Hanging Powers

In creating a gift of present interest in order to use the annual gift exclusions, the beneficiaries need to have "demand powers." Demand powers give the beneficiaries the right to withdraw a pro rata share of gifts made to the trust. Broad powers may create tax problems for the beneficiaries. Narrow powers may cause the donor to lose the annual gift tax exclusion.

One demand power that minimizes tax problems for beneficiaries yet enables the donor to take advantage of the annual gift tax exclusion is the "hanging" power.

Hanging powers consist of both non-cumulative and cumulative demand rights. The non-cumulative demand right lapses when not exercised by the beneficiary. The amount subject to a non-cumulative right is limited to the greater of $5,000 or 5% of trust assets. The cumulative demand right does not lapse; rather, if the beneficiary does not exercise it in any year, amounts subject to the cumulative demand right accumulate in the later year. The cumulative demand right applies to any gift amount in excess of $5,000 or 5% of trust assets.

Example:

A donor makes an annual gift of $11,000 to a trust which has one beneficiary. The trust would provide that the beneficiary could withdraw the full $11,000 in this first year. If the beneficiary chose not to exercise the demand right, the non-cumulative portion (the $5,000/5% amount) would lapse. This would not create any adverse gift or estate tax consequences to the beneficiary. The balance of the gift, $5,000, is carried over to the next year, and added to any gifts made in that year. Thus, if an $11,000 gift is made in the second year, the beneficiary could withdraw a total of $16,000. If the beneficiary chooses not to make a withdrawal, the non-cumulative portion (namely the $5,000/5% amount) would lapse. The remaining amount, $11,000, would carry over to the third year. Each year, to the extent that the total amount subject to the demand right exceeds the greater of $5,000 or 5% of trust assets, a $5,000/5% amount lapses, and the balance carries over. Once gifts to the trust cease, the total amount subject to withdrawal is gradually decreased, with the $5,000/5% amounts gradually lapsing under the non-cumulative power.

A potential problem with hanging powers occurs when the cumulative right of withdrawal becomes large enough to cause an estate tax problem for the beneficiary. In practice, trust beneficiaries should outlive the premium paying period and will "work-off" the cumulative rights, avoiding the estate tax problems.