By Bradley E.S. Fogel
One ubiquitous issue in estate planning is how to provide for young children--frequently, the client's children or grandchildren. If the client is willing to make lifetime gifts for the benefit of the child, then the client can make use of the federal gift tax annual exclusion to transfer substantial sums to the child free of gift or estate tax. The federal gift tax annual exclusion allows a donor to give up to $10,000 to any individual in any calendar year free of gift tax. Code § 2503(b). If the donor is married and the spouse consents to splitting the gift, then $20,000 may be transferred free of gift tax each year. Code § 2513. Congress indexed these amounts for inflation beginning in 1999. Code § 2503(b)(2).
This is a powerful technique. For example, if a donor and her spouse were to transfer $20,000 to a child on the day he was born and on every subsequent birthday until the child reached age 18, then at age 18 the child would have received about $750,000, assuming a 7% net annual return. At age 21, the child would have almost $1 million.
A problem arises because the federal gift tax annual exclusion is not available if the gift is of a "future interest" in property. Treas. Reg. § 25.2503-3(a). Thus, to make use of the annual exclusion, the donor must give to the donee a present interest in property, such as outright ownership. Treas. Reg. § 25.2503-3(b). This requirement is particularly problematic when the gift is made to a minor. For obvious reasons most donors do not wish to give minors substantial outright gifts. Certain devices, however, allow a donor to make gifts that qualify for the annual exclusion to a child while still allowing the gifts to be managed for the minor by a custodian or trustee.
This article describes three of these devices and the tax rules associated with them. The article first addresses gifts to a custodian for a minor under a uniform gifts or transfers to minors act. The article then considers the "2503(c) Trust," which is, not surprisingly, permitted by Code § 2503(c). The article concludes with a discussion of trusts with Crummey withdrawal powers.
All states and the District of Columbia have some form of the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act, which this article collectively refers to as "Minors Acts." Gifts to a custodian under a Minors Act qualify for the federal gift tax annual exclusion. Rev. Rul. 59-357, 1959-2 C.B. 212; Rev. Rul. 56-86, 1956-1 C.B. 449.
The forerunner of the Minors Acts was the "Act Concerning Gifts of Securities to Minors," sponsored by the New York Stock Exchange and the Association of Stock Exchange firms in the 1950s. In 1965 the National Conference of Commissioners on Uniform State Laws (NCCUSL) adopted the Uniform Gifts to Minors Act (UGMA). The UGMA broadened the earlier act by allowing custodial accounts to cover gifts of money as well as securities. In 1983 NCCUSL updated the UGMA and renamed it the Uniform Transfers to Minors Act (UTMA). One of the most significant changes that NCCUSL made in the UTMA was to expand the scope of property that a custodian could hold in a custodial account to include any property, real or personal, tangible or intangible. UTMA § 1. In contrast, the UGMA allowed custodial accounts for only securities, life insurance policies, annuity contracts and cash. UGMA § 1(e).
It is well settled that gifts to a Minors Act custodian qualify for the federal gift tax annual exclusion. Rev. Rul. 59-357; Rev. Rul. 56-86. Thus, gifts of $10,000 (or $20,000 if the donor is married and his or her spouse elects to split gifts) to the minor in a custodial account will qualify for the federal gift tax annual exclusion.
Minors Act custodial accounts are, in many ways, statutory trusts. The custodian of the account, who may be any person, including the donor or trust company, holds property for the benefit of the minor. The custodian has the power to pay any property in the account ("custodial property") to or for the benefit of the minor. UGMA § 4(d); UTMA § 14(a). Neither the UGMA nor the UTMA distinguishes between the income from and the corpus of the custodial property. Both the UGMA and UTMA provide that a court may compel a custodian to distribute to custodial property.
Generally, the custodianship will terminate when the minor attains age 18 or 21, depending on the state. UGMA § 4(d); UTMA § 20; D.C. Stat. § 21-230 (age 18); La. R.S. 9:770 (age 18); Pa. Stat. § 5320 (age 21); N.Y.
EPTL §§ 7-6.20, 7-6.21 (generally age 21; age 18 under some circumstances). California's version of the UTMA is unique in that it allows the donor to specify that the custodian will hold the property until the beneficiary reaches age 25. Cal. Prob. Code § 3920.5. When the beneficiary reaches the designated age, the custodian must distribute the custodial assets outright to the beneficiary. If the beneficiary dies before reaching the designated age, the custodian must pay the property to the beneficiary's estate.
The class of eligible custodians is relatively broad. The donor, the minor's parents, another adult or a trust company may act as custodian. If the donor acts as custodian, however, the custodial property will be included in the donor's gross estate for federal estate tax purposes if he or she dies before termination of the custodianship. Code § 2038; Rev. Rul. 70-348, 1970-2 C.B 193. If the custodian has a legal obligation to support the minor, such as a parent, then if the custodian dies before the termination of the custodianship, the IRS may argue that the parent's gross estate will include the custodial assets. Gen. Counsel Memo. 37840. For a further discussion of this issue, see the article by Jeffrey Pennell and Corey Fleming in this issue. Nevertheless, to avoid the issue (and possible litigation with the IRS) the donor should select a person other than the parent as custodian. As discussed below, in light of the fact that donors frequently create custodianships without benefit of advice of counsel, the donor may be unaware of the estate tax ramifications of his or her choice as custodian.
An important benefit of a custodial gift is its simplicity. To create a custodial account, the donor simply transfers the property to a custodian under the applicable act. UGMA § 2; UTMA § 9. Because of this simplicity, donors frequently create a custodianship without the assistance of a lawyer. The simplicity of a custodianship, however, has side effects. No substantial body of precedent exists concerning the legal rights and duties of a custodianship under a Minors Act, which may lead to uncertainty. See, e.g., In the Matter of Levy, 412 N.Y.S.2d 285, 287 (Sur. Ct. Nassau Cty. 1978) (noting that the "paucity of cases" is indicative of the success of UGMA in creating a simple method for making gifts to minors). Moreover, some courts in custodianship cases have refused to draw analogies from the more developed body of precedent regarding trusts and trustees, which exacerbates this problem. Id. This uncertainty may make custodianships inappropriate for substantial gifts or gifts of property that may be more difficult to administer, such as partnership interests.
A custodial gift indefeasibly vests the custodial property in the minor. In contrast, trust beneficiaries have only a beneficial interest in trust property. One significant result of this indefeasible ownership is that the IRS does not recognize a custodial account as a separate taxpayer and taxes the income from the custodial assets to the minor. Rev. Rul. 56-484, 1956-2 C.B. 23. If the minor is under age 14, the "kiddie tax" rules may tax income at the parent's marginal tax rates. See Code § 1(g).
The taxation of the income directly to the minor has both positive and negative aspects. The custodian does not need to file a separate tax return for custodial property. By contrast, if a trustee held the property, the trustee would be required to file a federal income tax return, subject to relatively minor exceptions. Moreover, considering the complexities of trust income taxation, it is unlikely that an individual would be able to properly complete the necessary tax returns for the trust.
On balance, the lack of a requirement for a separate income tax return is, at most, a relatively minor benefit of a custodianship. If, however, the value of the custodial property is small, the lack of a separate tax return may tip the balance in favor of the custodianship. An added advantage is that federal individual income tax rates are, as a general rule, more progressive than the federal fiduciary income tax rates. See Code § 1. For this reason, the fact that the Code taxes the income directly to the minor, as opposed to taxing it to a fiduciary with higher marginal rates, may provide an income tax savings. Of course, whether or not a custodianship results in income tax savings depends on the income earned, the minor's income tax brackets, the minor's parents' income tax brackets and the hypothetical trust.
Applicable state statutes set the terms of a custodianship, and donors generally cannot vary those terms. For example, Minors Acts dictate:
* the number of custodians that may serve (one);
* the mechanism of the appointment of successor custodians (the current custodian may appoint a successor);
* whether the custodian is required to give a bond (generally not);
* the permissible investments for the custodial property (generally very broad); and
* compensation to the custodian (UTMA provides for reasonable compensation).
For the most part, NCCUSL and state legislatures have drafted Minors Acts with terms that will be acceptable to most donors. The donor is unlikely to be interested in deviating from the terms of the Minors Act merely for the purpose of, for example, requiring the custodian to give a bond. Some Minors Act provisions, however, are likely to be quite distasteful to a donor.
The last significant drawback to a custodianship is that the custodian must distribute the custodial property to the minor at age 18 or 21, depending on the state. This requirement may be acceptable to a donor if the value of the custodial property at that time is expected to be relatively small. If, however, the donor plans to make frequent annual exclusion gifts to a minor via a custodian, the value of custodial property distributed to the beneficiary when he or she reaches the age of majority may be significant. If so, the donor will likely be interested in a gift giving device that will allow the donor to ensure that the minor will use the substantial sums the donor gives to the minor to pay for the minor's college tuition, rather than a Caribbean extravaganza. A partial answer to this concern may be the use of a minor's exclusion trust or Crummey trust.
A "2503(c)" trust is a trust that meets the requirements of Code § 2503(c). Gifts to a minor's exclusion trust allow a donor to make gifts to a minor in trust and receive the benefit of the federal gift tax annual exclusion. Code § 2503(c) imposes three requirements for a 2503(c) trust. The first is that the trust instrument permit the trustee to expend the trust assets for the benefit of the minor. Code § 2503(c)(1). A trust will meet these requirements if the trust instrument allows the trustee to make wholly discretionary distributions to or for the benefit of the minor.
If, however, the trust instrument places substantial restrictions on the exercise of the trustee's discretion to make distributions, the trust will not qualify as a 2503(c) trust. Treas. Reg. § 25.2503-4(b)(1). For example, in Rev. Rul. 69-345, 1969-1 C.B. 226, the IRS ruled that a trust that required the trustee to consider other assets available to the minor in determining whether to make distributions did not qualify as a 2503(c) trust. The IRS reasoned that the minor's parents as well as the minor had substantial other assets available, making distributions from the trust unlikely in light of the requirement to consider other assets.
Some restrictions on the trustee's discretion will pass muster with the IRS. In Rev. Rul. 67-270, 1969-2 C.B. 349, the IRS ruled that a trust instrument may limit a trustee's discretion by a standard that has no objective limitation, such as "welfare," "happiness" or "convenience" without running afoul of Code § 2503(c). More limited standards, such as health or education, may, however, be too restrictive. For example, in Mueller v. United States, 1969 WL 20748 (IRS 1969), the IRS argued that a trust that directed the trustee to make distributions as necessary for "support, health and education" of the beneficiary did not qualify as a 2503(c) trust because of the restriction. The Tax Court held for the taxpayer only after concluding that the standard was comparable to the standard used for a guardian under Missouri law. Id.
Therefore, although a trust that places more restrictive standards on the trustee's ability to make distributions to the minor may qualify as a 2503(c) trust, the safer course seems to be to provide the trustee with unfettered discretion or, at the very least, to include words such as "comfort" or "welfare" in the standard in reliance on Rev. Rul. 67-270.
The second requirement is that if a minor dies before age 21 (when the trust terminates), then the trustee must pay the trust assets to the minor's estate or as the minor appoints pursuant to a general power of appointment. Code § 2503(c)(2)(B). The purpose of this requirement is to include the trust assets in the minor's gross estate if he or she dies before termination of the trust. Code §§ 2033, 2041. The power of appointment may be exercisable either by will or inter vivos. Treas. Reg. § 25.2503-4(b). The trust instrument must place no "restrictions of substance" on the donee's exercise of the power. The fact that a legal disability (such as minority) may prevent the donee from exercising the power does not, however, prevent the trust from qualifying as a 2503(c) trust. Treas. Reg. § 25.2503-4(b).
The third, and most problematic, requirement for a minor's exclusion trust is that the principal and income of the trust must pass to the donee on attaining age 21. Code § 2503(c)(2)(A). Clients may hesitate to transfer substantial assets to a trust, the assets of which will be distributed to a minor beneficiary outright when he or she reaches age 21. This is similar to the problem discussed above for custodianships. When a minor reaches age 21, the assets of a 2503(c) trust may have considerable value. Consequently, the donor will likely be anxious to find a way to prevent the young donee from squandering his or her windfall.
The most common way to address this problem is to provide in the trust instrument that the beneficiary may elect to continue the trust or provide in the trust instrument that the trust will continue unless the beneficiary elects to terminate it. The regulations expressly provide that the trust will
not fail to qualify as a 2503(c) trust merely because "[t]he donee, upon reaching age twenty-one, has the right to extend the term of the trust." Treas. Reg. § 25.2503-4(b)(2). Thus, the trust instrument may allow the beneficiary to elect to continue the trust. The regulations, however, do not address a trust that continues unless the beneficiary elects to terminate it. For the most part, donors will probably not be satisfied with this option. Rather, donors generally prefer that the trust terminate only if the beneficiary affirmatively elects to terminate it.
In Rev. Rul. 60-218, 1960-1 C.B. 378, the IRS considered a trust that provided that, unless the beneficiary elected to terminate the trust after his 21st birthday, the trust would continue until he reached age 33. The IRS ruled that "[a] power conferred, as in the instant case, upon a donee to require immediate distribution of the property to him upon attaining the age of twenty-one years does not meet the statutory requirement [of Code § 2503(c)] that the property must pass to [the beneficiary] upon attaining the age of twenty-one years." In Rev. Rul. 74-43, 1974-1 C.B. 285, however, the IRS revoked Revenue Ruling 60-218 and held that a trust may qualify as a minor's exclusion trust if the beneficiary, on reaching age 21, has the right for a limited period of time to terminate the trust. The IRS has privately approved a trust provision allowing a beneficiary to elect to terminate the trust within 60 days of his or her 21st birthday. PLR 8817037. See also PLR 8334071 (90 days). Drawing an analogy from the context of Crummey powers, discussed below, a termination power that lasts only 30 days may also pass muster. See PLR 9232013, PLR 9030005, PLR 8922062.
No published authority requires a trustee to notify the beneficiary of his or her power to terminate the trust. If, however, the trustee does not so notify the beneficiary, the IRS may argue that the beneficiary's power of termination was illusory by analogy to situations involving trustees' failure to notify Crummey power holders of their powers. See Rev. Rul. 81-7, 1981-1 C.B. 474; TAM 9532001. Thus, the trust would not qualify as a minor's exclusion trust and the IRS could deny the annual exclusion for gifts to the trust. Considering this potential cost, the trust instrument should require the trustee to provide the beneficiary with notice of his or her right to terminate the trust when he or she reaches age 21.
Regardless of whether the trustee gives the beneficiary notice of the right to terminate the trust at age 21, a 2503(c) trust that gives the beneficiary only a temporary right to terminate the trust is likely to be much more attractive to the donor than a trust that requires outright distribution at age 21. As discussed above, a common concern of clients considering 2503(c) trusts or other devices for making gifts to minors is the risk that the minor beneficiary may squander the assets if he or she receives the assets outright at an early age. A 2503(c) trust that continues unless the beneficiary elects to terminate it significantly alleviates that risk. Even if the trust principal is substantial, it is likely that the donor and other of the donee's family members will be able to exert subtle familial pressure on the beneficiary to prevent him or her from exercising his withdrawal power. Moreover, human nature and the laws of inertia being what they are, and considering the fact that the beneficiary must take the initiative and affirmatively act to terminate the trust, it seems likely that the beneficiary would allow the trust to continue beyond age 21.
The donor, however, should be aware that for a period after the beneficiary reaches age 21, probably at least 30 to 60 days, the beneficiary must have an unfettered opportunity to terminate the trust. The donor may decide to run that risk, sensing that the beneficiary will be unlikely to exercise this power, thus allowing annual exclusion gifts to remain in trust until the donee reaches a more suitable age. Nevertheless, the donor must realize that, if the trust assets are substantial, it may be difficult to persuade the beneficiary not to exercise the termination power. This is particularly true if some family disharmony has transpired since the creation of the trust. Further, the donor must decide to give the beneficiary a termination power when the donor establishes the trust, when the donee is quite young. For these reasons, many donors are uncomfortable with the fact that the beneficiary will have the right, on reaching age 21, to terminate the trust and receive a potentially very substantial amount of assets outright.
Transfer tax reasons tend to restrict the choice of a trustee of a 2503(c) trust in a manner similar to the restrictions on the choice of a custodian. If the donor serves as trustee of a 2503(c) trust and dies before termination of the trust, the donor's gross estate will include the trust assets because of the donor's ability to make discretionary distributions of the trust assets. Code § 2038; Rev. Rul. 59-357, 1959-2 C.B. 212. In addition, as discussed above, the IRS believes that a similar result will occur if the trustee is a parent or other individual who has a legal obligation to support the beneficiary. Code § 2041. Thus, neither the parent of the beneficiary nor the donor should serve as trustee of a 2503(c) trust. The minor's parent, however, could serve as co-trustee without adverse transfer tax consequences, provided that the trust instrument gives the non-parent trustee the power to make distributions that might satisfy the parent's legal obligation. This option is not available in the context of custodianships because only one custodian may act.
Gifts to a trust other than a 2503(c) trust generally do not qualify for the federal gift tax annual exclusion. Treas. Reg. § 25.2503-3(a). If, however, the trust instrument provides that a beneficiary has a presently exercisable right to withdraw property transferred to the trust, the IRS will consider the gift to the trust to be a gift of a present interest and will allow an annual exclusion for the gift. These powers are known as "Crummey powers," based on the seminal Ninth Circuit case that approved the use of a withdrawal power held by a minor to create a present interest that qualified for the annual exclusion. Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).
A Crummey power works relatively simply. After a donor makes a gift to the trust, the beneficiary has a period of time, generally at least 30 days, to withdraw the assets of the trust with a value equal to the gift. E.g., PLR 9232013, PLR 9030005, PLR 8922062. If the beneficiary does not withdraw the gift within the allotted time, the Crummey power lapses and the gift stays in trust. This 30 day window, however, makes the gift to the trust a present interest for gift tax purposes, thereby allowing the donor to take advantage of the federal gift tax annual exclusion.
An important advantage of Crummey trusts over minor's exclusion trusts or custodianships is their versatility. After the Crummey power lapses, the trust may continue as long as the donor wishes, subject only to any applicable rule against perpetuities. The donor also has great flexibility regarding the other terms of the trust. For example, the trust could provide that before age 35 the trustee may make distributions of income and principal only for the beneficiary's school tuition. This flexibility, however, comes at a cost of the added administrative complexity of Crummey trusts as compared to 2503(c) trusts or custodianships.
If the donor is married, he or she may transfer up to $20,000 per beneficiary to the Crummey trust each year free of gift tax, provided the donor's spouse elects to split gifts with the donor on a timely filed federal gift tax return. In most cases, the beneficiaries will not exercise Crummey powers and will allow them to lapse. If a power to withdraw more than $5,000 (or 5% of the trust principal, if greater) lapses, then the excess is deemed a taxable gift made by the beneficiary to the other beneficiaries of the trust. Code § 2514(e). For example, if a beneficiary allows a $20,000 Crummey withdrawal power to lapse, he or she may be deemed to have made a $15,000 taxable gift.
Some lawyers simply ignore the potential taxable gift resulting from the lapse of a Crummey power. These lawyers reason that, although the taxable gift will use some of the beneficiary's unified credit, gift and estate taxes are unlikely to become a serious issue for the beneficiary for many years. Thus, the argument goes, it is unwise to plan for the estate tax owed by the beneficiary's estate when it is possible or even likely that there may be no (or a very different) estate tax payable at that time. Further, if the minor beneficiary died at a relatively young age, it is unlikely that his or her estate would owe death taxes due to the unified credit.
A second approach is to prepare the trust instrument so that no person other than the beneficiary has an interest in the trust. In this situation, the fact that the beneficiary allows a Crummey power to lapse will not result in a taxable gift because the only possible gift made is by the beneficiary to himself or herself. To accomplish this result, the trust instrument should provide that the trustee may make distributions from the trust only to the beneficiary. If the beneficiary dies before termination of the trust, the trust instrument should direct the trustee to pay the trust principal to the beneficiary's estate or as the beneficiary appoints under a general or nongeneral power of appointment. If the donor is worried that the beneficiary may exercise the power of appointment in an inadvisable manner, the trust instrument can, for example, limit the class of potential appointees or make the power exercisable only with the consent of a non-adverse third party.
It is important to note that a Crummey trust drafted so that no individual other than the minor beneficiary has an interest in the trust still gives the donor substantially more leeway to choose the terms of the trust than either a custodianship or a 2503(c) trust. Particularly, the requirement that the assets held in a 2503(c) trust be paid to the beneficiary's estate (if he or she dies before termination of a trust) or be expended for the minor's benefit during his or her lifetime, would alone eliminate any other party's interest in a Crummey trust. Thus, lapse of a Crummey power over such a trust bears no adverse gift consequences to the beneficiary. Further, such a Crummey trust has the added advantage of flexibility because it need not meet the other requirements of Code 2503(c). If the potential taxable lapse of a Crummey power does not concern the donor (for example, if no gifts over $5,000 per beneficiary are planned), then a Crummey trust with a group of beneficiaries may be attractive. In this case, a donor may be able to create one Crummey trust for all of the donor's nieces and nephews, children or grandchildren (subject to the generation- skipping transfer tax issues discussed below). In contrast, if the donor used a 2503(c) trust, he or she would have to establish a separate trust for each beneficiary.
The most significant drawback of a Crummey trust, compared to a 2503(c) trust or a custodianship, is its administrative complexity. The IRS requires that every time a donor makes a gift to a Crummey trust, the trustee must notify the holder of a Crummey power of the gift and of the power holder's right to withdraw his or her proportionate share of the gift from the trust. See Rev. Rul. 81-7, 1981-1 C.B. 474; TAM 9532001. Courts have been much more lax than the IRS in requiring a trustee to send Crummey notices. For example, in Crummey, the court noted that it was "likely" that some, if not all, of the beneficiaries had no knowledge of their withdrawal rights or even when contributions were made to the trust. 397 F.2d at 88. The court nevertheless allowed the annual exclusions claimed by the taxpayer. Subsequent rulings by the IRS, however, leave little doubt that the IRS believes that the law requires a trustee to notify Crummey power holders of their powers for the donor to receive an annual exclusion for the gift. Rev. Rul. 81-7, 1981-1 C.B. 474; TAM 9532001.
A trustee typically sends Crummey notices to a beneficiary when-ever a donor makes a gift to the trust. If the beneficiary is a minor, the trustee must send the notice to the minor's legally appointed guardian or the minor's parents. See PLR 8143045. If the minor's guardian is also the trustee, the IRS has privately ruled that the trustee need not notify himself or herself of the minor's withdrawal right. TAM 9030005. If a Crummey notice is required, the beneficiary (or the guardian) may be asked to acknowledge receipt of the notice in writing. These acknowledgements should be retained by the trustee or the lawyer. The acknowledgements are important because the IRS, when auditing the donor's estate tax return, may seek proof that the notices were sent and, thus, the annual exclusions were properly allowed, which may occur years after the gifts. The beneficiary's acknowledgements are powerful proof that notices were sent, which should preclude the IRS from denying annual exclusions. The acknowledgements should be carefully drafted to prevent the beneficiary from releasing the withdrawal power by expressly declining to exercise it. Instead, the beneficiary should allow the power to lapse. If the beneficiary releases the power, then the $5,000 or 5% exclusion discussed above is not available and the entire unwithdrawn amount may be deemed a taxable gift by the beneficiary. Code § 2514(e).
The requirement that the trustee send Crummey notices to the beneficiaries is a complication of Crummey trusts not found in either custodianships or minor's exclusion trusts. The comparative flexibility of the Crummey trust, however, makes up for the added complexity. Suppose, for example, that a donor wishes to create a trust for the benefit of her grandchild and the donor is anxious for the child's parent to be sole trustee. As discussed above, the IRS would likely argue that the use of a minor's exclusion trust or a custodianship would lead to inclusion of the principal in the parent's estate if the parent were to die before termination of the trust or custodianship because the parent could use the trust assets to discharge her legal obligation to support the beneficiary. Gen. Counsel Memo. 37840. In contrast, a lawyer can prepare a Crummey trust to prevent a parent serving as trustee from using the trust principal to discharge his or her obligation of support. Such an arrangement has the added advantage that the IRS apparently will not require the trustee-parent to send Crummey notices to himself or herself. TAM 9030005.
On the downside, if the trustee/ parent dies during the "window" in which the beneficiary could have exercised a Crummey power, the IRS is likely to argue that the amount the beneficiary could have withdrawn should be included in the trustee/ parent's estate because the trustee/ parent had the power to withdraw the gift and use it to satisfy his or her legal obligation of support. Code 2041. One should not overemphasize this factor, considering that the maximum amount included should be $20,000(if the donor is married and his or her spouse elects to split gifts). Furthermore, for this to be an issue, the trustee/parent must die within the period of time for the exercise of the Crummey power, frequently 30 days following the gift.
An additional drawback of Crummey trusts is that for some period of time, frequently 30 days, after a donor makes a gift to the trust, the beneficiary has a power to withdraw trust assets. If the beneficiary is a minor, then as a general rule the beneficiary's court appointed guardian or parent may exercise the power on the child's behalf. PLR 8143045. In some situations the donor may be uncomfortable giving the beneficiary or the beneficiary's guardian the right to withdraw contributions made to the trust. In this case, the client should not use a Crummey trust. Nevertheless, in the Crummey trust context, the power of withdrawal only covers the gift made to the trust at that time. In contrast, the withdrawal power in a 2503(c) trust allows the beneficiary to withdraw all of the assets held in the trust when he or she reaches age 21.
Beneficiaries or their guardians frequently realize that the donor would prefer that the beneficiary not exercise the Crummey power and, in practice, trust beneficiaries do not often exercise their Crummey powers. Indeed, this infrequency of exercise forms the basis for the Clinton administration's proposal to prohibit the use of Crummey powers to obtain an annual exclusion. The donor should not express his or her wish that the donees not exercise the Crummey power to the beneficiaries, especially in writing. The IRS could use such a request to argue that the Crummey power was illusory and deny the annual exclusion for the gifts subject to the power.
GST Tax Issues
If the beneficiary is the donor's grandchild, then in addition to assuring that the gifts to the trust or custodianship are exempt from federal gift and estate tax, the lawyer must also be mindful of the potential generation-skipping transfer (GST) tax issues. For the most part, a gift that qualifies for the federal gift tax annual exclusion under Code § 2503 has a zero inclusion ratio and is, therefore, exempt from the GST tax. Code § 2642(c)(1). If, however, the gift is to a trust, the gift will be GST tax exempt only if: (1) no trust income or principal may be paid to anyone other than one particular beneficiary and (2) if the beneficiary dies during the trust term, the trust principal will be included in the beneficiary's gross estate. Code § 2642(c)(2). Analogizing a custodianship to a trust, the custodianship would meet the requirements of Code § 2642(c)(2) because no distributions may be made to anyone other than the minor and if the minor dies before reaching age 21, the custodian must distribute property to the beneficiary's estate. Similarly, a 2503(c) trust will meet the requirements of Code § 2642(c)(2) and will, therefore, be GST tax exempt. See PLR 8334071.
The issue is more difficult in the context of Crummey trusts. As discussed above, a lawyer can draft a Crummey trust to prevent the beneficiary's failure to exercise a $20,000 withdrawal power from being a taxable gift. Fortunately, similar provisions would make gifts to the trust GST tax exempt. Code § 2642(c)(2). In such a Crummey trust, only one beneficiary receives distributions from the trust and the trust assets will be included in the beneficiary's estate if he or she dies before termination of the trust. Accordingly, the trust terms will satisfy Code § 2642(c)(2). If, however, the trust has more than one beneficiary, or if the assets will not be included in the beneficiary's estate for tax purposes, then gifts to the trust will not be automatically exempt from GST tax.
If gifts to a Crummey trust are not automatically GST tax exempt, then a portion of the donor's GST tax exemption may need to be allocated to the trust if grandchildren or other "skip persons" are beneficiaries. This may not be a significant drawback if the client has no plans to otherwise make use of his or her GST exemption and is willing to take the risk that no such plans will develop in the future. If substantial gifts that are potentially subject to GST tax are likely, the client must consider whether this is an efficient use of the GST exemption.
In such a case, it is probably wise to avoid the use of Crummey trusts gifts that are not GST tax exempt under Code § 2642(c)(2).
The three methods discussed above all allow the donor to make federal gift tax-free transfers to a minor beneficiary. In addition, gifts to a custodianship or a 2503(c) trust will always be GST tax exempt. A lawyer can also draft a Crummey trust so that gifts to it will be exempt from the GST tax without the use of the donor's exemption.
To some extent, these three methods fall on a spectrum. Custodianships are, administratively, the simplest of the three, but the donor has the least control over the terms governing the disposition of the property after he or she makes the gift. Crummey trusts, at the other end of the spectrum, allow far greater flexibility for the trust terms. With flexibility comes greater administrative burdens, including the requirement of sending Crummey notices. Between custodianships and Crummey trusts, 2503(c) trusts allow for greater flexibility than custodianships, although not as much as Crummey trusts, and are administratively simpler than Crummey trusts, although not as straightforward as custodianships. If the donor plans to make significant gifts to minors, the donor's main concern will likely be the possibility that the minor will receive the assets outright at what the donor feels is an inappropriate age. In this case, a custodianship, which requires distribution of the custodial property to the minor at age 18 or 21, will likely be inappropriate. A 2503(c) trust that continues unless the beneficiary affirmatively elects to terminate the trust at age 21 may satisfy the donor. The donor, however, must be made aware of the potential for the beneficiary to terminate the trust. Crummey trusts allow the donor to delay outright distribution until the beneficiary reaches a more suitable age, but the trust instrument must give the beneficiary (or his or her guardian) the temporary power to withdraw any contribution made to the trust, and the trustee must take on the added administrative difficulties in administering these powers.
Before employing any of these methods, the lawyer should discuss the pros and cons of each with the client. This discussion should involve the amount of property that the client plans to give because this will directly affect the selection. Regardless of the method that the client chooses, the lawyer should not overlook the use of the federal gift tax annual exclusion to make transfer tax-free gifts for the benefit of a minor beneficiary. Use of any of these methods allows the client to make very substantial gifts free of federal gift tax and remove the amount of these gifts (and any future appreciation on them) from the client's estate-an enormous transfer tax savings.
Bradley E.S. Fogel is a Visiting Assistant Professor at Widener University School of Law in Harrisburg, PA.
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