836 / What non-cumulative annual withdrawal rights may the grantor give beneficiaries without subjecting the power to estate and gift taxes?

In many situations, an insured or the grantor of a trust will wish to give his beneficiary not only all the income from the fund, but also a right to withdraw some limited amount of principal each year. If the beneficiary does not exercise his right of withdrawal in any year, the right expires or “lapses” at the end of the year. Where it cannot be carried forward to subsequent years, it is characterized as a “non-cumulative” withdrawal right.

Where the beneficiary permits such a right to lapse, gift and estate taxes may result by reason of the lapse. In other words, by not withdrawing the amount she could have withdrawn, the beneficiary has made a gift to those persons designated to receive the principal.

However, in framing the powers of appointment tax law, Congress recognized that modest annual withdrawal rights are socially desirable and that their use, within limits, should not be discouraged. Therefore, an exemption is granted in an amount equal to whichever is greater: (1) $5,000; or (2) 5 percent of the value of the fund as of the date of the lapse of the power.

Consequently, where a non-cumulative power of withdrawal is permitted to lapse, only the excess over and above the “$5,000 or 5 percent of the fund” limit will be subject to gift and estate taxes. This excess is treated as a transfer with life income retained. But the entire amount which could have been withdrawn in the year of death, but was not withdrawn, is includable in the gross estate since this power has not lapsed at the time of death.