There are many reasons why husbands and wives might want to create trusts that allow their spouses to withdraw income or principal. The most obvious is that allowing access to a trust confers extra financial security on the spouse. But there's a problem: Withdrawal rights can create additional gift tax, estate tax and generation skipping transfer tax.

There are ways to minimize such taxes. One way is to use annual exclusion withdrawal rights in trusts. Trust documents are typically drafted to maximize the use of annual exclusions, assuming that the donor will gift split with his spouse, thus doubling the number of annual exclusions available.

When individuals make gifts, they are allowed to give $11,000 a year per donee before using any of their lifetime gift tax exemption.1 If each spouse has individual property, each is entitled to the $11,000 exclusion, even if they both make gifts to the same person. If only one spouse makes a gift, the law allows the spouses to “gift split.” Doing so means that it's as if each spouse had directly given one-half of the couple's total gifts for the year. The election can apply only to gifts that either spouse makes to third parties, not gifts from one spouse to the other.

Gift splitting can have different consequences for gift, estate and generation skipping tax purposes.

For example, a trust that works perfectly well for gift tax purposes may have generation skipping tax problems, while a trust that cannot be gift split may still be fine for estate tax purposes.

If a donor transfers property to a trust while retaining the ability to receive distributions, the trust property likely will be included in his taxable estate under Internal Revenue Code Section 2036. But his spouse can elect gift splitting, which makes her a donor for the purposes of gift taxes but not estate taxes.2 Therefore, giving a spouse economic rights in a trust shouldn't present an estate-planning problem if the trust is drafted and funded correctly.

There also are other ways to avoid taxable gifts. One strategy is to limit a spouse's rights in a trust to the greater of $5,000 or 5 percent of the “aggregate value of the assets out of which, or out of the proceeds of which, the exercise of the lapsed powers could be satisfied,”3 with no future permissible distributions once the withdrawal rights lapse. IRC Section 2514(e) provides for this type of withdrawal right, known as a “five-by-five.”

Here's how a five-by-five4 could work. Assume that one spouse makes an initial contribution of $50,000 to a trust that grants the other spouse such a withdrawal right; further assume that the five-by-five right lapses after 30 days if unexercised. The trust also grants the other trust beneficiaries (the donor's two children and three grandchildren) the right to withdraw their allocable share of the excess over the spouse's withdrawal right, up to the amount of double the annual exclusion. The non-spousal withdrawal rights lapse only to the extent that they would not be a taxable gift by the child or grandchild.

So, how many annual exclusions is the donor entitled to on his Form 709 for this trust? Can the gift (or some portion of it) be split? And, assuming the couple wants to allocate some of their generation skipping transfer tax exemption to the trust, how much of each spouse's exemption will be used?

The donor is entitled to an annual exclusion up to the amount of the spouse's withdrawal right ($5,000). Because the spouse has no further interest in the trust, the remaining gift can be gift split. Dividing $45,000 by five other beneficiaries gives each of them a $9,000 withdrawal right. Once gift split, both spouses can take a $4,500 exclusion for the transfer to each beneficiary. Therefore, the donor will show $27,500 annual exclusions on his return, and the spouse will show $22,500.

Because the couple wants to allocate the generation skipping tax exemption, would they then allocate $27,500 of the donor's exemption and $22,500 of the spouse's? No. Treasury Regulation Section 26.2652-1(a)(4) says otherwise. As long as some portion of the gift can be split, each spouse is deemed the transferor of one-half of the whole gift. Therefore, each spouse allocates $25,000 of the exemption.5

Other than the generation skipping quirk, the example seems fairly straightforward. But in the real world, trusts don't always easily align with the provisions of the code and regulations.

For instance, what happens if, instead of the spouse's withdrawal right lapsing in 30 days, the $5,000 or 5 percent could be withdrawn any time during the year? There is no change in the gift tax results: The same $27,500 and $22,500 exclusions are available on Form 709. But when the couple attempts to allocate the generation skipping tax exemption, they run into a serious problem. If a trust, or any portion of it, would be included in the donor's or the spouse's taxable estate, then an allocation would not be effective, because the trust still would be in the estate-tax inclusion period.6 The right to withdraw $5,000 or 5 percent is a general power of appointment, so that portion of the trust would be included in the spouse's taxable estate under Section 2041.

There is an exception for five-by-five withdrawal rights held by the donor's spouse, but only if the rights lapse within 60 days of the transfer to the trust.7 Moreover, drafters should make clear that the rights lapse 60 days after the transfer, not 60 days after notice of the contribution. Precise language will avoid uncertainty regarding how much generation skipping exemption to allocate, and when the allocation becomes effective.

If an existing trust grants a spouse a withdrawal right that does not fit exactly within the regulation's exception, and allocation of the generation skipping tax exemption is important, it might be appropriate to reform the trust. The settlor can bring the withdrawal right into conformity, or the spouse might permanently waive his right to withdraw from the trust. Of course, the gift tax consequences of any changes must be considered.

What else can happen with spousal interests in a trust? What if a trust has a provision that allows an independent trustee to make distributions to a spouse for the spouse's best interests? “Best interests” is not an ascertainable standard, so the non-donor spouse cannot split the gift to that trust, other than the withdrawal rights given to third parties.8

Consider the scenario in which the donor transfers $50,000 to a trust and grants withdrawal rights to his spouse, children and grandchildren. Even though the spouse may receive distributions at some point in the future, she may gift split the amount of the withdrawal rights given to the children and grandchildren. Assuming the spouse's withdrawal rights lapse appropriately, the same generation skipping transfer tax exemption is allocated: $25,000 each from the husband and wife.

But if the donor doesn't have any grandchildren, only three people will hold withdrawal rights: the spouse for $5,000 and the two children for $22,000 each. That leaves $1,000 of the original $50,000 transfer not subject to withdrawal. Because the non-donor spouse's interest in the trust is unascertainable, she can't split that portion of the gift. So the donor spouse will show gifts of $28,000 on his return, in the guise of $27,000 annual exclusions, and a $1,000 taxable gift. The non-donor spouse will show gifts of $22,000 and $22,000 for the two annual exclusions.

Now for the generation skipping exemption (assuming the couple will eventually have grandchildren): Because some portion of the transfer was gift split, each spouse is deemed a transferor of one-half of the amount and each allocates $25,000 of their generation skipping tax exemption on Form 709.

What happens with that extra $1,000 if the spouse's interest in the trust permits her to receive distributions subject to an ascertainable standard? Treasury Regulation Section 25.2513-1(b)(4) implies that the balance of a gift can be split once the spouse's “ascertainable” interest can be valued. The regulations, applicable cases and rulings discuss such an interest in a number of places,9 with strong implications that it can be valued. There is a little guidance on valuing such an interest.10 Unfortunately, performing the calculations laid out in the 1987 case Weinstein Estate v. United States, required retaining an actuary. In other cases, courts have indicated that it's possible to calculate an ascertainable interest, but haven't explained how.11 As a practical matter, when the amounts are small, the value of the spouse's interest may indeed be unascertainable, which precludes the possibility of gift splitting that amount. If the amounts are substantial, a formal valuation of the spouse's interest may be required before gift splitting can occur.

A more vexing problem arises if a spouse has an unascertainable interest in a trust, there are no withdrawal rights, and both spouses' generation skipping transfer tax exemptions likely will be needed to fully exempt the trust. This typically occurs in two situations.

The first is when a trust document giving a spouse an unascertainable interest ties the withdrawal rights to available annual exclusions, but those exclusions were applied to gifts earlier in the year. This problem can be avoided by drafting (or amending) the trust to allow the withdrawal rights, even though the rights will not be offset by annual exclusions. The amount of the withdrawal rights given to third parties can be gift split, which is then sufficient to allow equal allocation of generation skipping tax exemption.12

The second is if grantor status is desired for income tax purposes and the power chosen to invoke grantor status is the ability of the trustee to distribute income or principal to the spouse of the donor (solely within the trustee's discretion).13 If this situation arises, none of the transfer to the trust can be gift split and, therefore, the donor remains the sole transferor for generation skipping purposes. If this problem is discovered after the trust has been executed, the trust may be only partially exempt, and a qualified severance under Section 2642(a)(3) may be the appropriate solution.

If it's important to the overall estate plan that both spouses use their annual exclusions, lifetime exemptions and generation skipping exemptions, advisors must pay special attention to the non-donor spouse's interest in the trust. Thanks to Treasury Regulation Section 26.2652-1(a)(4), if any portion of the trust can be gift split, the spouses will use equal amounts of their generation skipping exemption. Unfortunately, there is no equivalent provision in the gift tax rules, so difficult-to-value spousal interests in trusts are guaranteed to cause gift splitting problems. But with careful drafting, it is possible to integrate gift splitting and estate-planning goals and avoid surprises the following April 15 when the gift tax returns are prepared.

Endnotes

  1. Gifts must be of a “present interest” to be eligible for the annual exclusion, which is currently $11,000.
  2. PLR 200130030, April 30, 2001.
  3. IRC Section 2514(e)(2).
  4. Assumes that the trust is funded with separate property of the donor spouse. The use of community property to fund a trust in which a spouse has an interest is inadvisable for a number of estate planning reasons.
  5. PLR 200130030, April 30, 2001.
  6. Treas. Reg. Section 26.2632-1(c)(2).
  7. Treas. Reg. Section 26.2632-1(c)(2)(ii)(B).
  8. Treas. Reg. Section 25.2513-1(b)(4).
  9. Treas. Reg. Sections 25.2511-1(g)(2), 25.2511-2(b), 25.2514-1(c)(2), 20.2041-1(c)(2).
  10. Rev. Rul. 70-292, 1970-1 CB 187; Rev. Rul. 75-550, 1975-2 CB 357; Weinstein Est. v. U.S., 820 F.2d 201 (6th Cir. 1987).
  11. For example, Lloyd Estate v. U.S., 650 F.2d 1196 (Ct. Cl. 1981) (see footnote 12 for the factors to be considered in the valuation); PLR 8608002, Nov. 7, 1985; PLR 199908060 (issue 18), Dec. 2, 1998; Rev. Rul. 54-538, 1954-2 CB 316.
  12. Treas. Reg. Section 26.2652-1(a)(4).
  13. IRC Section 677(a)(2).

Collectors' Spotlight

Pierre-Joseph Redouté's “Album de Redouté,” a collection featuring this title page plus 30 hand-colored engraved plates by other artists, recently sold at Bonhams of London for about $174,000 U.S. dollars.