Wealthy individuals who have built a considerable legacy often hope that they can transfer as much of that nest egg as possible to the next generation without losing much of that value in federal taxes. In 2020, the estate tax exemption is $11.58 million per individual, meaning that any amount exceeding that exemption held by the decedent can be subject to estate taxes up to 40%. It would seem that the logical way to avoid the estate tax would be to give away the wealth to the next generation while the donor is still alive.
However, Congress and the Internal Revenue Service considered that scenario and put up a roadblock to avoid dodging the estate tax. Under current law, a person can give an individual up to $15,000.00 per tax year without any tax consequences. For any amount beyond that $15,000.00 exclusion amount, the donor must complete and file Form 709 (Gift Tax Return) and file it with the Internal Revenue Service. The $11.58 million exemption for estate taxes also applies to gift taxes – which is why the IRS refers to this as a unified credit. If a donor owes gift tax, the amount due does not have to be paid out of pocket. Instead, the donor can subtract the amount of the gift that exceeded the $15,000.00 exclusion amount from the $11.58 million unified credit. This can be done during any year where there is remaining credit to be used.
For example, a grandfather gifts $1.015 million in cash to his seven grandchildren. The first $15,000.00 to each child doesn’t count due to the 2020 gift tax exclusion, but the grandfather will have to file Form 709 and claim the balance of $7 million beyond the exclusion that was gifted. In lieu of paying gift tax out-of-pocket, the grandfather can subtract the $7 million from the $4.58 million unified credit. This means that the grandfather will not pay gift tax that year but has $4.58 million remaining in unified credit against his estate at the end of his life. This can cause a greater portion of his estate to be subject to taxes up to 40%.
To avoid both gift tax and estate tax, that grandfather could simply gift $15,000.00 every year to each of his grandchildren beginning at an early age until a considerable portion of assets are spent down. However, the grandfather may have reservations in giving $15,000.00 to very young children who would manage the money poorly. He would simply prefer to give a large sum of them as adults when they can properly handle the funds. Perhaps the grandfather could put the money into a trust that can manage the funds until the children come of age. However, this also presents another potential problem. If a gift of money is put into a trust for someone to receive as a future interest, then it does not qualify for the $15,000.00 annual gift tax exclusion. The gift tax exclusion only applies to gifts of present interest, meaning that the money or property was given to the donee with all rights to retain and beyond the ability of the donor to recall during the tax year. A future interest gift can be recalled and taken out of the trust by the grandfather before the trust specifies that the grandchild has a right to receive it. This means that the gift was not “completed” so it does not qualify for any exclusion.
The solution to this problem may be for the grandfather to establish a Crummey trust. The term comes from the court case Crummey v Commissioner, 397 F.2d 82 (9th Cir 1968) in which this particular strategy was pioneered and upheld as valid by the U.S. Court of Appeals. In a Crummey trust, a donor puts money into the trust up to the $15,000.00 exclusion amount for the benefit of another person. However, the trust permits that the donee has a specific amount of time in which he or she can withdraw those funds from the estate in the current tax year (e.g. 30 days from deposit) or else the funds remain in the trust until the donee is permitted to withdraw the funds at some future date. The Crummey case determined that a beneficiary’s right to withdraw assets gifted to a trust for a limited period of time creates a present interest in such assets that qualifies the gift for the gift tax annual exclusion.
The grandfather of seven now elects to put $15,000.00 per year into a Crummey trust established for each grandchild. All of the donees are very young, but the grandfather would prefer that the grandchildren do not access the money until age 25. To make the gift a “present interest” gift for the purposes of the gift tax exclusion, the grandfather deposits the money and sends a notice to the grandchild that they have a right to withdraw the money within the next 30 days or else the right will be revoked and the funds will stay in trust until age 25. If the grandchild does not take the money, then it stays in trust with no gift tax or estate tax consequences to the grandfather. Of course, the grandchild could legally withdraw the $15,000.00 and use it however he or she wished, but the grandfather could simply elect to stop funding the Crummey trust in future tax years if the grandchild actually withdrew the money against the grandfather’s true wishes. As long as the grandchild does not withdraw, the grandfather will continue to make $15,000.00 gifts to the trust every year.
The Internal Revenue Service is hostile towards Crummey trusts as they are viewed as a loophole to avoid gift tax liability. Although Crummey v Commissioner is settled law, the IRS is concerned that the trust beneficiaries do not actually have the right to withdraw funds or are not actually being provided notice according to law. In this way, many trusts purporting to be Crummey trusts are actually shams and do not operate as legally required. As a regulation of these rules, the IRS held that, after a gift is made to a Crummey trust, each adult beneficiary must have actual notice of his withdrawal right AND an adequate opportunity to exercise the withdrawal right prior to its lapse for it to be considered a present interest gift. Rev. Rul. 81-7, 1981-1 C.B. 474. If the beneficiary to a Crummey trust is a minor, then the gift is considered a present interest gift as long as the trust does not prevent the appointment of a guardian or conservator that can exercise the withdrawal right on the minor’s behalf. Rev. Rul. 73-405, 1973-2 C.B. 321.
Taxpayers scored another victory regarding Crummey trusts in the U.S. Tax Court. In Cristofani v. Commissioner, 97 T.C. 74 (1991), acq. in result only, the IRS challenged gifts to a Crummey trust for several reasons. First, the withdrawal period for the present interest gift was only 15 days. Second, none of the donees had any interest in any trust income (e.g. dividends, capital gains or other payments generated during the tax year) until after the donor’s death, meaning that the trust really did not exist to benefit them. Third, the primary beneficiaries of the trust were the donor’s children and the grandchildren who received Crummey gifts were only contingent remainders (remaining that they only inherited if one of the children died) so the trust was never intended to benefit them. The U.S. Tax Court disagreed with the Internal Revenue Service. The judge found that 15 days was sufficient notice for exercising Crummey powers, that not distributing trust income until after death does benefit any trust beneficiaries by shielding assets from creditors, and that the contingent grandchildren are considered beneficiaries because they had rights that could be exercised against the corpus. Essentially, a trust can be formed for a variety of purposes and can include some Crummey powers for some beneficiaries even if this is not the focus of the trust.
The IRS acquiesced to the Cristofani decision, but continued to issue regulations and rulings that attacked “prearranged plans” by trusts to penalize or prevent trust beneficiaries from exercising any Crummey powers. In Kohlsaat v. Commissioner, 73 T.C.M. 2732 (1997), the IRS challenged the gift tax exclusions for gifts made to two specific beneficiaries and 16 contingent beneficiaries provided through an alleged Crummey trust. They believed that trust was a “prearranged plan” where beneficiaries were not permitted to withdraw the gift or the actual ability to do so was illusionary. The Internal Revenue Service wanted the Tax Court to adopt the position that a prearranged plan exists if ANY of the following facts exist:
- The trust beneficiaries fail to exercise the right to withdraw
- The trust beneficiaries are led to believe they would be penalized if they exercised the right to withdraw
- The trustees failed to thoroughly explain the right to withdraw to the trust beneficiaries in a way where they can make intelligent and informed decisions
- The trust beneficiaries are led to believed their exercise of the right to withdraw would create family disharmony or upset the donor’s estate plan
The U.S. Tax Court upheld all of the annual gift tax exclusions and REJECTED the IRS’s prearranged plan argument. All trust beneficiaries were provided actual notice from the trustees regarding their withdrawal rights. There was no evidence to establish an “understanding” existed before the donor and contingent beneficiaries to not exercise their right to withdrawal. Finally, it would be too broad to create a presumption that a beneficiary not withdrawing funds suggests a prearranged plan. This Crummey trust survived scrutiny because it provided a fair and adequate notice to beneficiaries of their withdrawal rights. As long as there is no evidence that the donor or trustees communicated any adverse consequences to any beneficiaries, then the Crummey trust will likely retain its gift tax exclusion benefits.
Forming a Crummey trust (or adding Crummey powers to an existing trust) can be an effective way to transfer wealth while minimizing potential estate and gift taxes. A skilled lawyer can advise you if this type of trust is best for your situation and can guide you through the appropriate notice requirements to avoid the IRS disallowing the benefit. If you or a loved one have questions about Crummey trusts or need representation before the IRS, then do not hesitate to contact the experienced tax attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.