Gifts to Trust Qualify for Annual Exclusion

Estates, Trusts & Gifts

The Tax Court held that the withdrawal rights provided in a trust declaration were not illusory and that therefore a married couple’s gifts to the trust were gifts of present interests in property that qualified for the annual exclusion.

Background

On June 7, 2007, Israel and Erna Mikel established the IEM Family Trust, an irrevocable inter vivos trust. The trust’s beneficiaries were the Mikels’ children and lineal descendants and their respective spouses. On June 15, 2007, the Mikels jointly transferred property to the trust with an asserted value of $3,262,000. The trust at the time allegedly had 60 beneficiaries, many of whom were under 18 years of age.

For the year the trust was created and each subsequent year, Article V of the trust declaration allowed each of its beneficiaries to withdraw the lesser of a formula-derived amount or an amount equal to the maximum federal gift tax exclusion in effect at the time of the transfer. The trust was required to notify all beneficiaries (or, where applicable, their guardians) when it received property to which the beneficiaries had a demand right. The demand right was required to be exercised in writing and lapsed within 30 days.

In addition, Article VI of the trust declaration gave the trustees the power, “in their sole and absolute discretion,” to make discretionary distributions from income and principal for the health, education, maintenance, or support of any beneficiary or family member and, in the trustees’ “absolute and unreviewable discretion,” to assist a beneficiary in defraying “reasonable wedding costs, . . . purchasing a primary residence, or . . . entering a trade or profession.”

Article XXVI of the trust declaration provided that if any dispute arose concerning the proper interpretation of the distribution provision in Article VI, that the dispute “shall be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith” (in Hebrew, a beth din). The beth din was directed, in the event of any dispute, to enforce the trust declaration and give any party the rights he or she is entitled to under New York law and to construe the declaration as a whole “to effectuate the intent of the parties . . . that they have performed all the necessary requirements” for the trust declaration to be valid under Jewish law.

Further, Article XXVI of the trust declaration contained an in terrorem provision designed to discourage beneficiaries of the trust from contesting the trustees’ discretionary acts performed under Article VI. Under this provision, if a beneficiary did so, the provision in the trust for the beneficiary would be revoked and the beneficiary would be excluded from participating in the trust.

In October 2007, the trust provided each beneficiary notice of his or her right of withdrawal and that this right would lapse after 30 days.

The Mikels timely filed a gift tax return for 2007. On it, they reported gifts of assets appraised at $3,262,000 to the trust. The return indicated that the gifts were split gifts and claimed annual gift tax exclusions of $720,000 for each of the Mikels ($12,000 per beneficiary multiplied by 60 beneficiaries). After application of the Mikels’ lifetime unified credits, the returns showed no gift tax due on the transfers to the trust.

The IRS disagreed with the Mikels’ claims of the annual exclusion for the gifts to the trust and determined in separate notices of deficiency that the Mikels were ineligible for the exclusions. The Mikels each filed a petition with the Tax Court challenging the IRS’s determination, and the Tax Court consolidated their petitions for trial.

The Tax Court’s Decision

On a motion for summary judgment, the Tax Court held that the Mikels were entitled to the annual gift tax exclusion for their transfers of property to the trust. The court rejected the IRS’s argument that the annual exclusion was not available for the transfers because they were not gifts of a present interest in property.

In its opinion, the court first reviewed the annual gift tax exclusion and the requirements for a taxpayer to claim it for a gift. Under Sec. 2503, an annual exclusion is allowed for taxable gifts, the amount of which, as adjusted for inflation, was $12,000 in 2007. However, the annual exclusion is available only for gifts of a present interest in property, which is defined in Regs. Sec. 25.2503-3(b) as “[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.” Also, per the regulations, no part of the value of a gift of a future interest may be excluded from taxable gifts.

With respect to a gift to a trust, the IRS will generally not contest that the gift is a valid gift of a present interest in property where the trust instrument gives the beneficiaries of the trust the power to demand immediate possession and enjoyment of principal or income of the trust. This is known as a Crummey power (and trusts that contain such a power are known as Crummey trusts) after the case in which this device was first approved, Crummey, 397 F.2d 82 (9th Cir. 1968).

The court explained that despite following this general rule, the IRS has stated that it will challenge annual exclusions if there was a prearranged understanding that the withdrawal right will not be exercised or that doing so would result in adverse consequences to its holder (e.g., losing other rights or gifts under the trust instrument or other beneficial arrangement). The IRS argued that in the Mikels’ case, the withdrawal right was illusory because any attempt to seek legal enforcement of that right would result in adverse consequences to its holder.

According to the IRS’s theory, the trustees might refuse, without legal basis, to honor a timely withdrawal demand. In that event, Article XXVI of the trust declaration would require the beneficiary to submit the dispute to a beth din. If the beth din, again without legal basis, sustained the trustees’ refusal to honor the demand, the beneficiary could seek redress in a New York court despite the general reluctance of a state court to disturb an arbitration decision. However, the IRS further contended that a beneficiary would be extremely reluctant to go to court because, under the in terrorem clause in Article XXVI, the beneficiary would forfeit all of his or her rights under the trust by going to court. Thus, as a practical result, the beneficiaries’ withdrawal rights were “illusory” and did not constitute a “present interest in property.”

The court observed that there were two problems with the IRS’s argument. First, if the trustees were to breach their fiduciary duties by refusing a timely withdrawal demand, a beneficiary could seek justice from a beth din, which was required to enforce the trust declaration and protect a beneficiary’s rights under state law. A beneficiary would not suffer the adverse consequences of the in ­terrorem provision by submitting a claim to a beth din. Since a beth din was required to follow the rules in the trust declaration, there was no reason to believe that the beneficiary would have to take a dispute over his or her withdrawal rights to court.

The second problem the Tax Court cited was that the IRS misapprehended the in terrorem provision and gave it too broad a meaning. The court determined that the provision did not, as the IRS suggested, apply to any case in which a beneficiary went to court to challenge a decision of the trustees, including a decision by the trustees not to honor a withdrawal demand. Rather, the provision, when read in context of the rest of the trust agreement, should be interpreted to apply only when a beneficiary went to court to dispute the trustee’s decision to make a discretionary distribution from the trust as the trustee had a right to do under Article VI. The court stated that this interpretation gave the in terrorem provision “a coherent meaning that is consistent with the provisions of article VI affording the trustees ‘absolute and unreviewable discretion’ concerning such matters.”

Reflections

While the IRS has conceded that a gift to a trust with a valid Crummey power provision is a gift of a present interest, it has not given up the fight against this planning technique. This case makes clear that, even on fairly weak facts, it will not hesitate to litigate if it believes a taxpayer has tried to get the tax benefits that giving a withdrawal provision to a beneficiary provides without actually taking the risk that a beneficiary will take advantage of the provision against the donor’s wishes.

Mikel, T.C. Memo. 2015-64