Limits on Trusts

Trusts are extremely popular because they are flexible and offer a variety of other benefits. One of the greatest benefits is that you can make gifts to multiple beneficiaries, and by using the $15,000 (in 2020) annual gift tax exclusion, you can transfer significant wealth without being subject to gift and estate taxes.

Because trusts are utilized in many estate plans to minimize gift and estate taxes, the IRS has established several rules and limitations to govern them. There are four important rules being discussed here: (1) the five or five power, (2) hanging powers, (3) the ascertainable standard, and (4) the 65-day rule. You should be aware of these rules because the IRS keeps a very close watch and aggressively challenges the use of the annual gift tax exclusion when these rules come into play.

Some Basic Principles: General Power of Appointment and Crummey Trusts

In order to understand the rules that are being discussed here, you need to be aware of the context in which they apply. What follows is a brief summary of some basic trust principals that give rise to these rules.

General Power of Appointment

A power of appointment is the ability of someone other than the trustee to decide who gets the income and/or principal of a trust. A general power of appointment is one that is exercisable in favor of the powerholder, his or her estate, or the creditors of either. When a powerholder allows a general power to lapse, it is as if he or she is making a direct gift to the "takers" (i.e., those who benefit). As such, the lapse of a general power during life is a taxable gift, subject to gift and generation-skipping transfer tax (GSTT). There is an exception for certain five or five powers (see below). The lapse of a general power at death is a taxable transfer, subject to estate tax and GSTT.

Crummey Trusts

A Crummey trust is a trust designed to give the beneficiary Crummey withdrawal rights so that gifts made to the trust will qualify for the annual gift tax exclusion. A Crummey trust is one in which the trustee has discretion over trust distributions. Ordinarily, in order to qualify for the annual gift tax exclusion, the beneficiary of the trust must have a present interest in the trust.

The IRS contends that there is no present interest if the trustee has discretion over trust distributions (presumably because the trustee has the ability to say: "No, none of you beneficiaries can have any money from this trust right now."). The Crummey loophole adds a provision to the trust document which says that the beneficiary gets a chance to make a withdrawal from the trust (limited by time and amount). This chance is enough to make the beneficiary's interest a present interest in the eyes of the IRS and thus qualifies gifts made to the trust for the annual gift tax exclusion.

Example(s): Dick creates a trust and names Frank as trustee, giving Frank discretion to distribute income and principal to the beneficiary (Carol) as Frank deems best. Dick includes a Crummey withdrawal provision in the trust document. Carol has the ability to withdraw any funds that Dick places in the trust for 30 days after the funds have been added (but she never actually exercises this ability). Frank must notify Carol whenever Dick makes an additional transfer of funds to the trust. Dick funds the trust with an amount equal to the annual gift tax exclusion each year. Thus, none of the contributions made by Dick are subject to gift taxes.

Caution: Crummey provisions must be drafted carefully and other procedures must be followed to the letter in order to qualify for the annual gift tax exclusion.

What Is the Five or Five Power?

The five or five power refers to a power of withdrawal from a trust. A person who has been granted a general power of appointment (the powerholder) has a power of withdrawal. So, too, a beneficiary of a Crummey trust has a power of withdrawal. If a powerholder or a beneficiary fails to exercise his or her power within the time allowed, that failure is referred to as a lapse. A lapse is considered a taxable gift, subject to gift and/or GSTT.

The five or five power is a de minimus rule that says that the IRS shall ignore small amounts for economic reasons. Thus, to the extent that a lapse within a given year exceeds the greater of $5,000 or 5 percent of the value of the trust at the time of the lapse, the excess is taxable (or, conversely, whatever is not the excess is not taxable). That is, the excess only is either includable in your gross estate or is treated as a taxable gift, whichever the case may be.

Example(s): Jane sets up a trust in the amount of $90,000. Jane transfers $10,000 to the trust each year and gives Sue a Crummey power to withdraw an amount equal to such annual contributions. The power lapses each year to the extent that it is not exercised. Upon Sue's death, the principal of the trust will pass to Jill. In the first year, Sue withdraws $5.000 (half the amount she had the power to withdraw). The lapse of the power to withdraw $5,000 (the remaining half of the amount she could have withdrawn) is not a taxable gift to Jill because it does not exceed the greater of $5,000 or 5 percent of the trust assets ($100,000 x 0.05 = $5,000).

Example(s): However, in the second year, Sue does not withdraw anything from the trust. The lapse of the power is a gift to Jill. The amount taxable is $4,750 ($10,000 - $5,250) because that is the extent it exceeds the greater of $5,000 or 5 percent of the trust assets ($105,000 x 0.05 = $5,250).

What Is the Hanging Power?

The hanging power is a way of managing the five or five power (described above). A hanging power allows you to make gifts in excess of $5,000 or 5 percent of the value of the trust, yet avoid the lapse problem. This is accomplished by throwing the excess into a subsequent year or years. The excess is, in effect, suspended until enough time has gone by so that it is used up.

Example(s): Hal creates a trust and funds it with $90,000. Hal transfers $10,000 to the trust each year and gives Bob a Crummey power to withdraw an amount equal to such annual contributions. Under the trust terms, the power lapses each year to the extent that it does not exceed the greater of $5,000 or 5 percent of the trust corpus. Any power that does not lapse hangs and carries over to the next year. Upon Bob's death, the principal of the trust will pass to Mary. Bob does not withdraw any funds in any year. In the first year, Bob's $10,000 power lapses as to $5,000 ($100,000 x 0.05 =$5,000), and $5,000 ($10,000 - $5,000) hangs and is carried over to the second year. In the second year, Bob's $15,000 ($10,000 + $5,000 carryover from year 1) power lapses as to $5,500 ($110,000 x 0.05 =$5,500), and $9,500 ($15,000 - $5,500) hangs and is carried over to the third year. In the third year, Bob's $19,500 ($10,000 + $9,500 carryover from year 2) power lapses as to $6,000 ($120,000 x 0.05 =$6,000), and $13,500 ($19,500 - $6,000) hangs and is carried over to the fourth year. In later years, nonlapsing powers continue to hang and are carried over for many years, lapsing only when permitted under the five or five rule. Finally, in year 21, the entire $15,000 power lapses; $0 hangs and nothing is carried over to year 22.

What Is the Ascertainable Standard?

The ascertainable standard is used to limit a trustee's or powerholder's discretion and prevent inclusion of the trust in the trustee's or powerholder's gross estate for estate and gift tax purposes. Any individual who is empowered to make distributions from a trust to himself or herself or others may have to include the value of the trust in his or her estate. This can be prevented by limiting this power by a reasonably definite external standard set forth in the trust document. It is not required that the standard consist of the needs and circumstances of the beneficiary.

All that is needed is a clearly measurable standard to which the trustee or powerholder is legally accountable. For instance, a power to distribute income and principal for the "education, support, maintenance, or health" of the beneficiary would be limited by the ascertainable standard. Standards such as "for the beneficiary's reasonable support and comfort" or "to enable the beneficiary to maintain his or her accustomed standard of living" would also work. However, a power to distribute income for the "pleasure, desire, or happiness" of a beneficiary would not be limited by the ascertainable standard.

Caution: Careful drafting is essential here. It is worth employing an attorney who is a good wordsmith to draft a trust that relies on the ascertainable standard. The wrong wording could undermine your intentions.

What Is the 65-Day Rule?

The 65-day rule allows the trustee of a complex trust to elect to treat distributions paid from a trust within 65 days after the close of the trust's tax year as paid in the preceding tax year. This rule helps complex trusts avoid unwanted accumulations and the resulting throwback rules and procedures. This election (called a Section 663(b) election) is made by checking box 6 under "other information" on page 2 of Form 1041.

Tip: The 65-day rule is extended for distributions of estates, so that a personal representative may elect to treat distributions paid within 65 days after the close of the estate's tax year, as having been paid on the last day of that tax year.

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