Many strategies for high-net-worth clients involve the use of trusts. Getting money into a trust can trigger gift tax, though. An established planning technique still works but its days might be numbered under a new initiative from Washington.
“The annual gift tax exclusion applies to present interest gifts,” points out Mitch Kauffman, who heads a wealth management firm with offices in Pasadena and Santa Barbara, Calif. “Those are gifts that can be enjoyed now. By contrast, gifts to trusts such as an irrevocable life insurance trust are of a future interest so they do not typically qualify for the exclusion.”
Thus, if Joan Jones gives $60,000 to a trust for her children, that $60,000 generally will be considered a taxable gift. Joan probably won’t owe gift tax but that taxable gift will reduce her lifetime gift tax exemption (now $5.34 million) and a reduced gift tax exemption eventually will trim Joan’s estate tax exemption amount.
The answer? Advisors can talk with the client about using “Crummey” powers or provisions. The name comes from Clifford Crummey, who fought the IRS on this issue and won a landmark decision in the U.S. Court of Appeals for the Ninth Circuit in 1968. With this technique, says Kauffman, “gifts to a trust can use the annual gift tax exclusion, which usually isn't the case for transfers to trusts.”
For example, suppose George Johnson makes a $28,000 gift to a trust that has two beneficiaries, his son and his daughter. “The trustee will send letters to the trust beneficiaries,” says Kauffman, “notifying them that they have a specific period of time, perhaps 30 days, to claim their portion of the gift. Although they may not opt to do so, the option effectively creates a present interest and thus qualifies for the gift tax exclusion.”
Consequently, George’s $28,000 transfer will be covered by this year’s $14,000 gift tax exclusion (one per child) and won’t be a taxable gift. Once the 30 days pass, if the beneficiaries haven’t taken their $14,000, their rights to the gift will lapse and the trustee can use the $28,000, perhaps to pay life insurance premiums for a policy held in the trust, sheltered from estate tax.
In the years since the Crummey decision, the use of such powers has expanded. The Tax Court has sided with one taxpayer, for instance, who named 16 trust beneficiaries (children, grandchildren, great-grandchildren, a daughter-in-law) and claimed annual gift tax exclusions for all of them. Under current law, up to $224,000 could be transferred free of gift tax (16 times $14,000), or up to $448,000 by a married couple.
President Obama’s recently-released budget proposal for 2015 referred specifically to such cases and requested a Crummey crackdown. The IRS is concerned that taxpayers could “inappropriately exclude from gift tax a large total amount of contributions to the trust,” the Administration avers. Under the proposed change, the present interest requirement would be replaced by a $50,000 annual cap on gift tax exclusions for transfers to trusts.
Such a change might never be passed, or might be scaled back, but Crummey appears to be in the IRS crosshairs. For now, though, the Crummey rules remain in effect.
“We’ll put this tactic on the table for appropriate clients,” says Kauffman, “and suggest an estate planning lawyer, if the client needs one.” Using Crummey powers properly can be complicated, especially if multiple trust beneficiaries are involved, so it’s best to work with an adept attorney.