Using a Crummey Trust to Preserve Gift Tax Exclusion

A gift qualifies for the annual gift tax exclusion ($14,000 for 2014) only if the transfer is of a present interest in the property. A present interest is defined as an unrestricted right to the immediate use, possession, or enjoyment of the property or the income from it. This present interest requirement often prevents a gift to a trust from qualifying for the annual gift tax exclusion if the trust accumulates income and defers the distribution of principal.

A favorite tool of practitioners is the Crummey trust. It satisfies the present interest requirement while allowing the donor to avoid the requirement of the Sec. 2503(c) trust that all income and principal be distributed to the beneficiary at age 21 and the requirement of the Sec. 2503(b) trust that all income be distributed currently. It was named after a 1968 decision by the Ninth Circuit Court of Appeals that was subsequently accepted by the IRS in Rev. Rul. 73-405 (Crummey, 397 F.2d 82 (9th Cir. 1968)).

In the typical Crummey trust, a periodic contribution of assets to the trust is accompanied by an immediate withdrawal power that gives the beneficiary the right to withdraw the contribution for a limited time. However, the expectation of the donor is that the power to withdraw will not be exercised (although there should be no express agreement to this effect). The beneficiary's limited withdrawal right (a Crummey power) causes the gift to the trust to be a gift of a present interest that can be sheltered by the annual gift tax exclusion. It is the presence of a legal right, not the likelihood of its exercise, that is the determining factor.

In Letter Ruling 199912016, the IRS considered four factors in determining whether a beneficiary's withdrawal (Crummey) right qualified gifts to a trust as present interest gifts:

1. The trust is required to give the beneficiary reasonable notice in which to exercise the withdrawal right;
2. The beneficiary is given adequate time following notice in which to exercise the withdrawal right;
3. Upon exercising the withdrawal right, the beneficiary will have the immediate and unrestricted right to an amount equal to the amount contributed to the trust; and
4. There is no understanding or agreement, expressed or implied, that the withdrawal will not be exercised.

The trust's beneficiary must be given actual notice of the withdrawal right along with a reasonable period to exercise it, generally considered to be 30 days or longer. The IRS has privately ruled that without a current notice that a gift is being transferred to the trust, it is not possible for a donee to have the real and immediate benefit of the gift (Technical Advice Memorandum 9532001). The authors recommend the notification be written; also, a written acknowledgment should be received from the beneficiary or the beneficiary's representative. The trust instrument may limit the withdrawal right to the amount of the annual gift tax exclusion or the fair market value of the property contributed to the trust, whichever is less.

The IRS has long been concerned about trust arrangements that give individuals Crummey withdrawal rights but no other economic interest in the income or principal of the trust (sometimes referred to as "naked" Crummey powers). The IRS holds that the beneficiaries of a Crummey trust must have an actual economic interest in the trust property for the present interest requirement to be satisfied (Letter Ruling 9045002). In other words, the beneficiaries should have a vested right to principal or income for the annual exclusion to apply.

The IRS was dealt a major defeat on this issue in 1991 when the Tax Court ruled that the controlling factor in the present interest requirement was not the likelihood of the beneficiaries' exercising their withdrawal power, but whether the beneficiaries had the power to make the withdrawals (Estate of Cristofani, 97 T.C. 74 (1991), acq. 1992-1 C.B. 1, acq. 1996-2 C.B. 1). Although the IRS acquiesced in the Cristofani decision, it also issued an action on decision (AOD), which indicates it will continue to litigate in situations where the annual withdrawal power is granted to persons who do not have income or vested remainder interests in the trust other than the withdrawal power (AOD 1992-09).

In an unusual move, the IRS issued a second AOD (1996-10) on the Cristofani decision five years after the event. In addition to repeating the rationale of the earlier AOD, the second one states that the IRS will challenge Crummey powers if the withdrawal rights have no real substance, regardless of the power holders' other interests in the trusts. Specifically, the IRS Chief Counsel stated that if there is evidence of an agreement between the donor and the power holder that the withdrawal right would not be exercised, or if the exercise of the right would result in adverse consequences to the holder, the withdrawal right will not be considered a bona fide gift of a present interest. Simultaneously with the release of AOD 1996-10, the IRS issued Letter Ruling 9628004, in which it denied annual exclusions on transfers to trusts, based in part on its finding that the donor and beneficiaries had a "prearranged understanding" that the beneficiaries would not exercise their rights of withdrawal.

Caution: As a result of Letter Ruling 9628004 and AOD 1996-10, practitioners should be aware that the IRS will continue to look very carefully at the substance behind Crummey power holders' rights and the vested interest that a power holder has in the trust. The practitioner should assume that an annual gift tax exclusion will probably not be allowed for a power holder who has no interest in a trust other than withdrawal rights. In addition, the IRS will likely challenge exclusions for powers held by contingent beneficiaries. While the IRS acknowledges that in Cristofani not all of the power holders for whom a gift tax exclusion was allowed by the court had an income or vested remainder interest in the trust (although those that did not were contingent beneficiaries), it does warn that it will continue to deny exclusions for Crummey power holders where the withdrawal rights have no substance, regardless of the beneficiaries' economic interest in the trust.

When the income beneficiary and the remainderman are different individuals, a hidden gift tax trap awaits the Crummey power holder. If the power holder (i.e., the individual who has the power to withdraw the contribution from the trust for a limited period) allows the power to lapse at the end of the specified period, he or she has in effect made a transfer of a future interest in the property to the remainderman. If the power holder or his or her estate is the remainderman, no transfer has occurred, because he or she would simply be making a transfer to himself or herself. Where the power holder and the remainderman are different individuals, the lapse of the power may be a taxable gift from the income beneficiary to the remainderman under the power-of-appointment rules.

To avoid this unexpected gift from the income beneficiary to the remainderman, the Crummey power may be limited to a level that does not exceed the allowable lapsing right gift tax exemption (i.e., the "five and five" limitation, where withdrawals cannot exceed $5,000 or 5% of the trust's assets, if greater). However, this limitation may not allow for full use of the annual gift tax exclusion. Alternatively, the power holder could be given a testamentary power of appointment over the property, which would cause the trust property to be included in the beneficiary's estate. The obvious solution is to make the Crummey power holder the trust's sole beneficiary.

Under Sec. 678(a), a person other than the grantor will be treated as the owner of any portion of a trust over which he has a power to vest trust income or corpus in himself. Therefore, until a Crummey power is exercised or allowed to lapse, the power holder is treated as the owner of any income attributable to contributions made to the trust that are subject to the power. Such income is reported directly to the power holder under the grantor trust reporting rules. If the power holder (beneficiary) allows the withdrawal power to lapse, but retains an interest in the trust property (the usual case), the beneficiary will continue to be treated as the owner of that portion of the trust (Sec. 677 via Sec. 678(a)(2); Letter Ruling 200022035).

To the extent that trust income is taxed to a trust beneficiary under the age of 18, or if the child is age 18 or a full-time student age 19—23 who has earned income equal to less than 50% of his or her support, the kiddie tax rules will apply. To minimize the income tax effects, the trustee could be authorized to invest in non—income-producing property, such as growth stocks, or in tax-exempt bonds.

Other types of trusts may contain a Crummey power; that is, the beneficiary (child) is granted the power to withdraw a specific amount of income or principal annually. This power may qualify gifts to the trust for the annual gift tax exclusion, even though the withdrawals may not actually occur. Also, Crummey clauses can be structured to permit multiple beneficiaries to invade the trust.

Parents may prefer a Crummey trust over a Sec. 2503(c) trust to gain more certainty over the termination of the trust. Assets in a Sec. 2503(c) trust generally must be distributed when the child reaches age 21, unless he or she elects to let the trust continue. This distribution requirement does not apply to a Crummey trust, which can, by its terms, extend termination well past age 21.

To summarize, a Crummey trust can affect the clients' income, estate, and gift tax planning. Therefore, careful consideration should be given to the tax and trust rules before setting up a Crummey trust.

This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals , 15th edition, by Anthony J. DeChellis and Patrick L. Young, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 ( 800-431-9025) ; tax.thomsonreuters.com).