Annual exclusion gifts are often used to provide seed money for an estate freeze technique, or for payment of premium on a trust-owned life insurance policy, or to transfer fractional ownership in an asset (such as a limited partnership) in order to obtain valuation discounts.
Under IRC §2503(b), a donor can make annual gifts to an unlimited number of recipients, with each recipient being limited each year to $10,000 plus an inflation adjustment. The current inflation-adjusted amount for 2013 and 2014 is $14,000. (If the spouse consents to split gifts, annual exclusion can be doubled under IRC §2513.) The gift must be a completed gift, i.e., the donor has so parted with dominion and control of the property as to leave the donor no power to change its disposition, whether for donor’s benefit or another’s. The gift must also be of a present interest—not a future interest. To be a present interest, the gift must be of “an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain).” Treas Reg §25.2503-3(b). A future interest is defined as “a legal term, and includes reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time.” Treas Reg §25.2503-3(a). Outright gifts are generally present interests, but may be deemed future interests if benefit is highly restricted.
Gifts to trusts, postponing benefit to a future time, generally do not qualify for the annual exclusion; however, there are three exceptions: income trust, IRC §2503(c) minor’s trust, and Crummey trust. The rarely-used income trust only partially qualifies—it is a gift of both an income interest and a remainder, yet only the income interest qualifies for the exclusion; a gift tax return must be filed for the remainder given. The IRC §2503(c) minor’s trust statutorily qualifies for the annual exclusion even though it is actually a future interest; however, the beneficiary must be given the right to withdraw any remaining property at age 21. The Crummey trust is a popular alternative to both of these techniques because the entire gift may qualify for the exclusion, and the benefit can be postponed much longer.
In a Crummey trust (named after Crummey v Commissioner (9th Cir 1968) 397 F2d 82), the beneficiary has the power to withdraw all or a portion of contributions made to the trust. This power of withdrawal solves the present interest problem and qualifies the contributions for the annual exclusion. The Crummey case held the power to be effective even if given to minor beneficiaries, because a guardian could be appointed in time to exercise the power.
Although the holding itself did not actually require any particular form of notice, most practitioners agree that to qualify under Crummey, the beneficiary must have actual notice of the withdrawal right, and a reasonable time to exercise the right. There must not be any prearranged understanding that the beneficiary will not exercise the right. (The vast majority of beneficiaries seem to understand that exercising the right may diminish the likelihood of future gifts.) So-called Crummey letters are typically sent out notifying beneficiaries of the withdrawal window, which is generally recommended to be at least 30 days, though IRS has allowed windows as short as 15 days. Estate of Maria Cristofani (1991) 97 TC 74.
The Crummey power of withdrawal is a general power of appointment, and lapse of it will be deemed a transfer. The lapse of a Crummey power can have tax consequences (gift, estate, GST, and income) for the powerholder if the withdrawal power exceeds the greater of $5000 or 5% of the property from which the withdrawal power may be exercised. IRC §2514(e).
To avoid these consequences, the Crummey power of withdrawal should generally be limited to the lesser of the “5 or 5 amount” or the donor’s available annual gift exclusion (limit of $5000 until the account value grows over $100,000). Because each individual donee gets only one “free” lapse of a “5 or 5 power” each year, regardless of the number of trusts involved, it is important that the donee’s withdrawal power be reduced by any annual exclusion gifts made to the powerholder earlier in the year.
If any income tax consequence of a lapse in excess of the “5 or 5” amount is acceptable, there are two methods available to at least avoid a current gift (“gift over” to the other beneficiaries) at the time of lapse: special powers of appointment, and hanging powers.
A special power of appointment differs from the general in that it cannot be exercised in favor of the holder, the holder’s estate, or the creditors of the holder or of the holder’s estate, and is usually defined much more narrowly (for example, the holder’s descendants). If there is only one beneficiary and it is likely that the trust will be distributed to that beneficiary during life, or that the trust assets will be included in the estate of that beneficiary should the beneficiary die before termination of the trust, then the “gift over” problem may be avoided by giving the beneficiary a special power of appointment (to descendants) over the excess of the crummy power over the “5 or 5” amount. The power of the powerholder to alter the ultimate beneficiary of a gift will render the gift incomplete. Treas Reg §25.2511-2(b). Under Treas. Reg. § 25.2511-2(b), a gift by a grantor to a trust for his own benefit, of which he is the only beneficiary during his lifetime and the principal and undistributed income of which is subject to a special testamentary power exercisable in favor of his issue at his death, is not a taxable gift because the donor has not parted with “dominion and control”—though a complete gift is made if the power is exercised (or released) during life. Upon death of the holder, the value of property subject to any retained special power will be included in the holder’s estate (as it would with a general power). IRC §2036, IRC §2038. The full value will also be pulled into the estate in case of any release or exercise within three years of death. IRC §2035 (a). This solution may be appropriate for trusts intended to support a minor, with distribution before a family is started, or in other cases where regardless of the power the entire trust corpus is expected to be included in the estate of the beneficiary. However, this method is not recommended where there are multiple beneficiaries, or for generation-skipping trusts, due to estate and GST tax concerns.
For situations involving multiple beneficiaries or generation-skipping, hanging powers may be used. A “hanging” Crummey power simply “hangs” around (accumulating without lapsing), until gifts cease or there is enough growth in the trust corpus to allow it to lapse completely under the “5 or 5” rule. The trust is typically drafted so that all such powers lapse on the same day (for example, January 31 of the following year), but only to the extent they can under that rule. This approach may not work well if there is a concern about the beneficiary withdrawing under accumulated powers.
So-called “naked” Crummey powers are often given to friends or relatives set up as contingent beneficiaries, the powers having no purpose other than to benefit from multiple annual exclusions. Despite losses on the issue (Estate of Maria Cristofani (1991) 97 TC 74, acq 1992-1 Cum Bull 1, acq 1996-2 Cum Bull 1; Estate of Lieselotte Kohlsaat, TC Memo 1997-212), the IRS frequently challenges these arrangements on the basis that they are strong evidence of an advance agreement not to exercise the power.