The world in which we (including our clients and their families) live is also more uncertain than ever from a non-tax standpoint as well. Many of our clients’ families are currently experiencing, or may experience in the future, financial hardship, creditor issues, divorce, substance abuse, and/or disability.
Historically, estate planning attorneys have used trusts to eliminate or reduce transfer taxes for their clients and their families, and/or to address a client’s non-tax concerns for his or her beneficiaries, and trusts will continue to be used to address these tax and non-tax concerns. However, in light of the significant tax and non-tax uncertainty our clients and their families will likely face in the future, it is critical for us as estate planning attorneys to draft our clients’ trusts with provisions that are flexible enough to deal with this greater uncertainty. Through the use of powers of appointment granted to trust beneficiaries, limited trust beneficiary powers of withdrawal, and trustee termination provisions, clients can accomplish their goal of preserving their wealth for their family while at the same time giving persons whom they trust the ability to make changes to the trust’s plan of distribution in order to deal with future changes in the transfer tax laws or the circumstances of a client’s family.
A. Powers of Appointment.
Where a client will be establishing trusts for his or her family, prudent estate planning requires that the estate planning attorney consider at the outset of the engagement whether powers of appointment should be incorporated into the client’s trusts. The estate planning attorney should discuss in the initial meeting with the client the advantages and disadvantages of giving powers of appointment to the beneficiaries of the trusts to add flexibility from both a tax and non-tax standpoint. Although it may be somewhat difficult to explain to a client the complexities of a testamentary special (or general) power of appointment, clients appreciate an estate planning attorney who is thorough and who can give the client more options when it comes to the client’s disposition of his or her estate.
In situations where a generation-skipping transfer may occur upon the termination of a trust that might result in the imposition of GST tax, powers of appointment should be incorporated in the trust in order to eliminate these GST taxes. For example, often clients create trusts (either during the client’s lifetime or at the client’s death) for their children until the children reach some age in adulthood (for example, until age 40). If the child lives until age 40 and receives all of the assets in the trust at that time, there is, of course, no generation-skipping transfer. However, if the child dies before the trust terminates at age 40 and the terms of the trust provide in such event that the deceased child’s children are to receive the trust assets, then the distribution of those assets to the deceased child’s children will constitute a taxable termination under I.R.C. Section 2612, and if the trust has not be exempted from the GST tax by the allocation of the client’s GST exemption (either because the client had allocated all his GST exemption to other trusts he created, or he did not have enough GST tax exemption available to allocate GST exemption to all of his trusts), then the taxable termination will result in the assessment of GST taxes which could consume a substantial portion of the assets in the trust. This result can be avoided, however, by giving a child a testamentary general power of appointment over the assets in the trust which would cause the trust to be includible in the deceased child’s estate under I.R.C. Section 2041 for estate tax purposes, therefore making the deceased child the transferor under I.R.C. Section 2652 (a) of the trust property for GST tax purposes. Since the deceased child is considered the transferor for GST tax purposes because of the child’s testamentary general power of appointment over the trust, the distribution of the trust assets to the deceased child’s children at the child’s death is not considered a generation-skipping transfer. Often, the child will not have a substantial estate, and with the larger estate tax exemptions that we have now (and hopefully will be in existence going forward), the inclusion of the trust in the deceased child’s estate for estate tax purposes will result in no estate taxes in the child’s estate and therefore the property in the trust will pass to the child’s children without any additional transfer taxes.
This possible inadvertent GST tax issue can arise in multiple situations, such as in irrevocable trusts established by a client during his or her lifetime (for example, trusts created for a client’s children under an irrevocable life insurance trust or under an irrevocable trust created by a client as a vehicle for making gifts to the client’s children). Often, the client does not choose to allocate any of his GST tax exemption to these trusts since it is more likely than not that the child will survive until the time he or she reaches the designated trust termination age, and the client prefers to preserve his or her GST tax exemption for trusts that will be created at the client’s death that will have intentional generation-skipping transfers.
To deal with this possible adverse transfer tax consequence, the estate planning attorney should include the following power of appointment language in the child’s trust:
Distribution Upon Death of Child. Upon the death of the child before receiving or withdrawing his or her entire trust, the remaining principal, as then constituted, and all accrued or undistributed income of the child’s trust shall:
i. With respect to any portion of such trust which may be exempt for purposes of the generation-skipping transfer tax, or with respect to which said tax is not applicable, be distributed by the Trustee to such of the child’s issue, in such amounts or proportions, either outright or in trust, as the child may have appointed by specific reference to this power in the child’s Will.
ii. With respect to any portion of such trust which may be nonexempt for purposes of the generation-skipping transfer tax and with respect to which a generation-skipping transfer would occur but for the existence of this power of appointment, be distributed by the Trustee to such appointee or appointees, including the child’s estate, in such amounts or proportions, either outright or in trust, as the child may have appointed by specific reference to this power in the child’s Will.
The Trustee is authorized to rely, and is relieved of liability in so relying, upon any instrument admitted to probate in common or solemn form as the Will of the child. If no instrument is admitted to probate within sixty (60) days after the death of the child, the Trustee may assume that the child died intestate and shall be protected in acting in accordance with such assumption.
If any power of appointment hereunder is not effectively or fully exercised, principal of the child’s trust in an amount sufficient to pay all additional death taxes incurred by the inclusion of this trust in the gross estate of the child, if any, shall be paid to, or upon the order of, the personal representative of the child’s estate upon receipt of written request from the child’s personal representative. For purposes of this Subparagraph, such “additional death taxes” shall mean the excess of (1) all estate, inheritance, and other death taxes computed on the child’s taxable estate over (2) the amount of such taxes computed on the child’s taxable estate that would have been imposed if no portion of this trust had been included in the child’s gross estate. To whatever extent such property is not effectively appointed by the child, or paid as provided above, the same shall be paid over and distributed to the child’s then living issue, per stirpes, subject to the provisions hereinafter made for holdback trusts for beneficiaries under the age of thirty (30) years.
It should be noted that the above language only gives the child a general power of appointment if it is necessary to avoid the imposition of GST tax on the trust upon the death of the child. If the distribution of the child’s trust at the child’s death does not constitute a generation-skipping transfer (perhaps because the GST tax has been repealed at some point in the future), or if it does constitute a generation-skipping transfer but is not a taxable transfer because of the allocation of the parent’s GST exemption to the trust, then the child can only appoint the trust property to a limited group of beneficiaries (the child’s own issue).
If the parent is concerned about giving the child the broadest possible general power of appointment, then the permissible appointees of the child’s general power of appointment can be limited to the creditors of the child’s estate.
It should also be noted that the above language also provides that any estate taxes caused by the inclusion of the trust property in the child’s estate as a result of the general power of appointment shall be paid from the trust and not from the child’s estate. This has the advantage of clarifying exactly how these estate taxes are to be paid, thereby avoiding any disruption of the child’s own estate plan.
B. Beneficiary Powers of Withdrawal.
Another technique that should be considered when drafting trusts is giving the beneficiary of the trust a annual limited power to withdraw assets from the beneficiary’s trust. So long as the beneficiary’s withdrawal power in any calendar year of the trust does not exceed the great of $5,000 or five percent (5%) of the trust assets (commonly referred to as a “Five and Five power”), the beneficiary’s withdrawal power will not be deemed an I.R.C. Section 2041 general power of appointment over the trust, and the assets in the trust (other than the assets subject to the “Five and Five power” in the year of the beneficiary’s death – see discussion below) will not be included in the beneficiary’s estate for estate tax purposes.
This “Five and Five power” can be useful in a couple of types of trusts:
1. Family Trusts – Where a client has some hesitancy about creating a Family Trust for his surviving spouse, or is concerned the Trustee of the Family Trust may be too restrictive in providing trust assets to the surviving spouse for her needs, the client can give the surviving spouse a “Five and Five” withdrawal power without causing estate tax inclusion of the entire Family Trust in the estate of the surviving spouse. The surviving spouse will have the option of exercising this withdrawal power each year, and may choose in some years to withdraw nothing from the trust, or the entire amount subject to the withdrawal power, or some amount in between.
2. GST Trusts for Children - If the client desires to employ GST trusts for his children in order to minimize the ultimate amount of transfer taxes imposed on the assets passing to his family, but is concerned about the child not having sufficient access to the trust assets because of a parsimonious Trustee, the client can give the child a “Five and Five power” over the child’s GST trust.
3. Disadvantages of “Five and Five Powers” - The client should be advised of the disadvantages of giving a “Five and Five power” to a trust beneficiary. First and foremost, whatever property is withdrawn from the trust by the beneficiary will be subject to the beneficiary’s unfettered control and use. The beneficiary may choose to distribute the withdrawn property to persons other than the remainder beneficiaries of the trust. Or, the beneficiary may decide to spend it all.
If the beneficiary is, or could possibly be, subject to creditors’ claims and judgments, a creditor (or a court) may be able to require the beneficiary to exercise the withdrawal power each year in order to satisfy the creditor claim. Therefore, a beneficiary who has, or could possibly have in the future, creditor issues should not be given a “Five and Five power”.
If the beneficiary decides to exercise the maximum withdrawal right each year and consistently withdraws five percent (5%) of the trust assets each year, it is possible that at some point the trust may be fully exhausted by the withdrawal power. It is important to note that the “Five and Five power” is a ceiling, not a floor; i.e., the client could give the beneficiary an annual withdrawal power that is less than the greater of $5,000 or five percent (5%) of the trust. For example, the client could give the beneficiary an annual right to withdraw the greater of $5,000 or two percent (2%) of the trust. This might be more palatable to a client where the size of the trust will be very substantial.
The property subject to the withdrawal power in the year of the death of the beneficiary will be included in the beneficiary’s estate for estate tax purposes, even if the beneficiary did not actually withdraw those assets from the trust prior to the beneficiary’s death. See Treas. Reg. 20.2041-3(d)(1). For example, if a beneficiary has an annual “Five and Five power” over a trust with a value of $200,000, then $10,000 of the trust will be included in the beneficiary’s gross estate for estate tax purposes in the year of the beneficiary’s death.
Further, under I.R.C. Section 678(a)(1), the beneficiary will be treated as the owner for income tax purposes, under the Grantor trust rules, of that portion of the trust over which the beneficiary has a withdrawal power. See PLR 201216034. Therefore, if a beneficiary has a “Five and Five power” over a trust, then five percent of the trust’s taxable income (including capital gains) will be reported and taxed to the beneficiary each year, even if the beneficiary does not actually exercise his withdrawal right over the trust.
4. Sample Language – The following is sample language for giving a child a “Five and Five power” to withdraw assets from his trust each year (this language could also be used for a spousal withdrawal power by substituting “spouse” for “child”):
“The Grantor’s child shall further have the right, exercisable by written notice delivered to the Trustee, in each calendar year during the Grantor’s child’s lifetime, including the year in which such trust is established, to withdraw from the principal of this trust, in one or more installments, either in cash or in kind, or partly in cash and partly in kind, cash or property having an aggregate value not in excess of Five Thousand Dollars ($5,000) or Five Percent (5%) of the value of the principal of the trust estate on the first business day of the calendar year in which such withdrawal is made, whichever is greater. This right of withdrawal shall be noncumulative and, if not exercised in any calendar year, it shall lapse at the end of such calendar year.”
C. Trustee Termination Provisions.
The client may also want to consider giving the Trustee the power to terminate a trust at some point in the future in the event there is a change in the tax laws which would justify distributing the trust assets outright to the trust’s beneficiaries, or there is some change in circumstances which occurs with respect to the trust’s beneficiaries, or if the value of the trust has been reduced to a size such that it is no longer economically justifiable to keep the assets in the trust (this situation is more common now as bank trust departments have increased their minimum trust size). If the Trustee is also a beneficiary of the trust, however, and dies holding this trust power, the trust assets subject to this termination provision will be includible in the beneficiary’s estate for estate tax purposes as a general power of appointment under I.R.C. Section 2041.
In order to avoid this adverse estate tax consequence, a beneficiary of a trust who is also a Trustee should be precluded from exercising this power, and if there is another Trustee of the trust, then the other Trustee should be the Trustee to make this decision, and if there is no such Trustee, then the trust should provide for the appointment of an “independent” Trustee (i.e., someone who is not related or subordinate to the beneficiary under I.R.C. Section 672(c)), to make the decision to terminate the trust.
Here is some sample Trustee termination language which can be inserted in a trust:
“Power to Terminate. If the Trustee possesses the power of principal invasion with respect to any trust created under this Agreement, the Trustee shall have the power to terminate any such trust whenever the Trustee deems it advisable, for reasons of economy of administration, or for tax or other reasons, by distributing the assets of such trust to the then current mandatory or permissible income beneficiary of the trust, or if there is more than one such beneficiary, then in such amounts or proportions, as the Trustee, in its sole discretion, shall deem necessary or appropriate. Notwithstanding the foregoing provisions of this Paragraph, it is not intended that the powers in this Paragraph be construed to give a beneficiary who is a Trustee of any trust hereunder a general power of appointment. If such powers are considered to constitute a general power of appointment with respect to any property that would not otherwise be included in the estate of any Trustee who is also a beneficiary hereunder, such Trustee shall have no authority to participate in the exercise of such power; and if no other Trustee is serving thereunder, such Trustee shall appoint without the approval of any court an independent Trustee who is not related or subordinate to said Trustee as defined in Code Section 672(c), who shall, in such independent Trustee’s sole and absolute discretion, exercise the powers given the Trustee under this Paragraph.”
In the right situations, the use of powers of appointment, “Five and Five powers”, and Trustee termination provisions in a client’s trusts can add flexibility to deal with the many unforeseen circumstances and changes that can arise from a tax or non-tax standpoint over the life of a trust. Estate planning attorneys should consider the advantages and disadvantages of these powers when developing the estate plans for their trust clients, and should review these options with the client early in the engagement.