Each month I will be publishing a post discussing five advantages and five disadvantages of a particular estate planning technique – the post will be called The Monthly 5 and 5. In this first installment of The Monthly 5 and 5, I will be discussing the “5 or 5 power.” Notice the similarity? Yes, that’s right, the “5 or 5 power” was inspiration for The Monthly 5 and 5.

The “5 or 5 power” gives a beneficiary of a trust the power in any calendar year to withdraw the greater of $5,000 or 5% of the trust’s assets. This means that for any trust with assets of less than $100,000, the beneficiary will have the power to withdraw up to $5,000 each year; and, for any trust with assets of more than $100,000, the beneficiary will have the power to withdraw up to 5% of the value of the trust’s assets each year (i.e., because 5% of $100,000 is $5,000).

You may be asking yourself: Why $5,000 or 5%? What’s so magical about those numbers? Well, put most simplistically, because that is what the Internal Revenue Code (IRC) says. In order to avoid certain consequences, this annual withdrawal power is limited to $5,000 or 5% of the trust’s assets under the IRC. Why is it important to abide by the IRC? Well, for instance, if instead, you gave the beneficiary more than a $5,000 or 5% annual power to withdraw, the beneficiary’s withdrawal power could be deemed a general power of appointment over the trust and some or all the assets in the trust could be included in the beneficiary’s estate for estate tax purposes. This could create devastating tax consequences for the beneficiary.

Below are five reasons (each with an advantage and disadvantage) why the “5 or 5 power” can be a useful estate planning tool:

Reason 1: Minimum Distribution

Let’s say that the trust allows the trustee to only distribute the income of the trust (and not any of the trust principal) to the beneficiary each year for the beneficiary’s support. If in a particular year the trust generates very little income, the 5 or 5 power allows the beneficiary the power to withdraw up to $5,000 or 5% of the trust’s assets that year regardless of the amount of trust income.

Advantage: At a minimum, the beneficiary will be able to receive at least $5,000 per year for support.

Disadvantage: The amount subject to the beneficiary’s 5 or 5 power may not be protected from the beneficiary and/or creditors of the beneficiary.

Reason 2: Strict Trustee

Let’s say that the trust allows the trustee to distribute income and/or principal only for the health, education and support of the beneficiary. If a trustee is particularly strict when following this standard and distributes very little to the beneficiary, the 5 or 5 power allows the beneficiary the power to withdraw up to $5,000 or 5% of the trust’s assets each year even if it is not for the health, education and support of the beneficiary.

Advantage: The beneficiary will be able to withdraw at least up to $5,000 per year without having to satisfy the trustee that it is being used for health, education and support.

Disadvantage: The beneficiary could exhaust the trust more rapidly than intended over time, whether the trust is small (i.e., $5,000 withdrawn each year) or large (5% of trust assets are withdrawn each year), when the main purpose of the trust may have been to transfer wealth to future generations.

Reason 3: Benefit Without Estate Inclusion

Let’s say that both the trust grantor and his wife are near their lifetime exemption amounts for estate taxes (i.e., if they go over their exemption amount, part of their estate will be subject to estate taxes). The trust grantor sets up a trust for the benefit of his spouse during her lifetime with the remainder going to his children at his wife’s death. Here, the 5 or 5 power allows the wife to use the trust as another source of support and income during her lifetime (limited to $5,000 or 5%) but does not substantially increase her estate for estate tax purposes at her death.

Advantage: The amount of trust assets not subject to the 5 or 5 power are not included in the wife’s estate at her death; and, thus, not subject to estate taxes at her death.

Disadvantage: The amount of trust assets subject to the 5 or 5 power (i.e., the greater of $5,000 or 5% of the trust’s assets) will be included in the wife’s estate at her death; and, thus, if including this amount in her estate causes her total estate to exceed her lifetime exemption amount, the amount that exceeds the lifetime exemption amount will be subject to estate taxes at her death.

Reason 4: Crummey Trusts

Let’s say that the trust grantor set up a Crummey Trust for his two children. Each year his two children allow their right to withdraw the amount of the annual gift to lapse. When a beneficiary allows their withdrawal right to lapse, it is considered a deemed gift to the other beneficiaries of the trust. However, by adding the 5 or 5 power to the Crummey Trust, the lapsing of the withdrawal right is only considered a deemed gift to the other beneficiaries so much as it exceeds $5,000 or 5% of the trust’s assets.

Advantage: If the amount of the annual gift to the Crummey Trust is less than or equal to $5,000 or 5% of the trust’s assets, there will be no deemed gifts to the other beneficiaries by allowing the withdrawal right to lapse.

Disadvantage: While the main purpose of a Crummey Trust is to protect the trust assets from the beneficiaries until you see fit (as spelled out in the trust document), the 5 or 5 power gives the beneficiaries unfettered rights to withdraw up to $5,000 or 5% of the trust’s assets each year, regardless of the amount of the current year’s gift.

Reason 5: Hanging Crummey Trusts

Let’s use the same scenario as in Reason 4 except that the amount of the annual gift exceeds $5,000 or 5% of the trust’s assets. If the amount of the gift exceeds $5,000 or 5% of the trust’s assets, it is considered a deemed gift to the other beneficiaries of the amount in excess of the 5 or 5 power; and, thus, possibly causing gift tax consequences for the beneficiaries in the future. However, by adding a “hanging Crummey” provision, the amount of this deemed gift can be eliminated over time (I will explain this further in another post).

Advantage: Over time, the amount of any deemed gift to the other beneficiaries caused by allowing the withdrawal right to lapse will be eliminated; thus, not creating gift tax consequences for the beneficiaries in the future.

Disadvantage: The “hanging Crummey” provision allows the beneficiary to have continued withdrawal rights over the accumulated amount of gifts that have not  yet been offset by the 5 or 5 power; thus, allowing such withdrawal rights to possibly substantially increase over time, contrary to what the trust grantor may have intended.

As you can see above, adding a “5 or 5 power” to a trust document may be done for a number of reasons and it does have some really important advantages. But, like most things in life, the advantages must be weighed against the disadvantages. As always, if a “5 or 5 power” is something you are considering, you should consult an experienced estate planning attorney. It will be each individual’s personal situation and wishes that will control whether or not the advantages outweigh the disadvantages of utilizing a “5 or 5 power” in their estate planning.

– Attorney Matthew D. Brehmer

 

© 2014 Matthew D. Brehmer and Crummey Estate Plan.