AUG. 18, 2000

Trust Talk
'5 by 5 Powers' Under IRS Attack

In a recent Private Letter Ruling, the IRS ruled that a trust’s 5 by 5 clause converts the trust’s beneficiary into a trust owner over time for income tax purposes. The trust in question is a residual trust. The income beneficiary (the surviving spouse) had the power to withdraw or appoint all of the trust income annually, and a 5 by 5 clause gave her power "to withdraw annually from the corpus of the [residual trust] an amount not exceeding five thousand dollars or five percent of the market value of the net principal of [the residual trust]."

For those who are unfamiliar with the 5 by 5 clause, it is commonly included in many trusts, giving the beneficiary power to withdraw from the trust corpus up to $5,000 or 5% of the trust’s fair market value every year. This can guarantee an income beneficiary a minimum distribution regardless of the trust’s income. Also, it provides some extra cash for the income beneficiary if the trust’s income is insufficient to provide for his or her needs.

The 5 by 5 clause has generally been considered a safe addition to virtually any trust. It is designed to expand the beneficiary’s withdrawal options without subjecting him or her or the trust to additional transfer tax expense. However, under grantor trust rules, and previous PLRs, a 5 by 5 power can make its holder the owner (for income and capital gains tax purposes) of a small portion of the trust (the lesser of $5,000 or 5% of the fair market value).

But the IRS ruling in PLR 200022035 gives trust professionals cause for concern. In this case, the holder of the 5 by 5 power (the beneficiary) did not exercise that power other than with a partial withdrawal in the first year. According to the Service, since the beneficiary allowed her 5 by 5 power to lapse repeatedly, she will be treated as the owner of an increasing portion of the residual trust each year. If she lives long enough, she could become the taxpayer for virtually all of the trust’s income, capital gains, deductions, and credits.

For a detailed explanation of the PLR and the laws in question, see the article "How the ‘5 by 5’ Power Can Turn a Beneficiary Into a Trust Owner" by Professor Jerry A. Kasner in the August 4, 2000 edition of the Estate and Gift Tax Bulletin. Find it online at www.tax.org/taxa/tadiscus.nsf, in the Estate, Gifts, Trusts Archives.