amount permitted by I.R.C. §2503(b) and is given a hanging power over any amount in excess of the five and five safe harbor. For example, the settlor creates a new trust and contributes $13,000 to the trust in its first year. To avoid gift tax consequences to the child (on account of the excess over $5,000), the child is provided a hanging power over the excess. This $8,000 excess would remain subject to the child’s withdrawal right in year two and subsequent years until it lapses. In year two, if $13,000 is again contributed, the child would have the right to withdraw $21,000 ($13,000 plus the $8,000 subject to the hanging power). If the child were to die in year two right after the transfer of this second $13,000, $21,000 would be included in the child’s gross estate. This amount exceeds the annual exclusion amount under I.R.C. §2503(b). Therefore, the trust would not be a GST trust in year two and the GST exemption would not be automatically allocated to the trust for that year.
What we have in this second example is a trust that is a GST trust in year one but is not in year two and probably not in later years. This suggests that we could wind up with a trust that is only partially exempt for GST purposes — generally not a preferable result. This is why at least one author has suggested that settlors might wants to elect out of automatic allocation on a timely filed Form 709 for the first tax year of the trust.34 Then the settlor can, by notice of allocation, make his or her own allocation if that is what the settlor chooses to do.
Total discretionary trusts are being used more and more to meet the ever changing needs of clients. Crummey powers are just one type of power of appointment that can enhance a total discretionary trust. A future article will address these other types of powers of appointment that are sometimes used with total discretionary trusts and the consequences thereof.
1 For purposes of this article, a total discretionary trust is one in which the trustee has complete discretion over whether and when to make distributions of income and principal, and the amount thereof.
2 See Fla. Stat. §736.0505.
3 An individual who is a permissible current recipient of income or corpus from a trust has an interest in that trust. I.R.C. §2652(c)(1)(B).
4 See I.R.C. §2613.
5 I.R.C. §2612(a)(1).
6 I.R.C. §2041(b)(2) (first sentence) and §2514(e) (first sentence).
7 I.R.C. §2041(b)(2) (second sentence) and §2514(e) (second sentence).
8 Reg. 26.2612-1(c)(1) (next to last sentence).
9 Reg. 26.2652-1(a)(5), Example 5.
10 I.R.C. §2041(b)(2) (second sentence) and 2514(e) (second sentence).
11 Reg. 25.2514-3(c)(4).
12 I.R.C. §2041(b)(2) (first sentence) and 2514(e) (first sentence).
13 Reg. 26.2612-1(c)(1) (next to last sentence).
14 Reg. 26.2652-1(a)(5), Example 5.
15 Reg. 26.2612-1(b)(1)(i).
16 Reg. 26.2612-1(c).
17 I.R.C. §2603(a)(1). The transferee may be entitled to an income tax deduction for any GST tax he or she pays on the portion includable in his or her income. See §164(a)(4) and §164 (b)(4).
18 Holtz v. Comm’r, 38 T.C. 37 (1962); Estate of Outwin, 6 T.C. 153 (1981).
19 See Fla. Stat. §736.0505.
20 Helvering v. Hutchings, 312 U.S. 393 (1941).
21 Reg. 26.2612-1(c)(1) next to last sentence; Reg. 26.2652-1(a)(5) Example 5.
22 Reg. 26.2654-1(a)(2)(i).
23 Reg. 26.2612-1(c)(1); Reg. 26.2654-1(a)(5) Example 5.
24 Helvering v. Hutchings, 312 U.S. 393 (1941).
25 See Hodges, Issues to Consider in Drafting Generation Skipping Insurance Trusts, 26 Estate Planning 77, 82 (February 1999).
26 See Harris, Avoiding Taxable Lapse Treatment for Crummey Trust Transfers, Trusts and Estates 45, 46 (April 1992).
27 Reg. 25.2511-2(c).
28 Adriance v. Higgins, 113 F.2d 1013 (2d Cir. 1940); Holderness v. Comm’r, 86 F.2d 137 (4th Cir. 1936); Comm’r. v. Chase Nat’l Bank of NY, 82 F.2d 157 (2d Cir.), cert. denied, 299 U.S. 552 (1936); Marshall v. U.S., 338 F. Supp. 1321 (D. Md. 1971).
29 This assumes that the IRS will not bring up Ltr. Ruling 8901004 where the IRS argued that the hanging power in question was subject to a condition subsequent and, therefore, was ineffective.
30 Blattmachr and Slade, Life Insurance Trusts: How to Avoid Estate and GST Taxes, Estate Planning 259 (September/October 1995).
31 See Reiff, Using Crummey Powers in Trusts for Annual Giving, Taxation for Lawyers 346, 348 (May/June 1997).
33 See Fla. Stat. §736.0505.
34 See Zeydel, Handling Affirmative and Deemed Allocations of GST Exemption, 34 Estate Planning 12, 16 (February 2007).
Peter B. Tiernan is a vice president and senior estate settlement officer of JPMorgan Chase Bank, N.A., in its Palm Beach Gardens office. He received his J.D. from the University of Florida and his master’s of law in taxation from the University of Miami.
The views and opinions expressed in this article are solely the author’s and are not the views or opinions of JPMorgan Chase Bank, N.A., or its affiliates.
This column is submitted on behalf of the Tax Section, Frank M. Bedell, chair, and Michael D. Miller and Benjamin A. Jablow, editors.