Asset Protection: "UTC Section 505(b) - Pandora Opens The Box"

Crummey Powers and 5 and 5 powers are two of the most common forms of withdrawal rights granted to beneficiaries of trusts.  Planners using trusts containing such withdrawal rights must be aware that many states have passed versions of the Uniform Trust Code (the "UTC").  Section 505(b) of the UTC, a provision related to self-settled trusts, contains a rule applicable to trust agreements that include Crummey Powers and 5 and 5 powers.  This rule provides in relevant part:

(1) during the period the power may be exercised, the holder of a power of withdrawal is treated in the same manner as the settlor of a revocable trust to the extent of the property subject to the power; and (2) upon the lapse, release, or waiver of the power, the holder is treated as the settlor of the trust only to the extent the value of the property affected by the lapse, release, or waiver exceeds the greater of the amount specified in Section 2041(b)(2) or 2514(e) of the Internal Revenue Code of 1986, or Section 2503(b) of the Internal Revenue Code of 1986, in each case as in effect on [the effective date of this [Code]] [, or as later amended].

Review of Crummey Powers:  All gratuitous lifetime transfers of property by individuals are potentially subject to the gift tax under § 2501(a). ²  Nonetheless, the first $12,000 of gifts made to any individual during each year need not be treated as taxable gifts for such year. ³  An "annual exclusion gift" is a gift of a "present interest" in property, i.e., an interest in property which is an unrestricted right to the immediate use, possession, or enjoyment of the property gifted. ⁴

When there is a gift in trust, all or a portion of the transfer may be a future interest in property. ⁵  Under Regulation § 25.2503-3(a), no portion of the value of a gift of a future interest may be excluded in determining the amount of gifts made during the calendar period.  The term "future interest" is a legal term that includes reversions, remainders, and other interests or estates that are limited to commence in use, possession, or enjoyment at some future date or time. ⁶

A gift in trust can be converted to a present interest qualifying for the annual exclusion under § 2503(b) by granting one or more beneficiaries a limited demand power or withdrawal right (that is, a "Crummey Power") over a contribution of property to a trust. ⁷  A Crummey Power is a withdrawal right granted to a beneficiary as a result of a gift (or a deemed gift) to a trust.  It permits a beneficiary to demand that the trustee distribute the gift (or other assets of equivalent value in the trust) to the beneficiary. Typically, the Crummey Power may be exercised for a limited period such as thirty days or until the end of the year in which the contribution is made to the trust.  Upon the expiration of the withdrawal period, the property (or value) that was subject to the withdrawal power continues to be administered and disposed of as provided in the trust.

Review of 5 and 5 Powers:  A 5 and 5 power typically grants a beneficiary the right to withdraw property from a trust for an entire year or on a less frequent basis, for example, for one month or one day of the year.  A 5 and 5 power usually grants a beneficiary the right to withdraw an amount equal to the greater of $5,000 or 5% of the trust corpus valued on an annual basis.  The 5 and 5 power is granted to a beneficiary based on the amounts set forth in §§ 2041(b) (2) and 2514(e).  It is often used to give a beneficiary greater access to trust corpus during a year without interference by a trustee and without causing adverse gift or estate tax consequences should the beneficiary elect not to exercise all or any portion of such withdrawal power. ⁸

Section 505(b) of the UTC:  In interpreting Section 505(b) of the UTC, it is important to refer to Section 103(11) of the UTC which defines the term "power of withdrawal."  It provides that the term means a general power of appointment that is presently exercisable by the donee of the power except a power that:

(1) can be exercised by a trustee and is limited by an ascertainable standard; or
(2) may be exercised by another person only with the consent of:
            (a) the trustee; or
            (b) a person holding an adverse interest.

Hanging Powers.  When a trust contains "Hanging Power Provisions" annual exclusion gifts may be made to the trust subject to Crummey Power rights granted to one or more beneficiaries.  After a limited period, the portion of any transfer (or transfers) subject to a Crummey Power which may lapse within the 5 and 5 exemption under §§ 2041(b)(2) and 2514(e) is directed to lapse.⁹  The remainder of such transfer (or transfers) continues to be subject to the beneficiaries' Crummey Power rights.  The trust is designed so that the "hanging" amount will lapse (in whole or in part) within the 5 and 5 exemption for each successive tax year.  In trusts that contain Hanging Power Provisions it may be critical to ascertain the portion of a withdrawal power that is permitted to lapse or has previously lapsed at a particular time to resolve a controversy involving a creditor's rights to trust assets.

A crucial question is whether §§ 2041(b)(2) and 2514(e) of the Code (which are specifically referenced in Section 505(b) of the UTC) provide a sufficient basis for a court or litigants to determine the portion of a trust that is subject to the continuing withdrawal rights of an individual possessing a withdrawal power.  Surprisingly, the answer to this question may be determined by reference to Revenue Rulings, Private Letter Rulings, Technical Advice Memoranda, Chief Counsel Advice, and Field Service Advice published by the Internal Revenue Service (hereinafter referred to as the "Service").  An important question is whether this is appropriate authority for a state court to rely upon to make such a determination.  In other words, is it sensible to permit federal tax law and the interpretation of the Code by the Service through its published documents to have such a significant effect on State creditor's rights law.

Section 2514(e) of the Code provides that the lapse of a general power of appointment during the life of an individual possessing the power is considered a release of the power.  This rule, however, is only applicable with respect to the lapse of powers during any calendar year to the extent the value of property that could have been appointed exceeds the greater of (a) $5,000 or (b) 5% of the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied¹⁰The 5 and 5 exemption applies on an annual basis.  According to the Service, each donee is granted one 5 and 5 exemption each calendar year, regardless of the number of trusts in which a donee is granted a Crummey Power or the number of annual exclusion gifts made to a trust. ¹¹

A donee may possess multiple Crummey Powers if such donee is a beneficiary of more than one trust.  Additionally, successive contributions to a single trust may be made in the same calendar year.  Thus, multiple or successive lapses may occur in a single year.  Furthermore, multiple and successive lapses may occur under a trust or trusts created by the same or different grantors or to which different donors make gifts.

In Revenue Ruling 85-88, 1985-2 CB 201, the Service addressed the tax consequences of multiple and successive lapsing Crummey Powers in a single calendar year.  The ruling provided two fact situations.  In Situation 1, G established an irrevocable trust in March of 1982 under which S was given all of the income for life and the remainder was given to C.  S was also given a Crummey Power "to withdraw up to $5,000 from each contribution made by any donor to the trust."  S had the right to exercise the Crummey Power for sixty days following notice of the transfer to the trust.  G transferred $5,000 to the trust on the date it was established, and S did not exercise the Crummey Power.  In September of 1982, G transferred an additional $5,000 to the trust, and S also permitted that Crummey Power to lapse.  In Situation 2, G established two irrevocable trusts in February 1982 with the same terms as the trust in Situation 1.  G transferred $5,000 to each trust at the time the trusts were established.  S was notified of each transfer but failed to exercise either Crummey Power.  The ruling held that S was entitled to only one 5 and 5 exemption in 1982 and providing multiple 5 and 5 exemptions "would undermine the statutory purpose to limit the exemption provided by section 2514(e)."

Thus, in both situations, S was treated as the transferor of $5,000 of property to the trusts in 1982.  The ruling noted that there is no indication Congress intended the holder of multiple noncumulative general powers should be granted more than one 5 and 5 exemption for any calendar year.  The ruling also noted that the statute uses the term "powers" in the plural.  In determining what the "aggregate value of the assets out of which" the exercise of the lapsed powers could be satisfied, the ruling explained that:

[T]he 5 percent test . . . is stated in terms of 'the aggregate value of the assets out of which . . . the exercise of the lapsed powers could be satisfied.'. . . 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. [Citation omitted]. Where the donee has more than one noncumulative withdrawal power in the same trust that lapses in a calendar year, the 5 percent test is based on the maximum amount subject to the donee's withdrawal power on the date of lapse of any such power during the calendar year.  Where the donee has noncumulative powers to withdraw property from two or more trusts, the 5 percent test is applied by aggregating the amount determined pursuant to the preceding sentence for each such trust with respect to which the withdrawal power has lapsed during the calendar year. (Emphasis added.)

Ex. 1:  B has a withdrawal power over $20,000 from Trust A which lapses on 6/1. On 6/1 the corpus of Trust A has a fair market value of $300,000.  B has second withdrawal power over $20,000 from Trust A which lapses on 12/1 of the same year.  On that date the corpus of Trust A has a value of $400,000.

Ex. 2:  B has a withdrawal power over $20,000 from Trust A which lapses on 6/1. On 6/1 the corpus of Trust A has a fair market value of $300,000.  B has a second withdrawal power over $20,000 from another trust, Trust C, which lapses on 12/1 of the same year.  On that date the corpus of Trust C has a value of $400,000.

Based on the foregoing facts, the ruling stated "if B's second withdrawal power . . . is exercisable only with respect to a second, separate trust, B's 5-and-5 exemption for the year would be $35,000 (5% x $700,000)."

Several issues remain unanswered regarding the 5 and 5 exemption after Revenue Ruling 85-88.  The facts of Revenue Ruling 85-88 involved one donor and transfers to the same trust or to trusts with identical terms.  It is still uncertain how the 5 and 5 exemption will be applied in cases involving transfers to a single trust with multiple donors, transfers to multiple trusts with the same dispositive provisions and different donors; or transfers to multiple trusts with different dispositive provisions and the same or different donors.  It appears that the Service will permit a beneficiary only one 5 and 5 exemption in any calendar year regardless of the identity of the donor, the grantor or the number of trusts in which a donee is a beneficiary. ¹²

Thus, prudence dictates structuring a Crummey Trust (or any other trust containing lapsing withdrawal rights) on the assumption that a donee is only permitted one 5 and 5 exemption despite the potential for receiving a number of annual exclusion gifts from multiple donors.  The legislative history of the 5 and 5 exemption appears to support a narrow reading of the exemption. ¹³

Additionally, GCM 39371, a companion document to Revenue Ruling 85-88, states:

it is obvious that allowing multiple exemptions would frustrate the Congressional intent to provide a limited exemption . . . If we adopted the view of the proposed revenue ruling we would allow a donor, by structuring two $5,000 gifts as contributions to two identical trusts to gift his donee two 5 and 5 exemptions instead of one. Other donors could conceivably create more than two trusts and thus add potential for abuse.

Under Section 505(b) of the UTC, beneficiaries with identical withdrawal powers over the same trust and even an identical creditor may obtain different results under this provision if a creditor attempts to seize property subject to a beneficiary's withdrawal rights.

Example: A and B are first cousins who share common maternal grandparents.  Each is the beneficiary of a trust ("Trust 1") that was settled by their maternal grandparents.  This trust contains Crummey withdrawal provisions granting A and B withdrawal rights over gifts to the trust by an their maternal grandparents.

A's paternal grandparents have previously established a trust ("Trust 2") for the benefit of A and their other grandchildren that contains Crummey Power provisions.

A and B were involved in an unsuccessful business venture.  A and B are both personally liable on debt related to the venture.  The lender obtained a judgment against A and B relating to the debt and seeks to attach A and B's personal assets to satisfy the debt.

Trust 1 has a corpus with a fair market value of $80,000 all derived by gifts from A and B's maternal grandparents.  A and B are the only living beneficiaries of Trust 1 who possess withdrawal rights over gifts from their maternal grandparents.  To avoid adverse gift tax consequences, Trust 1 contains "hanging power" provisions.  In February of 2007, A and B's maternal grandparents gifted $40,000 to Trust 1 and in February of 2008, they gifted $40,000 to Trust 1.

Trust 2 has a corpus with a fair market value of $10,000,000.  Although A's paternal grandparents have not made any gifts to Trust 2 in several years, they decided to gift $200 to Trust 2 in January of 2007 and in January of 2008.  Under the terms of Trust 2, A and his cousin, C, are each given the right to withdraw one-half of each $200 gift in 2007 and 2008 for a period of thirty days immediately following the gift.

Under the terms of Trust 1, a Crummey power will lapse as to a particular gift not less than the earlier to occur of thirty days following the gift or December 31st of the year in which the gift is made and as to all outstanding withdrawal rights only at such time and in such amount as will not cause a taxable lapse under §§ 2041(b) and 2514(e) to an individual holding such a power.

Possessing a judgment against A and B, under Section 505(b) of the UTC the lender attempts to seize the assets of Trust 1 that are subject to the outstanding withdrawal rights of both A and B in September of 2008.

Unintentionally Tolling Withdrawal Period.  Some Crummey powers contain provisions that provide that a withdrawal period as to a particular gift will only terminate within a certain period following the time a trustee sends written notice to a beneficiary of such beneficiary's withdrawal right.  In addition to the problems this can create in other areas for a trustee who neglects to send written notice to a beneficiary, such a provision can create serious concerns under Section 505(b) of the UTC, especially if the trustee neglects to send written notices for several years.  It is important to ensure that Crummey Power provisions are drafted to provide that the withdrawal period commences on the date the gift is made to the trust and terminates within a certain period following the gift rather than basing the termination date on the time a trustee sends written notice.

Period of Withdrawal.  The question of how long an unfettered withdrawal right should remain outstanding for a gift to a Crummey trust to qualify for the annual exclusion is also an important issue to consider under Section 505(b) of the UTC. In Cristofani v. Commissioner., 97 T.C. 74 (1991), the Tax Court has approved a fifteen day withdrawal period as sufficient to create a present interest.  In the same year as Cristofani, TAM 9141008 held that twenty days was too short a withdrawal period. Cristofani was not the first case to rule favorably on a withdrawal period of less than thirty days.  Crummey permitted gifts in trust to qualify as present interests based on sixteen day and twelve day withdrawal periods.¹⁴  Perhaps Crummey Power provisions should always ensure that the withdrawal period remains open for at least a thirty-day period regardless of the day of the year a gift is made to the trust.  Regardless of the withdrawal period selected, the period used in Crummey trusts must be carefully considered in light of Section 505(b) of the UTC.

There is no time requirement, or controversy for that matter, involving the period that a 5 and 5 power must remain outstanding.  Trust documents generally contain a broad range of periods granted to a beneficiary to exercise a 5 and 5 power, some for as long as an entire year and others for as short as one day.  Prudence would dictate drafting 5 and 5 powers with short withdrawal periods because of Section 505(b) of the UTC.

Failure to Qualify for Annual Exclusion.  If the Service holds that a gift to a trust containing Crummey Power provisions will not qualify for the annual exclusion because of a "mechanical" issue with the Crummey Power Provisions, a reciprocal gift issue or for another reason, this may not affect a creditor's rights to reach the trust property. ¹⁵  There may be disparate tax treatment and creditor's rights treatment, that is, a gift might not qualify for the gift tax annual exclusion, however, a creditor may still be able to seize trust property subject to a withdrawal right under Section 505(b) of the UTC.

Power Exercisable Only with Consent of a Non-Adverse Party.  A beneficiary may be granted a power to withdraw property from a trust for a limited period following a gift.  Within a short time following a gift to this trust (for example, thirty days following the gift or the end of the year) the withdrawal power may lapse, however, only to the extent that the lapse will not produce a taxable lapse within the meaning of §§ 2041(b) and 2514(e).  The remaining portion of any such gift that does not lapse may continue to be subject to the beneficiary's power of withdrawal until it can lapse without constituting a taxable lapse under the foregoing sections of the Code.  The terms of the Crummey Provisions can be drafted so that the beneficiary possessing such a continuing withdrawal right can only exercise such right following the initial limited period with the consent of an independent trustee (that is, a non-adverse party).  Under Section 505(b) of the UTC the amount subject to the beneficiary's continuing withdrawal right (albeit only with the consent of the independent trustee) should not be subject to the potential claim of a creditor of an individual holding a power of withdrawal from the trust.  The beneficiary's continuing withdrawal right no longer constitutes a "power of withdrawal" under the definition of a power of withdrawal in Section 103(11) of the UTC.  Equally important, however, the lapse of the beneficiary's unfettered withdrawal right will not constitute a taxable lapse under §§ 2041(b)(2) and 2514(e).¹⁶  The comments to Section 505 of the UTC provide "If the power is unlimited, the property subject to the power will be fully subject to the claims of the power holder's creditors, the same as the power holder's other assets."  In this particular instance, however, the power is not "unlimited" and appears subject to argument that the power has "lapsed" for creditor's rights purposes within the parameters of the statute.

Fraudulent Transfers.  Under Section 505(b) of the UTC it is ambiguous whether an applicable fraudulent transfer statute will apply to the lapse of a Crummey withdrawal right.  The comments to Section 505 of Article of the UTC provide:

For powers limited either in time or amount, such as a right to withdraw a $10,000 annual exclusion contribution within 30 days, this subsection would limit the creditor to the $10,000 contribution and require the creditor to take action prior to the expiration of the 30-day period. (Emphasis added.)

Income Tax Consequences.  There are also income tax consequences related to Section 505(b) of the UTC.  In several private letter rulings the Service takes the position under §§ 678(a)(1) and (a)(2) that a powerholder is treated as the owner for income tax purposes of all or a portion of a trust since the powerholder possesses or possessed a Crummey Power over such property. ¹⁷

Under § 678(a), an individual who is not the grantor is treated as the owner of any portion of a trust if such individual has a power exercisable solely by the individual to withdraw trust corpus or the income therefrom.  Additionally, if that person previously released or modified his or her withdrawal power and thereafter retains such control over the trust which would otherwise make the grantor the owner under §§ 671 to 677 of the grantor trust rules, § 678(a) will continue to treat the powerholder as the owner. ¹⁸

Section 678(b) provides, however, that the general rule of § 678(a) shall not apply with respect to a power over income if the grantor of the trust is otherwise treated as the owner under any other provision in the grantor trust rules.  Consequently, § 678(b) resolves any potential overlap in favor of treating the grantor, rather than a beneficiary, as owner of the trust income. Thus, assuming any other provision of the grantor trust rules initially causes the grantor to be treated as the owner of a trust, the existence of a Crummey Power or a 5 and 5 power in one or more beneficiaries should not change this income tax treatment due to the ordering rule of § 678(b).

However, the holding of two earlier private letter rulings, 8142061 and 8545076, may be based on a different theory from the rulings cited in footnote 17.  Some commentators believe these earlier rulings could be read to hold that a powerholder who allows a Crummey Power to lapse is treated as having withdrawn the assets subject to the withdrawal right and to have recontributed such assets to the trust. ¹⁹  Under this theory, a powerholder is treated as the new grantor of the trust upon the lapse of the Crummey Power.  Furthermore, the original grantor cannot be taxed on the income earned by a grantor trust after the lapse because he is no longer considered the grantor of the trust. This "recontribution" theory has merit under Section 505(b)(1) of the UTC where the beneficiary possessing the withdrawal power "is treated in the same manner as the settlor of a revocable trust to the extent of the property subject to the power."  Perhaps the counter argument to this theory is that Section 505(b)(2) of the UTC provides "upon the lapse, release, or waiver of the power, the holder is treated as the settlor of the trust only to the extent the value of the property affected by the lapse, release, or waiver exceeds the greater of the amount specified in Section 2041(b)(2) or 2514(e)...or Section 2503(b)." Nevertheless, this argument may be weak because Section 505 clearly changes the common law rule that was fundamental to the manner in which general powers of appointment have been treated for creditor rights purposes.  Both Crummey Powers and 5 and 5 powers are lifetime general powers of appointment granted to a beneficiary of a trust.  At common law an inter vivos general power of appointment is considered an authorization to acquire property and not an interest in property. ²⁰ It is not considered the same as ownership.  In fact, the common law rule contradicts the current transfer tax rules under §§ 2041 and 2514 for general powers created after October 21, 1942 which treat property subject to a general power of appointment as owned by the beneficiary possessing such power.  Thus, estate planners must carefully consider the income tax consequences of Section 505(b) on the use of Crummey Powers and 5 and 5 withdrawal powers.

Conclusion:  There are a number of strategies that can be used to ameliorate some of the problems created by Section 505(b) of the UTC.  For instance, planners can recommend certain clients establish trusts in a non-UTC jurisdiction such as Alaska²¹These jurisdictions have favorable trust law and are unlikely to adopt the UTC.

Planners can also utilize a flee or change of situs/governing law clause in trust documents or improve an existing provision used in a form trust agreement.  Many trusts include such a clause as part of the standard boilerplate provisions.  A flee clause permits a trustee to move the situs and administration of a trust and change the governing law of a trust to another jurisdiction.  This authority can often be exercised by a trustee or a protector without the approval of a court or any beneficiary. ²²

Planners can also draft trust agreements that give trustees or the donor the authority to exclude a beneficiary from exercising a withdrawal power.  When drafting trusts with power of withdrawal provisions consider including a provision granting authority to the trustees or the grantor, prior to or contemporaneously with a contribution to a trust, to exclude a beneficiary from having powers of withdrawal.  This may address problems with a beneficiary who has a creditor issue or an estranged or hostile beneficiary.  If drafted properly, a donor should be able to retain the right to turn Crummey Power rights on and off, to exclude a powerholder from being able to exercise a Crummey Power as to a particular gift, and perhaps to change the period in which a Crummey Power may be exercised.  For example, the trust could provide a procedure for a donor to give the trustee written instructions regarding these matters prior to or contemporaneously with the gift but not at any time following the gift.  In PLR 9030005, the terms of a trust provided that a donor could declare in writing that no beneficiary is entitled to withdraw all or any portion of the donor's gift to the trust.  The ruling held that such a power would not cause the trust to be included in the donor's estate.  In PLR 8103069, however, the Service refused to rule on the estate tax consequences of a similar retained power.  In PLR 9030005, the trust provided that a donor could declare in writing that no beneficiary is entitled to exercise a Crummey Power over the donor's gift or any portion of it.  The Service had no estate tax concerns with this power in this ruling.  The Service had no transfer tax concerns with a similar retained power in TAM 9532001.  Additionally, such a power should not cause the trust to be a grantor trust for income tax purposes.  TAM 8901004.  In TAM 8901004, the terms of the trust provided:

The donor of any property added to the trust has the right by giving written notice to the Trustee, to exclude any person who has been given a power of withdrawal from exercising the power, but only as to property added after the date the notice is received by the Trustee.

Finally, the trust agreement could contain provisions that grant an independent trustee or protector the power to amend the Crummey Provisions and the 5 and 5 provisions in the trust.  This provision can give such a trustee or protector the ability to deal with some of the issues identified in this article both currently and in the future.  In drafting such a provision, care must be taken to avoid disqualifying gifts for the annual exclusion and to avoid adverse estate and gift tax consequences (if possible) to the beneficiary possessing the withdrawal right.