Crummey Tax Trap.

Is "Relief" in Store To Conform Gift Tax and GST Tax Annual Exclusions?

Atrap for the unwary: that is what obtaining an annual exclusion for gift tax vs. generation-skipping transfer (GST) tax purposes can create for some unsuspecting tax advisers and their clients. This trap occurs if there is a transfer to a trust that is subject to both gift and GST taxes. If a "Crummey power" is used to qualify the transfer for the gift tax annual exclusion, the transfer may not qualify for the GST tax annual exclusion.

GIFT TAX ANNUAL EXCLUSION

Under IRC Sec. 2503(b), annual gifts of "present interests" up to $10,000 (indexed for inflation) per donor per donor are exempt from the gift tax. This exemption is called the annual exclusion. Generally, a transfer in trust is not considered a transfer of a present interest to a trust's beneficiary. However, in Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968), a transfer in trust was considered a transfer of a present interest since the trust instrument permitted the beneficiary to withdraw the transferred amount for a limited period of time (often 30 days or less). Thus, so-called Crummey powers are often used to allow a transfer of a $10,000 gift to a trust to qualify for the annual exclusion.

In Crummey, the withdrawal power's holder was the trust's ultimate beneficiary. In more recent cases, such as Estate of Cristofani, 97 TC 74 (1991), and Estate of Kohlsaat, 73 TCM 2732 (1997), the trust agreement was drafted to give withdrawal rights to individuals who did not have substantial economic interests in the trust. However, by pre-arrangement or understanding, these individuals usually do not exercise those withdrawal rights.

GST TAX ANNUAL EXCLUSION

An annual exclusion also is available for the GST tax. However, the trap arises because, under IRC Sec. 2642(c), the GST tax annual exclusion does not apply to any transfer to a trust for an individual's benefit unless:

* During that individual's life, no portion of the trust's corpus or income may be distributed to, or for the benefit of, any other person; and

* If the trust terminates before the individual dies, the trust's assets will be includible in this individual's gross estate.

PRESIDENT CLINTON'S PROPOSAL

The Clinton administration is concerned that granting a withdrawal right to a person who does not have a primary interest in the trust to obtain the use of an additional gift tax exclusion constitutes an unreasonable, unintended expansion of the annual exclusion and the Crummey decision. Thus, the administration believes that:

* the Cristofani and Kohlsaat decisions, which allowed such expanded withdrawal rights, should be overruled;

* the mechanics of issuing withdrawal notices under Crummey are burdensome because of the paperwork involved;

* the differing requirements for an annual exclusion under the gift tax and GST tax provide a trap for the unwary; and

* this area would be simplified if the gift tax rules and the GST rules were conformed.

Therefore, President Clinton's 2001 fiscal year budget proposal would conform the gift tax annual exclusion rule to the GST tax rule. Under this proposal, the gift tax annual exclusion would not apply to any transfer to a trust for an individual's benefit unless the transfer meets the same requirements that exist to obtain a GST tax annual exclusion (described above). Also, no withdrawal right or notice to the beneficiary would be necessary for a transfer to such a trust to qualify for the annual exclusion.

This proposal would be effective for transfers to trusts after 2000, and a grandfather rule would apply to trusts in existence on the date of enactment. The grandfather rule would maintain existing law (allowing the use of Crummey powers to create a present interest) but would disallow any annual exclusion attributable to a withdrawal right in a person who is not a primary, noncontingent beneficiary of the trust.

The IRS would have authority to prescribe regulations that are necessary to carry out the purposes of this proposal, including rules for determining whether or not an annual exclusion is attributable to a withdrawal right.

Stuart R. Josephs, CPA, has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation and a member of the California CPA Editorial Advisory Board.