Will a Crummey beneficial interest qualify for an annual gift tax exclusion?

EXECUTIVE SUMMARY

* The IRS continues to embrace a theory it has maintained for a number of years--that a beneficiary's transitory right to enjoy the benefits of a gift in trust is not the only relevant test in determining the availability of the annual exclusion.

* While the Service has recognized the validity of the right-to-enjoy test, it has tried to proffer, in addition, another test before allowing the annual exclusion: the donor's intent that the beneficiary actually obtain some substantial additional benefit from the trust.

* To avoid annual exclusion challenges, the tax adviser should highlight the objective indicators of the client's benevolent intent: (1) the trustee should be required to give notice to beneficiaries of their withdrawal rights and (2) the trust agreement should allow a reasonable time period to make withdrawals.

Despite a number of pro-taxpayer court decisions, the IRS continues to deny the annual gift tax exclusion if a Crummey trust beneficiary has only a right to withdraw trust contributions, without some other economic interest in the trust. This article demonstrates how, even in the face of unfavorable judicial decisions, the Service continues to cling to this position, albeit with a new approach.

Irrevocable "Crummey trusts"(1) are one of the most powerful estate planning devices in use today. Their great utility stems from the fact that they qualify gifts for the Sec. 2503(b) $10,000 annual exclusion. This characteristic, combined with the post-gift control offered by a trust, adds up to a very effective tool for building up assets on the "home base" side of the transfer tax hurdle. Despite persistent IRS challenge, courts continue to support taxpayer interpretations of the law in this area, allowing annual exclusions to be obtained in a variety of contexts.

But tax advisers cannot afford to get complacent. Although recently the Service apparently abandoned one of its arguments for narrowing the scope of Crummey, it continues to embrace a theory it has maintained for a number of years-that a beneficiary's fleeting right to enjoy the benefits of a gift in trust is not the only relevant test in determining the availability of the annual exclusion. As this article explains, the IRS has consistently argued that the beneficiary's right to enjoyment must be accompanied by the donor's intent that the beneficiary actually obtain some substantial additional benefit from the trust. Recent rulings indicate that the IRS has found a new way to proffer this much-rejected contention.

The "Right to Enjoy" Test

Sec. 2503(b) permits taxpayers to transfer up to $10,000 per person per year free of gift tax, but gifts of future interests are not eligible. "Future interests" are defined by Regs. Sec. 25.2503-3(a) as interests limited to commence in use, possession or enjoyment at some future date or time. Most transfers in trust fall within this definition because the beneficiary's ability to use, possess or enjoy the gift is limited by the trust's terms. The Crummey power elevates the status of a gift in trust to that of a present interest, qualifying it for the annual exclusion.

The method is deceptively simple. Crummey powers give the trust beneficiary a limited opportunity to withdraw all or a portion of the donor's transfers to the trust. Because the beneficiary, by way of the withdrawal power, has a right to a present interest, he is deemed to have possession of the property subject to the withdrawal power, whether or not the power is actually exercised(2); courts have termed this the "right to enjoy" test.(3) Simply stated, if a demand of funds under the withdrawal power created by the trust cannot be legally resisted, the power creates a present interest in the funds. If the power is not exercised within a limited period of time, it usually lapses according to the terms of the trust instrument.(4) This "use it or lose it" aspect of Crummey trusts restores the integrity of the trust as a vehicle through which the grantor can control the management and ultimate disposition of the gift.

The IRS has repeatedly shown its willingness to recognize the validity of the right-to-enjoy test.(5) But post-Crummey IRS attacks on the ability of trust withdrawal powers to create annual exclusions have not focused exclusively on the beneficiary's right to enjoy the gift. In the most recent example, Letter Ruling (TAM) 9628004,(6) the IRS denied a total of 19 annual exclusions with respect to. two trusts in which the beneficiaries had lapsing powers to withdraw trust corpus. It concluded that the annual exclusion was unavailable because the facts and circumstances revealed a prearranged understanding that the withdrawal right would not be exercised.

The Donor's Intent Test

The IRS has consistently argued for the addition of a second test beyond the bare withdrawal power--that the donor must intend that the beneficiary enjoy some additional discernible benefit from the trust. The Service looks for evidence of this intent in the trust terms and in the parties' actions.

IRS attacks in this regard generally fall into one of two categories; the Service challenges either the form of the transaction or the insubstantiality of the beneficiaries' income or corpus interest aside from the withdrawal power. In challenges to form, the Service may contend that no annual exclusion is available because the beneficiaries waived their notice and withdrawal rights.(7) Alternatively, it may argue that the beneficiary had insufficient time to exercise the withdrawal power, perhaps because the contribution was made at the end of the calendar year. The crux of the Service's position is that the lack of proper form indicates an absence of donor intent that the beneficiary actually benefit from the gift.(8)

The second type of IRS challenge to annual exclusions is based on the Crummey trust beneficiary's role in the trust's gifting scheme. Essentially, the flimsier the beneficiary's interest in the trust, the more likely the IRS is to challenge the annual exclusion, maintaining that the donor lacked intent that the beneficiary actually benefit.

The IRS has been frustrated in sustaining this challenge.(9) For example, in Est. of Cristofani,(10) the IRS argued that the beneficiaries in Crummey had, in addition to the immediate right of withdrawal, "substantial, future economic benefits" in the trust, while the Cristofani beneficiaries had only a withdrawal right and a contingent remainder interest. The Tax Court refused to draw a bright-line distinction, stating that Crummey did not require that the trust beneficiaries have a vested present or remainder interest in the trust corpus or income to qualify for the annual exclusion.(11) The Tax Court also rejected the Service's argument that the contingent remainder interest in the Cristofani beneficiaries signified the donor's lack of intent to benefit them. In Action on Decision (AOD) 1992-09,(12) acquiescing to Cristofani in result only, the IRS vowed to "deny exclusions for powers held by individuals who either have no property interests in the trust except for Crummey powers, or hold only contingent remainder interests."

Form Over Substance

The IRS signaled a new approach to this issue with the release of AOD 1996-010,(13) in which it underscored its original acquiescence in result only in Cristofani, but offered some new reasoning. It stated that, from now on, it will deny the exclusions for Crummey powers, regardless of the power-holders' other interests in the trust, when the withdrawal rights are not in substance what they purport to be in form.

In TAM 9628004, the Service used the form-over-substance argument it later set forth in AOD 1996-010. Rather than simply deny annual exclusions in accordance with AOD 1992-09 because the beneficiaries had only withdrawal powers or contingent remainder interests, it enumerated several reasons that the withdrawal powers at issue in the TAM lacked substance.

First, one of the trust contributions was not technically entered on the books of the bank in which the trust account was located until after the withdrawal period expired, and beneficiaries in one case were given only four days to demand withdrawals. The Service concluded that the taxpayer's conduct in coordinating the trust's funding and notifying the beneficiaries indicated that the donor did not intend to make bona fide gifts. Second, the trust language did not require that notice be given to the beneficiaries of trust contributions or of their withdrawal rights. Third, some of the beneficiaries had no interest in the trust other than withdrawal powers, while others had only a discretionary income interest during the donor's life.

Finally, the Service compared the facts in the TAM to several substance-over-form judicial decisions. It concluded that while "the taxpayers purported to do something within the statutory provision at issue and set about satisfying all the requirements to ensure the benefit that particular statute afforded . . . the taxpayers intended to do in substance something other than what they purported to do in form."

The argument that the substance of a transaction should prevail over its form has been sparingly used by the courts to recast a transaction in a light unfavorable to the taxpayer; the theory was perhaps most famously employed in Gregory v. Helvering.(14) In that case, the Supreme Court stated that, regardless of whether the form of a tax statute was satisfied, the issue was whether the taxpayer did "the thing which the statute intended." If not, the taxpayer was not entitled to the benefits of the statute.

The intent of Sec. 2503(b) is "to obviate the necessity of keeping an account of and reporting numerous small gifts," and "to fix the amount sufficiently large to cover in most cases wedding and Christmas gifts and occasional gifts of relatively small amounts.(15) The question is, do Crummey powers qualify as such gifts?

A New Test

According to the IRS, the intent of the annual exclusion provision is accomplished by a gift in trust only when the individuals holding withdrawal powers have "current or long term economic interests in the trust and in the value of the corpus" (e.g., current income or vested remainder interests).

Before the IRS can persuade the courts to accept this new reasoning, it must convince them to recede from the rationale stated by the Tax Court in Cristofani, that Crummey does not require a beneficiary to have a vested interest to qualify a gift for the annual exclusion. In any event, the IRS will almost certainly have to drop its current litmus test of a "current or long term economic interest."

Recently, in Est. of Kohlsaut,(16) the decedent had made an inter vivos transfer of a commercial building to an irrevocable trust, and granted 18 beneficiaries (16 contingent) unrestricted rights to demand immediate distributions of trust property. Consistent with AOD 1996-010, the IRS argued that substance-over-form doctrine should apply to deny 16 of the annual gift tax exclusions claimed.

The Tax Court allowed the exclusions, finding no agreement between the decedent and the contingent beneficiaries not to exercise their withdrawal rights. The opinion does not address substance-over-form doctrine in detail; thus, the IRS is certain to raise the argument again at the next opportunity.

Conclusion

The IRS has not been idly standing by while taxpayers indiscriminately leverage their annual exclusions with Crummey trusts. In fact, as rulings and cases demonstrate, the IRS continues to fight on this issue. It continues to argue that no annual exclusion should be allowed when the donor does not intend that the done have any substantial benefit from the trust. Regardless of how courts react to the IRS's new substance-over-form approach to this argument, it is more important than ever for the tax adviser to highlight the objective indicators of the client's benevolent intent.

The trustee should be required to give notice to beneficiaries as soon as possible after a contribution subject to withdrawal rights is made to the trust; beneficiaries should have a reasonable time thereafter to make the withdrawal.(17) Although no safe harbor can be identified, it is very likely that notice within seven days of the contribution and a :30-day withdrawal period will suffice.(18) Obviously, the notice should be documented, as it must be actually given-merely including the requirement in the trust agreement will not suffice.

Beneficiaries with remote or attenuated interests in a Crummey trust (i.e., those without a current income or vested remainder interest) will continue to raise a red flag for IRS challenge. Therefore, despite significant taxpayer victories like Cristofani, withdrawal powers should be sparingly used to meet the taxpayer's needs. When they are used, the tax adviser should point out the risk involved in extending the number of Crummey trust beneficiaries past those with a vested interest in the trust.

(1) This term refers to the type of trusts involved in D. Clifford Crummey, 397 F2d 82 (9th Cir. 1968)(22 AFTR2d 6023, 68-2USTC 12,514), aff'g and rev'g TC Memo 1966-144 (holding that minor beneficiaries withdrawal rights were present interests that qualified for type annual exclusion.

(2) Ideally, the beneficiary would not exercise the withdrawal power; this would defeat the purposes of the trust. For generation-skipping transfer tax purposes, withdrawal powers qualify for annual exclusions only if no portion of the trust can be distributed to anyone other than the powerholder during his life, and the trust assets will be included in the powerholder's estate if he dies before the trust terminates.

(3) See, e.g., Genevieve U. Gilmore, 213 F2d 520 (6th Cir. 1954)(45 AFTR 1605, 54-1 USTC [paragraph] 10,948), rev'g 20 TC 579 (1953).

(4) Generally, the time period, which should be specified in the trust agreement, will be 30-60 days. The lapse of a withdrawal right may be deemed a taxable gift by the powerholder if the property subject to the withdrawal right may, due to the lapse, be held or distributed to someone else. This is an important issue to be aware of when advising in this area, but is beyond the scope of this article.

(5) See, e.g., IRS Letter Ruling 8004172 (11/5/79) (lapse of withdrawal power after 30-day notice period did not preclude availability of annual exclusion).

(6) IRS Letter Ruling (TAM) 9628004 (4/1/96).

(7) See, e.g., IRS Letter Ruling (TAM) 9532001 (4/12/95).

(8) In denying an annual exclusion in Rev Rul. 81-7, 1981-1 CB 474, the IRS focused on the donor's and trustee's failure to notify the beneficiary of the demand right, and the short time period given to exercise it. The IRS concluded that those two factors indicated that the withdrawal power was illusory. In Rev Rul. 83-108, 1983-2 CB 167, the IRS distinguished Rev. Rul. 81-7 because notice was required within 10 days after the transfer, and the beneficiary then had 45 days to exercise the withdrawal power. In ruling for the taxpayer, the Service stated that imposition of the notice requirement on the trustee serves to better ensure that the beneficiary will have an opportunity to exercise the withdrawal right.

(9) Apparently, the IRS has always struggled when creating guidelines as to the class of beneficiaries that can have effective Crummey powers in trust agreements. Courts have been willing to accept withdrawal powers as qualifying gifts for the annual exclusion even when the beneficiary has very little interest in the trust aside from the withdrawal power. Despite holding for the taxpayer, the Ninth Circuit in Crummey note 1, observed the gulf between the practical use of such trusts and the theoretical arguments on which its opinion was based; it opined that it was highly unlikely that any demand would be made on the trust assets, and that it was likely that some (if not all) of the beneficiaries did not even know that they had a withdrawal right.

(10) Est. of Maria Cristofani, 97TC 74 (1991).

(11) Id., p. 83.

(12) AOD 1992-09 (3/23/92)

(13) AOD 1996-010 (7/15/96).

(14) In Evelyn E Gregory v Helvering, 293 US 46s (1935)(14 AFTR 1191, 35-1 USTC [paragraph] 9043), the IRS argued that a tax-free spin-off without a business purpose should be ignored and that the shareholder should pay income tax on corporate stock as though it had been distributed to her as a dividend. In holding for the IRS, the Supreme Court concluded that form should not be honored over substance; the plan effected by the taxpayer performed no other function than that of a "mere device" to reduce her tax liability.

(15) See S. Rep. No. 72-665, 72d Cong., 1st Sess. (1932), 1939-1 (Part 1) CB 525.

(16) Est. of Lieselotte Kohlsaut, TC Memo 1997-212.

(17) See, e.g., Rev. Rul. 83-108, note 8 (annual exclusion permitted because the trustee had to give notice within 10 days after a contribution and the beneficiary had 43 days after receipt of such notice to exercise the withdrawal power).

(18) See IRS Letter Ruling (TAM) 8712014 (12/18/86) (annual exclusion permitted because the trustee was required to give notice within seven days after the contribution and the beneficiary had at least 30 days to exercise the withdrawal right); IRS Letter Ruling 8004172, note 5 (notice within seven days, 30 days to exercise sufficient).