The reader should first read our article on Wills and Trusts and Life Insurance Trusts.
Gift tax is imposed on gifts of one person to another, and while one may have a life time exclusion from gift tax of one million dollars, a life time is a long time and that exclusion may be very much wanted intact as one gets older and inflation makes one’s estate larger and larger. One is also entitled to an annual exclusion from gift tax of up to thirty thousand dollars per year per person. Thus, a couple could give away to a son or daughter up to 26,000 each year and if they have two children up to 52,000 a year and not use up any of the life time exclusion.
But there is a catch. A gift must be a “present interest.” That is, if I am to get the gift tax annual exclusion, I must give the gift to you in full, with you having full ownership. This can be a significant issue if one wishes to give a gift in trust to one’s children or grandchildren since you want restrictions on the use…e.g. to be used for education or to pay life insurance policy premiums, etc. One can still make the gift…but one does not get the annual exclusion.
There is a way to make the gift, get the exclusion, yet still use the trust and that is by making the gift subject to the Crummey Rules described in this article.
The Basic Crummey Approach:
Many estate plans call for annual gifts to heirs, often through trusts. To be eligible for the annual gift tax exclusion — currently thirteen thousand dollars each year — these gifts must be of a “present interest,” which means that the recipient must be able to access the assets immediately without restriction. In many cases, gifts to trusts are of a “future interest” because the beneficiary’s access is restricted until some future date or event. The Crummey power, named after a taxpayer from the landmark tax case in 1968, is an often used trust provision that allows a gift that would otherwise be a future interest gift to be treated as a present interest gift, and thus be eligible for the annual gift tax exclusion.
Crummey powers give the beneficiary a limited time (often 30, 45 or 60 days) to withdraw contributions to a trust at will, converting the future interest gift to a present interest gift. This withdrawal right is generally limited to an amount equal to the current annual gift tax exclusion. If the beneficiary does not exercise this right within the specified time, the Crummey power is deemed to have lapsed and the assets remain in trust.
Normally if the beneficiary understands that the ultimate benefit of the trust is for the beneficiary, such as paying for education, a home in the future, life insurance or education or the like, the beneficiary will not exercise the right of withdrawal and the money stays in the Trust. Further, should the beneficiary be foolish enough to pull the money out, the Settlor of the trust can always refuse to make contributions in the future. THERE CAN BE NO AGREEMENT BETWEEN THE SELLOR AND THE BENEFICIARY THAT THE FUTURE RIGHTS TO WITHDRAW WILL NOT BE EXERCISED OR THE IRS WILL CONSIDER THE PRESENT INTEREST A NULLITY. Instead, the Settlor just has to hope the beneficiary understands the benefit of letting the right to withdraw lapse.
The process is usually an annual written notice to the beneficiary describing the right to withdraw the amount and indicating the time limit for that withdrawal. Usually the beneficiary is asked to waive that right by signing the notice form and returning it.
This is done annually and the gift tax exclusion is maintained.
Attacks On Crummey Powers
The Internal Revenue Service examines Crummey powers closely to make sure that there is not a hidden agreement that no one intends for the beneficiary to actually exercise withdrawal power. Despite unsuccessful challenges to Crummey powers in the courts, the IRS continues to attack them.
Accordingly, trustees, advisors and beneficiaries must follow Crummey rules closely to avoid such disputes. The most basic step, sometimes forgotten by careless trustees and advisors, is providing notice to beneficiaries of the withdrawal power when a gift is made to the trust. The IRS has confirmed in multiple private letter rulings that in certain situations actual knowledge of the gift is sufficient notice of the withdrawal power, such as when the Crummey power holder is a trustee. The tax courts, despite many rulings, have never specifically stated that a beneficiary must be given notice upon a contribution to a trust, leaving some practitioners to speculate that notice is not required as long as the beneficiary is aware of the withdrawal right.
However, written notification is always wise, since it provides concrete proof that notice was given.
To follow the IRS’ accepted practices relating to Crummey withdrawal powers, trustees, trust advisors and grantors should take these additional steps:
- Ensure that there is no express or implied agreement between the trustee or the grantor and the beneficiaries that the withdrawal power won’t be exercised. The benefits of keeping assets in the trust can be explained to beneficiaries, but the trustee or grantor should never imply that withdrawals are prohibited.
- Specify a withdrawal period of at least 30 days in the trust document. While a shorter time may be accepted, if it is too short, the IRS may argue that the Crummey power holder was not given sufficient time to consider or exercise the withdrawal right.
- Encourage beneficiaries to simply allow the withdrawal period to lapse without acting, rather than proactively notifying the trustee that they do not wish to exercise their withdrawal rights. This is because when a beneficiary expressly decides not to exercise his or her withdrawal right, the money that could have been withdrawn is considered a gift to the other beneficiaries for gift tax purposes. However, when the beneficiary allows the withdrawal right to lapse there is no deemed gift so long as the Crummey power does not exceed the greater of $5,000 or 5 percent of the value of the trust property (commonly referred to as the 5 and 5 exception). Note that the exception applies only to the lapse, not to the waiver or release, of a Crummey power.
- Do not allow a beneficiary to waive his or her withdrawal right for current or future contributions to the trust. The IRS prohibits such waivers.
- For trusts that own life insurance policies, make sure there is cash in the trust to fulfill any potential beneficiary distributions during the entire withdrawal period. For example, using most or all of the cash contributed to the trust to pay premiums before the beneficiary’s withdrawal period expires undermines the legitimacy of the Crummey withdrawal power, as it leaves insufficient cash available to fulfill the withdrawal right. Many advisors recommend that insurance trusts be funded with some cash up front to alleviate this problem.
- For insurance trusts, do not allow the grantor to pay annual insurance premiums directly. The trust should make all premium payments.
- Send Crummey notices using a method that can provide proof of mailing date, such as certified mail or a courier service. In addition, the trustee or trust advisor can have the beneficiary sign the notice of withdrawal acknowledging that it has been received; however, as noted above, the signature should not specify a release or waiver of the withdrawal power.
- Do not provide Crummey withdrawal powers to an individual who doesn’t have a substantial economic interest in the trust, often referred to as “naked Crummeys.” Absent some potential future benefit from the trust, it is likely that an individual would exercise his or her withdrawal right. A naked Crummey holder’s failure to take the money casts doubt on the legitimacy of the Crummey power.
- Try to avoid making contributions to the trust so late in the year that the withdrawal period extends into the next year. This prevents potential complications in determining the year in which the gift is made or when the Crummey withdrawal rights lapse.
As with so much involving estate planning and taxation, tremendous benefits are available if one is willing to jump through some hoops and carefully structure the documents and procedures. The widespread use of this method should indicate to the reader that this benefit is well worth considering.