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Hanging 5 x 5 Powers

A common term thrown around in the world of federal Estate and Gift Taxes is “Hanging 5 x 5 Powers” or “Hanging Withdrawal Rights”. This concept exists in trust planning to balance two concepts of tax law when making gifts to an irrevocable trust:

  1. In order for a gift to qualify for the annual gift tax exclusion of $14,000 per recipient (as of 2014), the gift must be a gift of a present interest (not a gift of a right to receive something in the future).
  2. When a trust beneficiary allows a general power of appointment to lapse, the beneficiary is deemed to have made a gift to the other trust beneficiaries, unless the value of the lapsed power of appointment was no greater than the larger of (i) $5,000 or (ii) 5% of the value of the trust assets.

These two concepts cause tax free gifts into trusts to be quite complicated. If the Settlor of a trust has two children and wishes to make gifts into a trust for the continuing support of her two children, she can make cash gifts into the trust of up to $28,000 each year ($14,000 per child) with no federal gift tax consequences. But a gift into a trust is not a gift of a present interest and therefore not eligible for the $14,000 per recipient, per year gift tax exclusion.

To remedy this problem, estate planning attorneys include “Crummey Withdrawal Rights” in many trust documents. These withdrawal rights are named for a court case from the late 1960’s. In the case of Clifford Crummey v. Commissioner, the 9th Circuit Court of Appeals ruled that a trust which contained a provision allowing the beneficiary to withdraw the lesser of (i) the annual exclusion amount or (ii) the amount gifted to the trust, qualified as a present interest as to the trust beneficiary possessing the right to withdraw the funds. Because of the Crummey decision, estate planning attorneys can now draft irrevocable trusts in a way that will allow the Settlor to make gifts into the trust which will qualify for the annual gift tax exclusion.

But a withdrawal right, by definition, is a general power of appointment. In the example above, with gifts of $14,000 per beneficiary being made to the trust, each beneficiary is being given a general power to appoint $14,000 in the year the gift is made to the trust. When the beneficiary does not exercise his or her Crummey withdrawal right in a given year, he or she has allowed a $14,000 general power of appointment to lapse. To the extent this $14,000 exceeds the greater of (i) $5,000 or (ii) 5% of the value of all trust assets (the “corpus”) the beneficiary has a gift tax problem. This is often remedied by allowing the withdrawal right to “hang”.

Allowing the withdrawal rights to hang merely means that the right lapses only as to the greater of $5,000 or 5% of the trust, with any excess withdrawal right continuing on and lapsing in subsequent years only to the extent that the total of the subsequent year gifts to the trust and the cumulative hanging powers do not exceed the greater of $5,000 or 5% of the trust corpus.

This technique is most often found in Irrevocable Life Insurance Trusts (ILIT’s). In an ILIT, there is eventually an event which causes the corpus to instantly increase to a relatively large number. When the insured dies, the life insurance proceeds are payable to the ILIT, causing a drastic increase in the value of the trust corpus. This causes a large portion of the hanging 5 x 5 powers to lapse without tax consequences because the 5% threshold becomes a much larger dollar amount and eats up a substantial portion of the cumulative withdrawal rights.

Irrevocable trusts containing hanging 5 x 5 powers can be a very useful tool in reducing estate and gift taxes for wealthier individuals.

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