Contingent beneficiaries and the annual gift tax exclusion.

A longtime and basic tax-planning device for individuals making lifetime gifts is the annual exclusion.(1) With a proper gift tax strategy, an individual may make large lifetime transfers of wealth that escape the gift tax and reduce his taxable estate. As a result of this capability for facilitating large tax-free transfers of wealth, the gift tax exclusion has the potential for being abused as a tax planning technique. This article will review the traditional and intended use of the annual exclusion and examine a more recent liberal interpretation involving gifts to contingent beneficiaries. At odds with the IRS, this new interpretation may portend new, larger and vastly different tax planning techniques for transfers of wealth.

Background

Sec. 2511(a) provides that the gift tax applies to a transfer by gift whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and regardless of what kind of property is transferred. When property is transferred for less than full consideration, the amount by which the value of the property exceeds the value of the consideration will be deemed a gift.(2) Sec. 2501 imposes a tax on the transfer equal to the excess of the tax on the transferor's aggregate taxable gifts over the tax for the transferor's aggregate taxable gifts for prior calendar periods.(3) Taxable gifts here means "the total amount of gifts"(4) less the annual gift tax exclusion, i.e., the first $10,000 of these gifts to each donee is not included in the total amount of gifts made during the year.(5)

Under Regs. Sec. 25.2503-3(a), "[n]o part of the value of a gift of a future interest may be excluded in determining the total amount of gifts made during the |calendar period'." "Future interest" includes reversions, remainders and other interests, whether vested or contingent, that are limited to begin in use, possession or enjoyment at some future date or time.

Regs. Sec. 25.2503-3(b) describes those interests that qualify for the exclusion as any gift of a present interest, an interest that is "[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property...." The distinction between a future interest and a present interest focuses on the immediacy of the right to enjoyment. While the regulations seem to be fairly specific that only a present interest qualifies for the annual exclusion, an issue that keeps arising is the degree of donee ownership in the interest that must be present in order to be considered a present interest. This question was left unanswered in Crummey,(6) and in various letter rulings the IRS has taken conflicting stands. Est. of Cristofani,(7) a 1991 Tax Court case, and IRS Letter Ruling 9030005(8) address the issue of donee ownership in donated property and the impact on eligibility for the annual exclusion. Their conclusions expand on Crummey and may open the door for greater tax-free transfers of wealth.

In most situations, including Crummey, the implication is that the donee has a vested interest or, at least, a certain interest. In Crummey, the settlors established an irrevocable living trust, giving minor beneficiaries annual withdrawal rights and naming them as permissible current distributees under the trustee's power to sprinkle income. At issue was the allowance of the annual exclusion for the minor beneficiaries on the grounds that the minors, withdrawal powers were not gifts of present interests in property.

The Ninth Circuit found that the minor beneficiaries had a legal right to demand payment from the trustees that could not be legally resisted and, therefore, allowed the settlors to claim annual exclusions with respect to the minor trust beneficiaries. The court concluded that all exclusions should be allowed based on the "right to enjoy" test in Gilmore,(9) but never addressed the issue of ownership of an interest.(10)

Subsequent revenue rulings have also recognized that when a trust instrument gives a beneficiary the legal power to demand immediate possession of corpus, that power qualifies as a present interest in the property.(11) This standard, generally known as a Crummey power,(12) has become the criterion for constructing trust instruments that purport to give beneficiaries a present interest and, consequently, allow the donor to use the annual exclusion.

The IRS's Position

While Crummey helped define withdrawal powers that would be eligible for the annual gift exclusion, variations on Crummey powers required further clarification by the Treasury Department. In IRS Letter Ruling 9141008,(13) the taxpayer established a trust to benefit her three children, giving them a limited right of withdrawal. On the death of any of the children, that child's portion of the trust estate would be divided into separate trusts for the then living issue of that deceased child. In addition, the trust provided that for a period of 20 consecutive days following a contribution, but ending before December 31 of the year of the contribution, each child as well as his or her issue or spouse had the right to withdraw from the trust estate an amount that would not exceed the amount of the annual exclusion. Thus, the grandchildren had current demand rights but only a remote contingent interest in the income or the trust corpus. At the time the trust was established, the decedent had three children and 32 grandchildren and great-grandchildren.

At issue in this ruling was a question that had not been addressed in Crummey, namely, whether an annual exclusion would be permitted only for those beneficiaries who had a continuing interest in the trust or whether the exclusion also would apply to those beneficiaries with more remote, contingent interests. The IRS found it significant that none of the 32 grandchildren and great-grandchildren ever exercised any withdrawal rights and inferred that the contingent beneficiaries had reached a prior understanding with the donor that the withdrawal rights would not be exercised.(14) Consequently, naming the grandchildren as beneficiaries lacked economic substance and was motivated purely to reduce transfer taxes. The IRS concluded that the decedent was entitled to annual exclusions attributable to transfers in trust only for the benefit of the primary beneficiaries, the decedent's three children. The annual exclusion was denied for those gifts to remote, contingent beneficiaries.

Although the result of this ruling did not directly answer the question of whether gifts to remote, contingent beneficiaries may qualify for the annual exclusion, the Treasury did address the complementary issue of illusory transactions, distinguishing between those gifts legitimately intended to benefit named beneficiaries and those gifts designed solely to take advantage of the annual exclusion.

Illusory Transactions

The Deal(15) case (which was cited in Letter Ruling 9141008) is an example of an illusory transaction that also did not qualify for the annual exclusion. Deal transferred land in trust for the benefit of her four daughters and received noninterest-bearing demand notes as alleged consideration for a portion of the land's value. Deal subsequently canceled the notes, without consideration, on four different dates. One cancellation occurred the day after the transfer of the land and execution of the notes. Deal then used her specific exemption and four annual exclusions to report as nontaxable the gift of the land's remaining value and the cancellation of the notes. The IRS determined there was a gift of the land's full value and disallowed the annual exclusions. The Tax Court upheld the IRS, stating that there was no evidence that Deal intended to sell the land to her daughters. Instead, a donative intent was evidenced. The notes executed by the daughters and subsequently canceled by Deal were not intended to be enforced and therefore were not intended as consideration. Consequently, these notes did not serve to reduce the amount of the gift. The facts instead supported the IRS's claim that the making and canceling of the notes was a mere device to enable Deal to avoid the gift tax and to claim the annual exclusion on cancellation of the notes.

In Heyen,(16) the taxpayer transferred blocks of stock each worth less than $10,000 to 29 transferees. Each recipient immediately endorsed the stock certificates in blank and the stock was reissued to members of the taxpayer's family. The taxpayer died nine months after the transfer. The court held that the transfers were shams to use the annual exclusion and had no purpose other than tax avoidance. Finding no intent by the donor to make gifts to the transferees, the court upheld findings of fraud.

In Rev. Rul. 85-24,(17) reciprocal withdrawal powers were used to exploit the annual exclusion. Citing Crummey and Rev. Rul. 81-7,(18) the Treasury ruled that when similar trusts are established with matching beneficial interests, no exclusion will be allowed other than for the transfer of property to the trust. Mutual withdrawal privileges of beneficiaries as a tax-saving device will not be considered present interests and thus will not be allowed the annual exclusion. In contrast, the Tax Court concluded in Cristofani that a tax-planning strategy was irrelevant in structuring a transaction.

The Cristofani Ruling

Maria Cristofani established an irrevocable inter vivos trust for her two children (Children's Trust). At her death, the Children's Trust was to be divided into shares equal to the number of surviving children plus deceased children leaving issue. The trust instrument also stipulated that if Cristofani's children survived her by 120 days, each child's trust would be distributed to the child. However, if either child predeceased Cristofani or did not survive her by 120 days, that child's portion of the Children's Trust would be passed in trust to his or her children (i.e., Cristofani's grandchildren). Thus, the five grandchildren were remote and contingent beneficiaries of the Children's Trust. Both of Cristofani's children survived the required time period and, consequently, their trusts were distributed to them.

During Cristofani's life, the Children's Trust also provided the seven beneficiaries with Crummey powers by stipulating that, following a contribution by Cristofani to the Children's Trust and ending 15 days later, each of the seven beneficiaries could withdraw an amount not to exceed the amount of the annual gift tax exclusion under Sec. 2503(b). There were no agreements or understandings among Cristofani, the trustees and the beneficiaries that the grandchildren would not exercise their withdrawal rights following a contribution to the Children's Trust. Nevertheless, none of the five grandchildren exercised their withdrawal rights during 1984 or 1985. Also, none of the five grandchildren received a distribution from the Children's Trust during either year.

For each year 1984 and 1985, Cristofani transferred land valued at $70,000 to the Children's Trust but did not report the two transfers on Federal gift tax returns. Rather, each year Cristofani claimed seven $10,000 annual exclusions for gifts of present interests to Cristofani's two children and five grandchildren.

The IRS disallowed the exclusions, determining that the 1984 and 1985 transfers by Cristofani to the grandchildren as contingent beneficiaries were not transfers of present interests. At issue was not whether a beneficiary had a "present" or "future" interest, or a vested or contingent interest, but whether each of the trust beneficiaries held a sufficient interest in the property that would be eligible for the annual exclusion. Because the regulations include both vested and contingent interests in the definition of a future interest, this issue likely predicts the direction of future challenges to the question of a gift's eligibility for the annual exclusion.

Also germane to Cristofani is the Service's attempt to classify beneficiaries. The Service's efforts to require that a beneficiary hold a "continuing" and "sufficient interest in the property" to qualify for the annual exclusion has no supporting authority and is contrary to published rulings. In Rev. Rul. 81-7, the Service stated that if the courts recognize that a trust instrument gives a beneficiary the power to demand immediate possession and enjoyment of corpus or income, the beneficiary has a present interest eligible for the annual gift exclusion.

* Primary and nonprimary beneficiaries

The IRS attempted to distinguish Cristofani from Crummey by examining the beneficiaries' future economic benefits in the trust corpus and income. In Crummey, the beneficiaries possessed substantial and certain economic benefits. The beneficiaries were entitled to trust income; trust corpus would be distributed to the issue of the beneficiary some time following the beneficiary's death.

In contrast, Cristofani's Children's Trust identified the children as "primary beneficiaries" and the grandchildren as "beneficiaries of secondary importance" who held only contingent remainder interests. The IRS argued that withdrawal rights would qualify for the annual exclusion only when united with "|substantial future economic benefits' in the trust corpus and income." By focusing on the issue of contingent beneficiaries, the Service attempted to add a new dimension to the concept of a present interest, a dimension not explored in Crummey. The Tax Court, however, was not persuaded and concluded that the unrestricted right of withdrawal was sufficient to constitute a present interest eligible for the annual exclusion. Addressing the degree of interest in property necessary to be eligible for the annual exclusion, the court stated that Crummey did not require or imply that beneficiaries of a trust have a vested present interest or vested remainder interest in the trust corpus or income in order to qualify the gift for the annual exclusion. Rather, the court focused on the ability of the beneficiaries to exercise their legal right to withdraw trust corpus and the trustee's right to legally resist a beneficiary's demand for payment. Without any agreement or understanding that withdrawal rights would not be exercised, the Tax Court found that each grandchild received a legal right to withdraw trust corpus. In reaching this conclusion, the court removed any distinction between a contingent beneficiary and a primary beneficiary by focusing on the legal powers of withdrawal held by a beneficiary and by treating a beneficiary's remoteness or contingent status as inconsequential. The court's finding also addressed indirectly the issue of sham transfers, implying that direct, objective evidence is required to establish the existence of a nonexercise agreement.

The IRS's Contradictory Conclusions

The IRS's conclusion regarding contingent beneficiaries in Letter Ruling 9030005 contradicts its findings in Letter Ruling 9141008 and Cristofani. In Letter Ruling 9030005, taxpayer A established an irrevocable trust, with trust income to be paid to B, or if B was not living, to B's living children or to A's son if B had no living children. During A's life, the trustee possessed discretionary authority to distribute trust principal to B for B's support, health and education, or for the special needs of B's children.

The trust also provided that during each year A made a gift to the trust, B and B's children had the right to withdraw from the trust an amount equal to the lesser of the annual exclusion or the beneficiary's share in the donor's accumulative gifts to the trust for the year. When a gift was made to the trust that was subject to a power of withdrawal, the beneficiaries had 30 days to exercise their withdrawal rights.

Citing Crummey and Rev. Rul. 73 405,19 the IRS noted that "[i]f a trust beneficiary is given the power to demand immediate possession and enjoyment of corpus or income, [the beneficiary] may have a present interest." Consequently, it becomes necessary to consider the terms of the trust as well as the circumstances in which the gift was made in order to determine whether the gift is a present or future interest. The Service added that if a gift is made to the trust accompanied by limitations on the donee's present enjoyment of the property, the interest is a future interest even though enjoyment may be deferred for only a short while. Accordingly, the relevant question is not when title vests, but when enjoyment begins.(20)

As in Letter Ruling 9141008, some of the beneficiaries had demand rights but only a remote contingent interest in the income or the trust corpus However, in Letter Ruling 9030005, the Service determined that the contingent beneficiaries held present interests eligible for the annual exclusion As discussed above, the Service reached an opposite conclusion in Letter Ruling 9141008, holding that the gift structure was simply a design tc avoid transfer tax and that the contingent beneficiaries had no intention of exercising their withdrawal privileges.

In all of these decisions, remote and contingent beneficiaries possessed current withdrawal rights. Yet only in Letter Ruling 9030005 were gifts to contingent beneficiaries deemed eligible by the IRS for the annual exclusion. When then may a taxpayer safely claim the annual exclusion for a gift to a contingent beneficiary?

One reason for the IRS's different conclusions may be attributed to the perceived intent of the parties involved. Predicting the IRS's position in Cristofani, both Letter Ruling 9141008 and Heyen focused substantially on sham transactions. In each situation, the structure of the transaction was seen as a device to claim the annual exclusion and avoid the gift tax.

In Letter Ruling 9141008, the IRS also focused on the illusory nature of the powers of invasion, finding it significant that none of the 32 grandchildren or great-grandchildren ever exercised their withdrawal rights over the four-year period from the time the trust was created to the taxpayer's death. The IRS inferred that the 32 beneficiaries had reached a prior understanding with the donor that withdrawal rights would not be exercised and consequently disallowed exclusions for the gifts to the grandchildren.

A second distinction may involve abuse of the annual exclusion. In Letter Ruling 9141008, the donor's claim of exclusions for gifts to 32 beneficiaries who never exercised their withdrawal powers may have seemed offensive to the IRS. In Cristofani, however, there were only five contingent beneficiaries. Does the number of beneficiaries affect whether the IRS considers gifts eligible for the exclusion? If so, how many beneficiaries is considered too many? Five contingent beneficiaries qualify for the exclusion but 29 or 32 beneficiaries will not. Would 13 or 14 beneficiaries be deemed abusive? In Letter Ruling 9141008, would the IRS have reached a different conclusion if any of the beneficiaries had exercised their withdrawal rights? Heyen and Letter Ruling 9141008 appear to concentrate on the abuse of the exclusion and the illusory nature of the transaction. While Cristofani's grandchildren made no withdrawals, perhaps her intent to benefit the grandchildren convinced the Tax Court to allow the exclusions.

Still another distinction between the IRS's rulings involves the length of time permitted for the contingent beneficiaries to exercise their rights of withdrawal. Cristofani involved what appears to be suboptimal conditions and thus may account for the IRS's opposition to present interests. Similarly, in Letter Ruling 9141008, the beneficiaries had only 20 days in which to exercise their withdrawal rights, a period the Service may have considered so short as to render the withdrawal rights illusory in nature. In contrast, in Letter Ruling 9030005, the IRS ruled that a 30-day period allotted to the primary and contingent beneficiaries constituted adequate time to exercise their withdrawal rights. Although these differences in the withdrawal period may appear nominal, they may partially account for the different positions taken by the IRS.

Recent Developments

The Service's recent acquiescence "in result"(21) with Cristofani indicates an intent to question further this technique. While the IRS did not concede Cristofani, it will not continue to litigate this case. Nevertheless, the IRS reserves the right to litigate future cases on these same issues. The court's decision in Cristofani to focus only on the beneficiaries' withdrawal rights permits the exploitation of beneficial tax provisions that were not intended for gifts that would, in all likelihood, never vest. Crummey powers are being used to avoid transfer taxes in ways that the Treasury, and perhaps Congress, never intended. Consequently, this entire arena of avoidance of transfer taxes may be a prime target for judicial or legislative action aimed at altering the result in Cristofani. Significantly, no provisions prohibiting the annual exclusion for gifts to contingent beneficiaries appeared in the Revenue Reconciliation Act of 1993.

Because the Cristofani decision in some cases permits an individual to use contingent beneficiaries in order to increase the number of annual exclusions, the taxpayer may manipulate the amount of wealth transferred free of estate or gift taxes. A donor's tax-free transfer of wealth will be limited only by the number of contingent beneficiaries that he can expect will forgo their withdrawal rights. Consequently, by giving away only contingent interests that may have a negligible chance of vesting, the donor can increase the amount of wealth transferred free of tax. While there is some risk of a contingent beneficiary exercising his right of withdrawal, careful selection of those donees who will receive withdrawal rights will minimize this possibility.

A second consideration for the estate planner and the donor is the interplay of Federal gift tax and Federal estate tax. If a gift is not considered taxable by virtue of using the annual exclusion, the transfer generally also escapes estate taxes at the donor's death, since only adjusted taxable gifts are added to the donor's gross estate for purposes of calculating the estate tax liability. However, if the statute of limitations has expired on a gift that the IRS considers should have been taxable but which it did not contest, the basis for tax liability in the prior closed period may be recomputed for the purpose of calculating the tax liability for the estate's open period.(22) Accordingly, if the IRS has not contested the use of the annual exclusion for gifts to contingent beneficiaries, it may still attempt to include these gifts in the donor/decedent's gross estate.

Planning Tips

Whether gifts to contingent beneficiaries qualify for the annual exclusion has been a question of growing interest since Crummey. By concluding that the withdrawal rights of Cristofani's grandchildren represented present interests and, consequently, qualified for the annual exclusion, the Tax Court ignored the contingent beneficiary argument posed by the IRS. In doing so, the court opened the door to broader, more flexible gift tax planning.

With the Tax Court's approval of Cristofani, estate planners should advise their clients to take an aggressive position, using contingent beneficiaries to effect tax-free transfers of wealth. Although the taxpayer may be challenged by the IRS, he will be no worse off by taking an aggressive position, and the Service, as Cristofani proves, does not always win its contests. The IRS's acquiescence has provided tax planners with little, if any, insight regarding what minimum criteria must be present to qualify remote beneficiaries as donees of present interests. Nevertheless, an overall review of Letter Rulings 9030005 and 9141008 as well as Cristofani creates some guidance. As a reviewed opinion, Cristofani has a greater impact than ordinary Tax Court decisions. In addition, the Tax Court's conclusion is not being questioned by the IRS. But Cristofani should not be viewed as a certain defense of the creation of contingent beneficiaries. Only additional rulings or cases will enable taxpayers and estate planners to know with certainty what types of contingencies will qualify for the annual exclusion. While the Tax Court determined that Cristofani's contingent beneficiaries were not illusory, it remains unclear whether a beneficiary's trust interest will be considered inconsequential and thus challenged by the IRS. Regardless, Cristofani broadens and clarifies the findings in Crummey and provides some understanding of the Tax Court's position. Consequently, the estate planner now has a clearer view of how to construct Crummey powers with regard to contingent beneficiaries.

It is now clear that beneficiaries need not have a vested income interest or a vested remainder interest to be considered in possession of a present interest. Donors may take the annual exclusion for these contingent interests as long as there exists a legal right of current withdrawal and as long as trustees may not legally resist this withdrawal privilege. As such, Cristofani has strengthened the Crummey power as a more powerful tool for wealth transfers.

For now, the aggressive estate planner will rely on the lessons of these cases and rulings. Thus, designation of a beneficiary with a remote and contingent interest will most likely qualify as a gift of a present interest providing the following criteria are met:

* The beneficiary possesses the right of current withdrawal, and the trustee may not legally resist the withdrawal.

* The beneficiary is granted an adequate period of time in which he may exercise his power of withdrawal.

* There is no prior arrangement between the donor and donee not to exercise the right of withdrawal, and the beneficiary's power of invasion is not otherwise illusory in nature.

* The grantor's use of the annual exclusion is not abusive in nature.

Conclusion

The primary rule of Crummey still applies, but Cristofani and Letter Ruling 9030005 have clarified that its scope includes not only beneficiaries with vested interests but also those with mere possibilities of future benefits. While the Cristofani decision strengthens a previously unexplored gift and estate planning technique, the IRS's opposition in that case and in other rulings, as well as its acquiescence "in result," indicate that the Service has not put this issue to rest. Unless withdrawal privileges for contingent beneficiaries are structured in a manner similar to that of Cristofani or Letter Ruling 9030005, the IRS may challenge future attempts to use annual exclusions for contingent interests. Indeed, if there is abuse of the use of contingent beneficiaries who will likely forgo their withdrawal powers, Congress may act to curtail this misuse. In that case, Crummey powers and the Cristofani result may become the target of future legislative or judicial actions to prevent the unintended use of the annual exclusion for the tax-free transfer of large amounts of wealth. Until then, Crummey powers have been strengthened in their potential to permit the tax planner greater flexibility. (1) Sec. 2503(b). (2) Sec. 2512(b). (3) Sec. 2502(a). (4) Sec. 2503(a). (5) Sec. 2503(b). (6) D. Clifford Crummey, 397 F2d 82 (9th Cir. 1968) (22 AFTR2d 6023, 68-2 USTC [paragraph] 12,541). (7) Est. of Maria Cristofani, 97 TC 74 (1991), acq. in result 1992-2 CB 1. (8) IRS Letter Ruling 9030005 (4/19/90). (9) Genevieve U. Gilmore, 213 F2d 520 (6th Cir. 1954)(45 AFTR 1605, 54-1 USTC [paragraph] 10,948). (10) Also citing George W. Perkins, 27 TC 601 (1956). (11) Rev. Ruls. X5-24, 1985-1 CB 329; 81-7 1981-1 CB 474. (12) A Crummey power allows its holder to withdraw amounts transferred to a trust for some period of time after the contribution is made. If the holder does not exercise the power, the withdrawal right will lapse, and the funds transferred to the trust remain part of the trust corpus. (13) IRS Letter Ruling (TAM) 9141008 (6/24/91). (14) Citing Minnie E. Deal, 29 TC 730 (1958), and Est. of Elizabeth B. Murphy, TC Memo 1990-472. (15) Deal, id. (16) Mary Ann Heyen, 945 F2d 359 (10th Cir. 1991) (68 AFTR2d 91 6044, 91-2 USTC [Paragraph] 60,085). (17) Rev. Rul. 85-24, note 11. (18) Rev. Rul. 81-7, note 11. (19) Rev. Rul. 73-405, 1973-2 CB 321. (20) The IRS cited William D. Disston, 325 US 442 (1945) (33 AFTR 857, 45-2 USTC [Paragraph] 10,207), and Ella F. Fondren, 324 US 18 (1945) (33 AFTR 302, 45-1 USTC ]Paragraph] 10,164). (21) Acquiescence "in result" means acceptance of the court's con elusion but disagreement with some or all of the reasons assigned for the decision. (22) Est. of Myrtle S. Levin Prince, TC Memo 1991-208, aff'd, sub nom Marc Alan Levin, 986 F2d 91 (4th Cir. 1993) (71 AFTR2d [Paragraph] 49,083,93-1 USTC [Paragraph] 60,128), cert. denied.

Ronald S. Ross, Ph.D., CPA Assistant of Business Administration Georgetown University Washington, D.C.