IRS curbs use of Crummey powers.

A very common estate planning technique (and one employed in most insurance trusts) is the granting of Crummey withdrawal powers to trust beneficiaries. The inclusion of such powers in a trust agreement enables the grantor to qualify gifts to the trust for the Sec. 2503(b) gift tax annual exclusion, thereby avoiding gift tax or use of the lifetime unified credit.

Normally, gifts to trusts do not qualify for the gift tax annual exclusion, because they are almost always considered transfers of future interests; only transfers of present interests are eligible for the exclusion.

Law

Under Sec. 2503(b), the first $11,000 of gifts (other than gifts of future interests in property) made by a donor to any donee during a calendar year are excluded from the total gifts made during such year. Thus, an individual can make "present interest gifts" of up to $11,000 per year per donee, with no limit on the number of donees, without having those gifts treated as taxable gifts.

For example, if a donor desired to benefit 20 of his or her closest friends and family, he or she could gift (and, thus, remove from his or her estate) a total of $220,000 a year, without gift tax or use of the available lifetime credit, provided each of the gifts were gifts of present interests. If the donor followed this gifting pattern over a 10-year period, he or she could effectively remove $2.2 million from his or her estate gift tax free, with no depletion of the lifetime credit. Thus, annual exclusion gifts are an extremely powerful tool.

Regs. Sec. 25.2503-3(b) defines a present interest in property as "an unrestricted right to the immediate use, possession or enjoyment of property or income from property (such as a life estate or term certain)." In contrast, Regs. Sec. 25.2503-3(a) defines a future interest in property to include "reversions, remainders, and other interests or estates, whether vested or contingent ... which are limited to commence in use, possession, or enjoyment at some future date or time."

Donors often prefer making gifts in trust for the benefit of family members, rather than gifting them outright, especially when the potential donees are minors or individuals who cannot presently be trusted to effectively manage a gift. Gifts in trust, however, are typically future interest gifts, because the trust provisions often delay the beneficiaries from using or enjoying the trust property until a later date. To ensure that gifts in trust qualify for the gift tax annual exclusion, the most common drafting technique is to give one or more beneficiaries the right to withdraw amounts contributed to the trust for a specified period (usually not less than 30 days) after the contributions are made; these rights of withdrawal are commonly known as Crummey powers, after Crummey, 397 F2d 82 (9th Cir. 1968), in which the Ninth Circuit approved their use. That court found that the lapsing withdrawal rights given to four trust beneficiaries, although never exercised, gave those beneficiaries the right to immediate possession of the contributed property; thus, the donor was entitled to the annual exclusion for the gifts deemed made to each of the four beneficiaries.

On the Attack

Over the years, the IRS has been on the attack (largely unsuccessfully) in trying to limit the use of Crummey powers. The Service has indicated its intent to deny exclusions for gifts to holders of Crummey withdrawal powers when (1) the powerholders have no beneficial interest in the trust other than their withdrawal powers; (2) the powerholders hold only contingent remainder interests or discretionary income interests; or (3) the facts and circumstances indicate a prearranged understanding that the powerholder will not exercise his or her withdrawal power.

While to date, no court has ruled on whether an annual exclusion is available for a gift to a powerholder having no other beneficial interest in a trust, the Tax Court has upheld Crummey powers given to persons holding only contingent remainder interests in a trust and allowed the annual exclusion; see Est. of Cristofani, 97 TC 74 (1991) and Est. of Kohlstaat, TC Memo 1997-212 (1997). Despite its defeat in these decisions, the IRS is still trying to adhere to its position of denying annual exclusions to persons with only contingent remainder interests; see AOD 1992-09.

Pre-arrangement: More recently, the IRS has tried to deny annual exclusions by inferring from the powerholder's nonexercise a prearrangement between the grantor and the powerholder not to exercise withdrawal rights. The IRS has argued that, when a powerholder only has a contingent remainder interest in the trust and lets his or her Crummey power lapse, there must be an implied understanding that no exercise is to occur; thus, such power lacks real substance. If that were not the case, argues the ILLS, why would a powerholder let his or her right lapse, when his or her chance of realizing future economic benefit from the trust is tenuous?

The IRS has largely had a difficult time proving the existence of a prearranged agreement. Courts have generally rejected its position, finding its evidence of an "implied understanding" wanting; see Est. of Kohlstaat and Est. of Holland, TC Memo 1997-302 (1997), but see Est. of Trotter, TC Memo 2001-250.

Newest Ruling

In its latest ruling on the matter, Letter Ruling (TAM) 200341002, the IRS ruled that a grantor was not entitled to the gift tax annual exclusion for gifts he made to a trust subject to Crummey withdrawal powers in the hands of four charities. It concluded that the charities' non-exercise of such powers indicated an implied understanding among the parties that no exercise was ever to Occur.

Facts: In the ruling, a grantor created an irrevocable life insurance trust for the benefit of his children and four named charities. During the grantor's life, the trustee could invade the trust to pay to any individual beneficiary the principal and/or income deemed necessary for such beneficiary's education, health, maintenance or support. On the grantor's death, the trust agreement provided that the remaining trust corpus and undistributed income was to be divided among the grantor's children and the named charities in specified percentages. Additionally, during the trust term, the grantor's children and the four named charities all had a 30-day Crummey power, allowing each beneficiary the right to withdraw a specific share of any gift made to the trust.

The trustee sent written notifications to all the powerholders regarding annual gifts made to the trust. However, none of the powerholders ever exercised any withdrawal right.

Ruling: In the ruling, the IRS did not challenge the availability of the gift tax annual exclusion for the withdrawal powers held by the grantor's children, but denied the grantor the gift tax annual exclusion for the withdrawal powers held by the four charities. The IRS concluded that the latter Crummey powers lacked substance and were illusory; there was an implied understanding between the grantor and the charities that the latter would never exercise those powers.

The IRS also noted that, under the trust terms, any amounts the charities failed to withdraw could fall subject to distribution, at the trustee's discretion, to an individual beneficiary during the grantor's life, leaving nothing remaining for the charities on the grantor's death. Thus, the IRS found that the trust agreement essentially gave the charities the choice of withdrawing the funds from each gift to the trust, or allowing the funds to remain in trust subject to distribution to the grantor's children for noncharitable purposes, with the charities potentially receiving a distribution on the grantor's death. In light of the strict ban state law imposes on the use of a charity's property for private purposes and the fiduciary, obligations imposed on a charity and its directors not to allow diminishment of the charity's property, there was no way the charities would risk losing the funds subject to their withdrawal rights and allow all 44 withdrawal opportunities to lapse; thus, there must have been an implied understanding between the grantor and the charities that the latter would not exercise its power. Thus, the IRS found the charities' Crummey powers to be illusory and denied annual exclusions.

Conclusion

In light of the IRS's continued attacks on Crummey powers, taxpayers should take care in selecting powerholders and not grant such powers to charities or individuals having no other economic interest in the trust.

FROM IRA C. OLSHIN, CPA, J.D., LL.M., NEW YORK, NY