Query: How about a quick primer on "hanging powers?"
Answer: "Hanging powers" are often used when an irrevocable trust has multiple "Crummey," or present interest gift beneficiaries, and where the value contributed to the trust exceeds the greater of $5,000 or 5% of the trust value. With "hanging" powers, the entire value of the gift (per power-holding donee) is a gift of a present interest. But if the beneficiary doesn't withdraw the gift, the amount of the gift that lapses is the greater of $5,000 or 5% of the trust corpus. The remaining amount of the gift (the amount in excess of the 5/5 limitation) "hangs around" and is subject to the beneficiary's continuing, or hanging, right to withdraw.
Consider a joint ILIT created in 2008 as an example. Assume there are two beneficiaries and that the annual insurance premium is $48,000. We will look at one beneficiary's side of the equation to keep things simple. We will also assume that the corpus of the trust does not exceed $100,000 to keep the math of our lapsing withdrawal rights simple. The application works exactly the same for both beneficiaries.
In our example, the Grantors transfer $24,000 into trust for each Beneficiary. Each Beneficiary is given "Crummey" withdrawal right that has some expiration feature built in; in this case, "hanging powers." The Crummey power makes the gift to the trust qualify for the annual exclusion of $12,000 per donor, per donee. (Remember that this is actually $10,000 in the Code, inflation adjusted to $12,000 in 2008.)
Because we have two grantors (or with spousal gift-splitting) the entire $24,000 is covered by annual gift exclusion, assuming Grantors haven't made other gifts that would cause total gifts to the donee in the calendar year exceed $12,000. With two beneficiaries, two grantors, and a $48,000 gift to the trust (to pay the premium), the entire $48,000 would be covered under §2503(b) as annual gift exclusions. No lifetime credit burned until the first dollar over $48,000.
When Beneficiary fails to exercise the withdrawal right, what happens?
$5,000 of Beneficiary's right to withdraw lapses; it disappears forever. (Remember that if the trust corpus exceeds $100,000, 5% of the trust would be greater than $5,000.) The rest of the gift to the beneficiary, the remaining $19,000 from the original $24,000, "hangs around" and is subject to Beneficiary's continuing right to withdraw. Beneficiary's continuing right to withdraw is a general power of appointment under §2041, and the hanging amount would be includable in Beneficiary's estate if Beneficiary dies. Further, if Beneficiary gets sued the hanging right to withdraw may be subject to attachment by Beneficiary's creditors.
These may seem like bad consequences, and they do have potential negative implications. But we must consider the alternative. If we didn't use hanging powers and permitted Beneficiary's entire gift to lapse at once, the $5k/5% amount again disappears, but the lapse of the remaining $19,000 of the gift is deemed to be "gifted over" from the donee Beneficiary to the other beneficiaries of the trust. Because those other beneficiaries don't have a right to withdraw any portion of that $19,000 gift over, the gift over is a gift in trust of a future interest, not entitled to treatment under the annual gift exclusion.
Hanging powers do accumulate over time. Assuming our facts above, each Beneficiary has a $19,000 hanging power in Year 1. If the gift is repeated in Year 2, the first $5,000 per Beneficiary lapses away, and another $19,000 is added to the Beneficiaries' hanging powers ledger; in Year 2, each Beneficiary has a $38,000 hanging power.
So how do we get rid of these hanging powers?
Remember that the amount that lapses is limited to the greater of $5,000 or 5% of the trust corpus. Once the trust corpus exceeds $100,000, 5% of the trust is the "greater" amount. In the case of an ILIT, the trust value may build up as cash value builds in the policy, or when the life insurance policy matures on the death of the insured. In the case of a $1,000,000 life insurance policy (or $1,000,000 value in the trust), the amount that can lapse in a calendar year is $50,000 (5% of $1,000,000). So the value of the trust eventually grows to a point where it can "wipe out," or erase the Beneficiaries' hanging powers.
Matthew T. McClintock, JD