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Cascading Crummey Powerssm
By Jonathan G. Blattmachrand Michael L. Graham
All Rights Reserved. © 2006.
Introduction
Unless falling under an exception, exclusion or special rule, a generation-skipping transfer tax is imposed by Code Sec. §2601 whenever property is transferred through or around one
younger generation (such as the generation of the transferor's children) in favor of an even more remote generation (such as the generation of the transferor's grandchildren) unless an estate
or gift tax is imposed at the generation around which or through which the property is transferred. (Descendants more remote than children, and others assigned to the generations of these more
remote descendants, are known as "skip persons," all others are called "non-skip persons.") As indicated, the tax may be imposed even if a gift or estate tax is imposed on
the transferor or the transferor's estate. More than 70 percent of property exposed to both estate and generation-skipping transfer tax can be eroded by those taxes.
Technically, the generation-skipping transfer tax is imposed upon any generation-skipping transfer, which is defined as consisting of direct skips, taxable terminations or taxable
distributions. The meaning of those terms is set forth in the Code and the final regulations.
Overview of Planning
Although the generation-skipping transfer tax, in many ways, is a much more "tight" tax regime than the estate and gift tax, there are times when planning can significantly reduce
the impact of the tax. Usually, planning will occur by using the exclusions, exemptions, exceptions or special rules which are available under the generation-skipping transfer tax system.
Failure to use those effectively can result in a significant loss of protection from the tax.
Annual Exclusion
As an analogue to the gift tax annual exclusion (up to $12,000 allowed for present interest transfers under Code Sec. § 2503(b)), Code Sec. § 2642(c), in effect, allows certain transfers
to pass free of generation-skipping transfer tax to the extent the transfers fall under the protection of the gift tax annual exclusion. This means, for example, that a grandparent can make
present interest gifts each year to each grandchild of up to $12,000 (or $24,000 if the grandparent is married and the grandparent's spouse elects "gift splitting" under Code Sec. §
2513) free of both gift tax and generation-skipping transfer tax.
Code Sec. § 2642(c)(2) contains a special rule, however, where the transfer is in trust. In such a case, the annual exclusion generation-skipping transfer tax analogue applies only if the
trust is structured so that (i) only the skip person (e.g., the grandchild) for whom the transfer is made is permitted to receive distributions from the trust during his or her lifetime, and
(ii) the trust will be includible in the skip person's (e.g., the grandchild's) estate if it does not terminate prior to the time he or she dies. That means, for example, that the trust must
be structured so that if it is still in existence at the death of the skip person it will terminate in favor of his or her probate estate or he or she must hold a general (estate taxable)
power of appointment under Code Sec. § 2041. However, income is not required to be distributed to the skip person beneficiary. Rather, income can be accumulated or may be distributable (as
may corpus) to the skip person beneficiary in the discretion of a trustee.
A person is treated as holding a general (estate taxable) power of appointment under IRC § 2041 even if it is exercisable with the consent of a non-adverse party (that is, someone other
than one whose interest would be adversely affected by the exercise of the power; an example of someone adversely affected would be a taker-in-default of the exercise of the power). Treas.
Reg. § 20.2041-3(c)(2). Therefore, a transfer to a trust may qualify for both the gift tax annual exclusion and the generation-skipping transfer tax analogue under Code Sec. § 2642(c)(2) if
(1) the skip person beneficiary (e.g., the grandchild) for whom the transfer is made has the immediate right to withdraw an amount equal to the annual exclusion when the transfer to the trust
is made which lapses in full after at least 30 days (i.e. a so-called "Crummey power of withdrawal"), (2) the trustee is permitted to accumulate trust income or distribute it (and
corpus) to the skip person beneficiary and (3) the skip person beneficiary holds a testamentary general power of appointment even if it is exercisable only with the consent of a non-adverse
trustee. (It may be noted that because the skip person beneficiary has a general power of appointment, the lapse of the Crummey power of withdrawal even in excess of the non-taxable lapse
limit of 5% and $5,000 ("5 and 5") contained in Code Sec. §2514(c) will not be a taxable gift: the gift is incomplete on account of the testamentary power.) Making the testamentary
general power exercisable only with the consent of a non-adverse trustee tends to insure that the skip person beneficiary will not exercise it in a way which would be incompatible with the
wishes of the grantor of the trust. Such a provision, perhaps, should be considered for inclusion in instruments creating such trusts. Although a transfer to a trust described in Code Sec. §
2503(c) and a transfer to a Uniform Gift (or Transfer to Minors Act account would also qualify for the annual exclusion for gift and generation-skipping transfer tax purposes, the property
must be distributed or made to the beneficiary at age 21, an age many believe is too young to receive substantial property.
The strict requirements of Code Sec. § 2642(c)(2) also mean that transfers to a "standard" irrevocable life insurance trust will not qualify for the generation-skipping
"annual exclusion" allowable under that section. An irrevocable life insurance trust almost always has beneficiaries in addition to one skip person. The final regulations provide
that a transfer to a trust which is not itself a skip person (because it has at least one current non-skip person beneficiary) will not be subject to generation-skipping transfer tax even if
skip person beneficiaries of the trust are given Crummey powers of withdrawal which lapse under the so-called "5 and 5" limit under Code Sec. § 2514(c). Treas. Reg. § 26.2612-1(f).
Example 3. That means, however, that a generation-skipping transfer tax will be imposed when property from the trust is distributed to a skip person or when the interests of all non-skip
person beneficiaries and (e.g., upon the death of the survivor of the beneficiaries of the trust who are non-skip persons), unless another exception or special rule applies to protect the
transfer from generation-skipping transfer tax, such as the allocation of GST exemption to transfers to the trust..
Cascading Crummey Powerssm
An irrevocable life insurance trust can be an excellent tool to avoid estate and gift tax, especially if it results in the effective use of annual exclusions which the insured otherwise
would not use by granting each beneficiary a so-called "hanging Crummey power of withdrawal," See, generally, Slade, "Personal Life Insurance Trusts," BNA Tax Mgt.
Portfolio No. 836. However, as noted, such trusts usually do not avoid generation-skipping transfer tax on the transfer of trust assets to skip persons except to the extent GST exemption is
allocated to the trust. Hence, as interests in the irrevocable life insurance trust "move down" to grandchildren or more remote descendants, generation-skipping transfer tax will be
payable unless some exemption or exception applies.
Of course, a preferable result from the perspective of the beneficiaries would be to avoid the generation-skipping transfer tax (as well as estate tax) as children die and their interests
in the irrevocable life insurance trust terminate in favor of grandchildren. It appears that can be accomplished, in significant part in some cases, through Cascading Crummey Powerssm if there
are skip person beneficiaries (e.g., grandchildren) and non-skip person beneficiaries (e.g., children) of the trust.
When a Crummey power lapses, the power holder is treated as making a gift if and to the extent the amount of the lapse each calendar year exceeds the greater of $5,000 or 5% of the property
over which the power could have been exercised. Suppose, for example, an insured (whose spouse will "gift split" under Code Sec. § 2513) creates a trust and transfers $20,000 to it,
giving her child the immediate right to withdraw $20,000 from the trust. Most practitioners allow that power of withdrawal to lapse each calendar year only to the extent of the greater of 5%
or $5,000, the gift tax-free threshold, with the balance of the power of withdrawal "hanging around" until it can lapse gift tax-free under the 5% and $5,000 rule in a future year.
One consequence is that the power holder continues to have a general power of appointment over the unlapsed amount, which will be included in his or her gross estate except to the extent it
lapses in a future year. In fact, if additions are made each year for a considerable period, the power holders general (estate tax) power applies to an increasingly greater amount -- $15,000
in the first year, $30,000 in the second year, $45,000 in the third year and so on.
But, with a Cascading Crummey Powerssm structure, the trust provides that after 30 days, each child's power of withdrawal lapses in full. Because the amount of the lapse exceeds the $5,000
"no transfer" threshold under IRC § 2514(e) by $15,000, the child is deemed to have made a gift of $15,000. Hence, there has been an "excess" lapse of $15,000. However,
the trust further provides that the grandchildren of the insured have the immediate right to withdraw a pro rata portion of the excess lapse amounts from the trust. There are two
grandchildren. This means that the $15,000 gift deemed made by the child will be treated as made one-half to each of the two grandchildren (that is, $7,500 each) and, by reason of each
grandchild's right of withdrawal, should qualify for the gift tax annual exclusion. (Note that the child is not "using up" the parent's annual exclusion with respect to the
grandchild. The child is simply using her own annual exclusions with respect to the grandchildren.) In addition, no excess lapse amount should be includible in a child's estate if the child is
not entitled to income from the trust but is only eligible to receive it in the discretion of an "independent trustee" (see Code Sec. § 2036), and the child holds no power (e.g., a
special power of appointment) to control the beneficial enjoyment of the excess lapse amount (see Code Sec. § 2038). That, of course, is probably the same result that would have been achieved
if the annual lapse had been limited to the 5 and 5 threshold.
There are two consequences to that. First, the child after the lapse no longer holds a general (estate tax) power of appointment over the trust. Hence, when the child dies, no part of the
trust is included in his or her gross estate unless the child dies before the power for that calendar year has expired. However, it is also critically important that the child not be given the
right to income from the trust or be given a power to control the disposition of the "excess lapse" such as by holding a special power of appointment. Otherwise, the excess-lapse
will be included in the child's estate under Code Sec. 2036.
The second difference is what happens for generation-skipping transfer tax purposes: The child has become substituted for the parents as the transferor for generation-skipping transfer tax
purposes of the excess lapse amount. Hence, the child has become the transferor of 75% of the $20,000 the insured parent contributed to the trust. That means that no generation-skipping
transfer will occur when a child dies with respect to three quarters of the trust (assuming the property is transferred "down" to a generation no younger than that of the insured's
grandchildren). Of course, if additional contributions are made, the number of children or grandchildren is different, or annual exclusions are used elsewhere, the ratio of the trust
attributed to the insured, the insured's spouse and to each child, as transferors for generation-skipping transfer tax purposes, may be different.
The final generation-skipping transfer tax regulations confirm that contributions by different transferors are treated as separate trusts for generation-skipping transfer tax purposes and
can be divided at any time. Treas. Reg. §§ 26.2654-1(a)(2)(i) and 26.2654-1(a)(3). Hence, the instrument should authorize the trustee to divide any trust into separate trusts with respect to
different transferors. Whether the trustee divides the trust or not, the trustee should maintain separate records (if not accounts) showing which part of the trust assets is attributable to
each transferor. The trustee should make distributions to the children (and exempt transfers to the grandchildren, such as certain transfers for medical care and tuition under Code Sec. §
2642(c)(3)(B)) first from the trust of which the insured parent is the transferor, and make distributions to the grandchildren (not otherwise falling under an exemption or exception) first
from the trusts of which the children are treated as the transferors. As a result, over time, significant property may escape estate and generation-skipping transfer tax as property
"moves down" to the grandchildren's generation.
* Cascading Crummey Power is a service mark of Jonathan G. Blattmachr
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