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Income shifting through gifts and trusts.

One of the most fundamental yet far reaching means of shifting income while reducing one's taxable estate is through the making of gifts. While recent changes in the law have reduced some of the allure of gift giving, e.g, the Tax Reform Act of 1986 amendments largely eliminating the utility of a Clifford or Spousal remainder trust(1) and establishing the IRC Section 1(1) Kiddie Tax, the making of gifts remains a vital element in financial and tax planning. In order to maximize the benefits of gift giving, it is desirable to have the gift qualify for the annual exclusion from gift tax.(2) In certain instances it may be advantageous to make gift transfers in excess of the available exclusion amount. Gift tax on such transfers will generally be averted through use of the unified credit.(3) Making such sizeable gifts can be useful both to shift income and get property that is anticipated to appreciate in value out of one's estate and avoid being subject to a large income tax should the appreciated asset be sold.

Despite these beneficial aspects, many taxpayers are reluctant to make gifts for fear that in order to merit the gift tax exclusion a direct transfer to the intended beneficiary must be made. This reluctance is most prominent when the beneficiary is a minor or a person whom the taxpayer perceives as irresponsible. In large measure, this fear is based upon the requirement that to qualify for the gift tax exclusion the gift must be of a present interest in the property. Reg. 25.25033(b) defines a present interest in property as an unrestricted right to the immediate use, possession or enjoyment of property or the income therefrom.(4) Nevertheless, the tax law does provide relief from having to make such direct transfers by allowing the annual exclusion for transfers made to certain types of trusts even though the beneficiary may not actually get to currently enjoy the use of the transferred asset.

The Section 2503(c) Trust

Probably the most attractive arrangement enabling qualification for the annual exclusion without making a direct transfer to a beneficiary is the Section 2503 (c) trust. According to Section 2503(c) a transfer to a trust will be considered a transfer of a present interest in the property and the income therefrom:

1. May be expended by or for the benefit of the donee before his attaining the age of 21 years and

2. Will to the extent not so expended (a) pass to the donee or his attaining the age of 21 years and (b) in the event the donee dies before attaining the age of 21 years be payable to the estate of the donee or as he may appoint under a general power of appointment as defined in Section 2514(c).

On the face of it, Section 2503(c) already appears generous in that it enables qualification for the annual exclusion despite there being no guarantee that the beneficiary will receive anything from the trust prior to his reaching age 21. In reality however, Section 2503(c) has been constructed by both the courts and the service to be even broader than the language of the statute might suggest. Despite this latitude there does exist pitfalls which one must take into account in structuring the trust to assure its qualification under Section 2503(c).

One of the cardinal virtues of Section 2503(c) is that it enables qualification for the annual exclusion without requiring that a distribution made to a beneficiary. The provision does require, however, that the trustee have discretion to make such a distribution. While having no language interpretable as limiting the trustee's discretion is the safest means to assure satisfaction of this language, both cases and service pronouncements indicate that some qualifying language is permissible. According to Reg. 25.2503-4(b), sufficient discretion exists if "There is left to the discretion of the trustee the determination of the amounts, if any, of the income or property to be expended for the benefit of the minor and the purpose for which the expenditure is to be made, provided there are no substantial restrictions under the terms of the trust instrument on the exercise of such discretion."

As evidenced by the preceding language, a key element to Section 2503(c) qualification is not that there be absolutely no limitation on the trustee's discretion, but instead that there be no substantial restrictions" on such discretion. Thus, in Rev. Rul. 67-270, the Service ruled that trust language giving the trustee the discretion to use principal for the donee's support, care, education, comfort and welfare could still satisfy Section 2503(c). Cases have gone even further by finding that language providing the trustee with discretion to expend trust funds for the support, maintenance or education of the beneficiary(5) and for the support, maintenance, education, medical care and general welfare of the beneficiary (6) do not constitute substantial restrictions on the trustee's discretion.

In contrast to the above situations, substantial restrictions on the trustee's discretion have been found where the payment of any amount to a beneficiary was based upon a contingency or standard. For example, in the case of Ritland, (7) a trust otherwise qualifying undersection 2503(c) was found not to satisfy Section 2503(c) where the trust had multiple trustees who could only make a distribution upon their unanimous consent. Requiring such unanimity was found a contingency preventing Section 2503(c) qualification. Likewise a trustee's having discretion to make distributions only after examining the beneficiary's other available resources prevented Section 2503(c) qualification due to the unlikelihood based upon the circumstances that a distribution would then be made.(8)

Use of the trust to satisfy legal obligations of the grantor is yet another factor which may prevent Section 2503(c) qualification.(9) Where such is found, the trust will likely be considered a grantor trust with its income taxable to the grantor, with no gift being deemed made.

21 - The Magic Age

Section 2503(c) provides that the beneficiary should be provided with what amounts to a general power of appointment over the property upon reaching age 21. Any language limiting the beneficiary's testamentary power over the property in the trust will jeopardize qualification for the annual exclusion. For example, cases reveal that language in the trust providing that the property shall pass to the donee's heirs at law or next of kin constitutes a limitation on the donee's dispositive powers which will prevent satisfaction of Section 2503(c).(10) While limitations on the beneficiary's dispository powers are taboo under Section 2503(c), absolute distribution of the assets to the beneficiary upon the beneficiary's reaching age 21 is not mandatory.

For many years the Service assumed a hard line stance, asserting that distributions were required upon the beneficiary reaching age 21. After defeats on this point in the courts, the Service finally altered its position in 1974 with the issuance of Rev. Rul. 74-43. According to Rev. Rul. 74-43, a gift to a minor in trust which provides that upon reaching age 21 the beneficiary has either the continuing right to compel the immediate distribution of the trust corpus upon providing the trustee with written notice, or allowing the trust to continue under its own terms or a right "during a limited period" to compel immediate distribution of the trust corpus through the providing of written notice, or allowing the trust to continue under its own terms will not cause the interest transferred to be considered a future interest for gift tax purposes.

As indicated by numerous private letter rulings, the use of a clause giving the beneficiary a limited period of withdrawal in a Section 2503(c) trust has become commonplace. A safe period as reflected by these rulings for allowing the exercise of the right of withdrawal is 60 days.(11)

Tightening the Belt

In 1981, with the issuance of Rev. Rul. 81-7, the Service added a further gloss to the circumstances whereby Section 2503(c) could be satisfied by giving the beneficiary a right to demand distribution. The tenor of this ruling coincides with the ruling pertaining to Crummey Trusts. According to the ruling merely providing a right to demand distribution will not enable qualification as a present interest, if such right is illusory. To avoid having the right be potentially found illusory, adequate notice of the right must be provided the beneficiary to enable the beneficiary to have a reasonable opportunity to exercise it, and the beneficiary should be legally capable of exercising the right. Thus, in Rev. Rul. 81-7 where the donor established a trust near year end and did not inform the beneficiary of the demand right before such right had lapsed, the right was deemed illusory and the annual exclusion not qualified for. In Rev. Rul. 83-108, the Service helped clarify what it considered a reasonable opportunity to utilize a right to demand distribution. In the ruling, a 45-day withdrawal period with regard to which the beneficiary was given adequate notice was considered adequate to qualify for the annual exclusion.

In Rev. Rul. 81-7, the actions of the donor in providing adequate notice resulted in the denial of the gift tax exclusion. While one-sided action such as that illustrated in Rev. Rul. 81-7 may well reflect the stereo-type illusory transfer, there exist other scenarios in which an illusory transfer may be found, such as where at the time of the transfer the beneficiary suffers from a disability preventing the valid exercise of the right of withdrawal. To some degree the regulations mitigate this problem by stating that giving a minor a power of appointment exercisable during his lifetime or pursuant to his will, which the beneficiary is unable to exercise under local law, will not cause failure of Section 2503(c). Although encouraging, the application of this regulation appears limited to the disability being that of minority. Where the beneficiary suffers from some other disability, e.g., physical, mental or emotional, steps should be taken to assure that a guardian or someone else with a fiduciary obligation to the beneficiary is appointed to act on the beneficiary's behalf with regard to the power in order to protect the transfer from being deemed illusory.

In recent private letter rulings pertaining to Crummey Powers, but also relevant to transfers under Section 2503(c), where withdrawal rights are provided the beneficiary, other grounds for finding the transfer illusory have been established. According to the rulings, a transfer made to a trust concerning which the beneficiary has a right to demand distribution will not be recognized as the transfer of a present interest where the beneficiaries and grantor have entered into an agreement pursuant to which the beneficiaries will not exercise their rights to demand distribution.(12) As reflected by PLR 9045002, such an agreement may be inferred from the facts and circumstances.

PLR 9045002 involved a transfer in trust to multiple beneficiaries. While each beneficiary was given a right to demand withdrawal from the trust, a number of the beneficiaries were remote contingent beneficiaries whose only probable chance for deriving any benefit from the trust was through the exercise of their rights to demand distribution. Based upon the transfer in trust the grantor claimed multiple annual exclusions. These exclusions included those for the remote contingent beneficiary's proportionate share of the trust. Some four years had passed and the remote contingent beneficiaries had not exercised their power to demand distributions. The Service reasoned that given the length of time that had passed and the unlikelihood that the remote contingent beneficiaries would receive any benefit from the trust absent their exercise of the right to demand distribution, an agreement must have existed according to which the remote contingent beneficiaries would not exercise their rights of withdrawal.

Thus, the Service denied gift tax exclusions for the proportionate shares in trust of the remote contingent beneficiaries.

Conclusion

The Section 2503(c) trust holds great promise as a tool for income shifting and estate reduction. Already generous by the express terms of the statute, an examination of the tax law concerning Section 2503(c) reveals that it is even more liberal than a literal reading of its wording might suggest. Thus, Section 2503(c) trusts constitute a valuable and flexible tool for practitioners. By being aware of Section 2503 (c) and what is permitted in qualifying under it, practitioners can better help clients meet their tax and financial planning objectives.

Footnotes

1. IRC Sections 673(a) and 672(e).

2. See IRC Section 2503(b) regarding the annual exclusion from gift taxation and Section 2513 regarding split gifts.

3. IRC Section 2505.

4. Note Peg. 25-2503-3(a) provides a definition of a future interest in property.

5. Mueller v, Commissioner 23 AFTR 2d 1864 (W.D. Mo., 1969).

6. Williams v. United States, 378 F. 2d 693 (Ct. Cl. 1967).

7. Ritland, TC Memo 1986-298, Note also that too narrowly defining the basis of distribution may result in ineligibility as a Crummey Trust, e.g., solely for expense of illness. Faher, 435 F. 2d 1189 (6th Cir. lg 71).

8. Rev. Rul. 69-345, 1969-1 C.B. 226.

9. See however UpJohn v. United States, 30 AFTR 2- 5918 (W.D. Michigan 1972).

10. Ross z,. Commissioner, 652 F.2d 1365 (9th Cir. 1981) and Herzherg, 30 TCM 1046 (1971).

11. PLRs 8521089 and 8507017, and Rev. Rul. 85-2,4.

12. Note in PBR 87270C3 the Service denied an annual exclusion where an express agreement existed between the grantor and beneficiaries pursuant to which the right to demand distribution would not be invoked.
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Author:Segal, Mark A.
Publication:The National Public Accountant
Date:Jul 1, 1991
Words:2272
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