Probate & Property Magazine
Maybe the Best Annual Exclusion Vehicle Around
By Jonathan G. Blattmachr and Michael L. Graham
Jonathan G. Blattmachr is a member of Milbank, Tweed, Hadley & McCloy LLP. Michael L. Graham is the founder and member of the Graham Law Firm. Messrs. Blattmachr and Graham are co-developers of Wealth Transfer Planning (WTP), a computerized document assembly and advice system offered for lawyers, which offers a form of ExtraCrummeyTrust sm. WTP is published by Interactive Legal (www.interactivelegal com). The sample language contained in this article is derived from WTP documents and is published here with the permission of Interactive Legal. ExtraCrummeyTrust sm is a servicemark of Jonathan G. Blattmachr, who hereby grants license for anyone to use it if attribution to Mr. Blattmachr as holder of the servicemark is made.
In this article, we discuss a concept called the “ExtraCrummeyTrust sm.” It is a variation of the Crummey trust, one of the most widely used vehicles in estate planning, named after the famous case Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968), which the IRS embraced in Rev. Rul. 73-405, 1973-2 C.B. 321. Under a Crummey trust, powers of withdrawal granted to beneficiaries permit contributions to qualify for the gift tax annual exclusion under section 2503(a) of the Internal Revenue Code. Unlike a traditional Crummey trust, the ExtraCrummeyTrust sm also allows transfers to qualify for the generation-skipping transfer tax (GST) annual exclusion under Code § 2642(c) when transfers are made for the benefit of grandchildren, more remote descendants, or other “skip-persons” defined in Code § 2613(a). In other words, it does something “extra.”
Before describing the ExtraCrummeyTrust sm in detail, we discuss certain matters relating to the annual exclusion, including making transfers for minors through a trust described in Code § 2503(c) (a “section 2503(c) trust”) and under the Uniform Transfers to Minors Act (UTMA).
The Lowdown on Benefits of Annual Exclusion Gifts
Except, perhaps, for the ultrawealthy, the gift tax annual exclusion allowed under Code § 2503(a) represents a powerful lifetime estate planning tool. Depending on whether the property owner is married and whether the gift is of community property (or if not, whether his or her spouse will consent to gift splitting under Code § 2513), the number of potential donees (descendants, for example) that a property owner wishes to benefit and the period over which the annual exclusion gifts are made, millions of dollars potentially may be removed from his or her gross estate entirely free of gift tax. For example, a couple giving $24,000 per year under the annual exclusion to their three children and six grandchildren each year for 20 years will have removed over $4 million from their estates, even without considering appreciation and income earned on transferred property. If the transferred property grows at 8% a year, over $10 million would be excluded from their estates. And these numbers are based on the assumption of a fixed $12,000 per year annual exclusion. Because the amount of the annual exclusion is adjusted for inflation under Code § 2503(b)(2), these numbers are likely understated.
Transfers Qualifying for the Gift Tax Annual Exclusion
Every individual may make a gift of up to $12,000 a year to each of as many recipients as the donor wishes, gift tax free under the protection of the gift tax annual exclusion. The annual exclusion is allowed, however, only for gifts of a present interest and not a future interest. A present interest is defined in Treas. Reg. § 25.2503-3(b) as the unrestricted right to the immediate use, possession, or enjoyment of property or the income from property. Outright transfers of property almost certainly will qualify for the gift tax annual exclusion under Code § 2503(b). Property owners, however, often do not want a person of a young age (as their child and grandchild may be) to receive ownership of property directly, instead preferring for the ownership to be deferred until that person reaches a more mature age or certain needs arise, such as for college education. Although transfers to trusts usually do not qualify for the annual exclusion, at least in part, certain trust or trust equivalent transfers may qualify in full. Three common techniques used to capture the benefit of the annual exclusion while avoiding direct ownership by the donee are transfers (1) under the Uniform Transfers (or Gifts) to Minors Act if the donee is a minor; (2) to a trust (called a “section 2503(c) trust”) described in Code § 2503(c), if the donee is under age 21 years; and (3) to a trust under which the beneficiary holds a so-called Crummey power of withdrawal, regardless of the beneficiary’s age. (In Crummey v. Commissioner, it was held that a currently exercisable, although annually lapsing, power of withdrawal held by a minor qualified transfers to a trust for the gift tax annual exclusion to the extent the power could be exercised.)
Annual Exclusion Gifts to Minors
Can an outright gift be made to a minor? Does a minor have the capacity to accept the gift, and if not, can a completed gift be made? Even if this is solved by the appointment of a guardian, guardianships are so restrictive and expensive that they are rarely, if ever, used as the vehicle by which annual exclusion gifts are made to a minor.
As indicated, transfers to certain trusts and similar vehicles may qualify for the annual exclusion despite the fact that, in general, transfers in trust qualify for the exclusion only in part or not at all. See the examples under Treas. Reg. § 25.2503-3(c). The section 2503(c) trust qualifies for the annual exclusion, but only if created for someone under the age of 21 years and only while he or she is alive and under that age. The terms of the trust are somewhat restrictive. One perceived limitation is that the trust must end when the beneficiary reaches age 21 years or the beneficiary must have the right to terminate it, for at least a brief period, at that time. See Rev. Rul. 74-43, 1974-1 C.B. 285.
An alternative to a transfer to a section 2503(c) trust is one to a UTMA account. Transfers to a custodian (the title of the fiduciary who holds the property for the minor under the UTMA arrangement) are treated as gifts to the minor and qualify for the annual exclusion. According to the IRS, such transfers so qualify under Code § 2503(c), with the UTMA essentially being treated as the equivalent of a section 2503(c) trust. Like such a trust, the assets in a UTMA account must be created only for a minor and must be distributed to the minor at age 21 years. See Rev. Rul. 59-357, 1959-2 C.B. 212. It is interesting to note that in some states, the distribution age is 18 years; in a few other states, the distribution may be extended beyond age 21. Such a delayed payout, however, almost certainly will cause the transfer to fail to qualify for the gift tax annual exclusion.
What About Annual Exclusion Gifts to Adults?
As indicated, section 2503(c) trusts and UTMA accounts may be used only for those under the age of 21 years. Of course, gifts may be made directly (outright) to someone 21 years of age or older, unless incapacitated, in which case he or she is likely to have a guardian who could accept the gift.
But gifts to trusts, whether for minor or adult persons, generally are preferable. A trust provides protection from creditors’ claims in many cases, may provide some protection from the foolish dissipation of wealth, may present an opportunity to reduce income taxes, and may give an opportunity to avoid estate taxation when the individual for whom the transfer was made dies. In contrast, property held in either a section 2503(c) trust or a UTMA account will be included in the gross estate of the minor whether he or she dies before or after age 21 years; outright transfers, of course, also will be included in the recipient’s gross estate unless expended before death.
One type of trust that may be used for an adult or a minor beyond reaching the age of 21 years, and that qualifies for the annual exclusion, is the Crummey trust, under which gifts to the trust qualify for the gift tax annual exclusion to the extent the beneficiaries are given the immediate right to withdraw the transferred property from the trust (even though the power to withdraw eventually may lapse). One of the additional benefits of the Crummey trust is that, unlike a section 2503(c) trust or a UTMA account, one trust may be used for multiple beneficiaries.
Income Tax Advantages of Trusts
As indicated above, a trust may provide an opportunity for income tax planning. Unfortunately, a UTMA account provides little planning opportunity. The income earned by the UTMA account, as a general rule, is taxed directly to the minor and that income may be subject to the so-called kiddie tax under Code § 1(g) (under which the income is taxed at the rates of the minor’s parents, in some cases, until the child reaches age 23 years). Thus, a UTMA account has no income tax advantage.
In contrast, the section 2503(c) trust, as a general rule, is treated as a taxpayer, separate and independent of its grantor and beneficiary. Hence, income earned by the trust may be taxed to the trust rather than to the minor. Although trusts reach the maximum federal income tax bracket at quite low levels of taxable income (for 2007, it was $10,450), taxing the income to the trust may provide an opportunity to avoid state and local income taxation. See, e.g., New York Tax Law § 605 (essentially providing that a trust without a New York trustee, New York situs property, and New York source income is not subject to New York income tax even if the grantor is a New Yorker). Alternatively, distributions could be made to or for the minor, causing the trust’s income (to the extent of its distributable net income, or DNI, defined in Code § 643(a)) to be taxed to the minor.
Crummey trusts with multiple beneficiaries provide even greater flexibility for the shifting of taxable income. By making distributions to one (or more) beneficiaries, the trust’s DNI may be shifted to such beneficiary (or beneficiaries), providing an opportunity for an overall reduction in income taxes. See Code §§ 661 and 662.
A further potential advantage of a trust is the ability to have the income of the trust taxed to its grantor under the grantor trust rules of the Code (Code §§ 671 to 679). Although attributing income to the grantor may not lower overall income taxation, it may provide significant additional tax-free transfer advantages for estate, gift, and generation-skipping transfer tax planning. The grantor’s payment of income tax on the income attributed to the grantor under the grantor trust rules is not a gift. Rev. Rul. 2004-64, 2004-2 C.B. 7. (That is one reason why an assumption of a net 8% annualized return on gifts to the trust, used in the illustration above, may not be unrealistically high.)
Annual Exclusion Transfers to Grandchildren
There is an annual exclusion equivalent for generation-skipping transfer tax (GST) purposes under Code § 2642(c). Hence, an annual exclusion gift to a “skip-person” (that is, a grandchild, more remote descendant of the transferor, or someone treated as being in the generation or such grandchild or more remote descendant) may qualify for both the gift tax and the GST tax annual exclusion. Under Code § 2642(c)(2), however, a transfer in trust will qualify for the GST annual exclusion only if the skip-person is the only beneficiary of the trust and, to the extent not distributed to him or her during lifetime, will be included in his or her gross estate for federal estate tax purposes. Of course, transfers to a section 2503(c) trust or a UTMA account will qualify for both exclusions. But a transfer to a multiple-beneficiary Crummey trust will not. The cure is to use an ExtraCrummeyTrust sm.
The ExtraCrummeyTrust sm is a single document that creates a separate trust for each one of multiple beneficiaries for purposes of using the annual exclusion. Each contribution (unless specified otherwise at the time of its contribution) is divided into equal shares for then-living beneficiaries. Beneficiaries usually are defined to include all descendants living at the time of the contribution. Hence, if the contributor has three children and six grandchildren, the contribution would be divided into nine equal shares, with a share added to a separate trust for each descendant then living. As the number of descendants changes (such as by the birth of another grandchild), the division of future gifts changes.
In addition, a trust may be created under the ExtraCrummeyTrust sm document for each descendant-in-law. Transfers to such a trust for a descendant-in-law also should qualify for the annual exclusion if the descendant-in-law is a real beneficiary of the trust. Cf. Estate of Cristofani v. Commissioner, 97 T.C. 74 (1991), acq. in result only, Action on Decision CC-1992-009. As discussed below, however, the property in a trust for a descendant-in-law ultimately may be preserved for a descendant of the transferor.
Here is sample language on how divisions of contributions are treated under an ExtraCrummeyTrust sm:
Any property assigned, conveyed, transferred or delivered by the Grantor or any other person or persons to the Trustee shall be set aside for the Grantor’s descendant (whether born before or after the date of this Agreement) for whose benefit the Grantor or such other person or persons shall have advised the Trustee at the time such property is assigned, conveyed, transferred or delivered to such Trustee in writing or, if the Grantor or such other person or persons do not so advise, the property shall be divided into a sufficient number of equal shares such that there shall be set aside one
Trusts for Non-skip-persons
Each trust under the ExtraCrummeyTrust sm document would provide for its beneficiary to have a Crummey power of withdrawal, allowing the transfer to qualify for the gift tax annual exclusion and, if the beneficiary is a skip-person, for the GST annual exclusion. The power of withdrawal under each trust for a non-skip-person (such as a child or child-in-law) would lapse in a manner and time to prevent the lapse from constituting a taxable gift, under Code § 2514(e), by the beneficiary and to prevent the trust from automatically being included in the gross estate of the non-skip-person. (Under Code
It should be noted that persons other than the named grantor also may make contributions for the beneficiaries of the ExtraCrummeyTrust sm. The terms of the trust will automatically allocate the contributions based on the relationship between the person making the contribution (whether or not the named grantor) and the beneficiary for whom the contribution is made. For example, a sibling of the grantor may make contributions for the grantor’s descendants. Because the sibling is a transferor in the same generation as that of the grantor, the identity of each descendant as a skip-person or non-skip-person is the same for the sibling as for the grantor. If someone in another generation, such as a child of the grantor, makes a contribution, the identity of each person as a skip-person or non-skip-person will be different than it would be for the grantor. For example, a child may add a contribution to the trust for his or her own children. Because these beneficiaries are non-skip-persons, the shares for them, under the above language, would automatically be allocated into trusts for non-skip-persons.
Each non-skip-person (such as a child) may be and often is granted a special testamentary power of appointment, but the power may be structured so it is exercisable only with the consent of a non-adverse person, such as an independent trustee. That permits the trustee essentially to prevent property passing in a manner the trustee determines is not consistent with the wishes of the transferor of the property. For example, the trustee could block a child (or a child-in-law if a trust is created for the in-law) from exercising the power outside of the grantor’s bloodline or in any other manner that the non-adverse person determines inappropriate. In default of the effective exercise of any such power of appointment, the property usually will pass outright to or will remain in trust for the descendants of the non-skip-person, if he or she was a child of the grantor, or if the skip-person was a child-in-law for his or her spouse who was a child of the grantor, or if such child is not then living, for his or her descendants.
Although the trust property is not included in the gross estate of the non-skip-person who is the beneficiary of the trust, that property still may be subject to generation-skipping transfer tax on the death of that non-skip-person if it passes to or for a grandchild or more remote descendant of the transferor. (There will be no such tax if it passes to or for another child of the transferor or anyone else who is not a skip-person.) Nevertheless, by appropriately exercising the special power of appointment, the non-skip-person can trigger the so-called Delaware Tax Trap, causing the property subject to the power to be included in his or her gross estate under Code § 2041(a)(3) and thereby be subjected to estate tax rather than GST tax. See generally Jonathan G. Blattmachr & Jeffery N. Pennell, Using “ Delaware Tax Trap” to Avoid Generation-Skipping Taxes, 68 J. Tax’n 242 (1988), updated and reprinted in 24 Real Prop. Prob. & Tr. J. 75 (1989).
Here is sample language describing the trust for each non-skip-beneficiary:
Trust for Beneficiary
Property that is to be held in a Trust for Beneficiary shall be held under this Article and all references to a “Trust for Beneficiary” shall be to any trust or trusts held under this Article.
A. During Beneficiary’s Life. The following provisions shall apply during the Beneficiary’s life:
1. The Trustee shall distribute to one or more of the Beneficiary and the Beneficiary’s descendants as much of the net income and principal of the trust as the Trustee (excluding, however, any Interested Trustee) may at any time and from time to time determine, in such amounts or proportions as the Trustee (excluding, however, any Interested Trustee) may from time to time select, for any purpose. Any net income not so distributed shall be accumulated and annually added to principal.
2. Without limiting the Trustee’s discretion, the Trustee may consider the needs of the Beneficiary as more important than the needs of the Beneficiary’s descendants or of any other beneficiary.
B. Upon Beneficiary’s Death. Upon the Beneficiary’s death, the property then held in his or her trust shall be:
1. distributed to such one or more persons (other than the Beneficiary, the Beneficiary’s estate, the Beneficiary’s creditors or the creditors of the Beneficiary’s estate) on such terms as the Beneficiary may appoint by a Will or other signed writing that is acknowledged before a notary public specifically referring to this power of appointment, provided that anyone other than the Grantor’s descendants may be given only an interest in the income of a trust under an appointment which must be in further trust and no interest in or power over principal, or, in default of appointment or insofar as an appointment is not effective;
2. distributed, if the Beneficiary was the spouse of a descendant of the Grantor and such descendant survives such Beneficiary, to the Trustee of a Trust for Beneficiary for such descendant of the Grantor to be held as a separate trust to be disposed of under the terms of the Trust for Beneficiary under this Article, such descendant of the Grantor to be the Beneficiary of his or her own Trust for Beneficiary, or if such descendant of the Grantor does not survive such Beneficiary who was the spouse of a descendant of the Grantor or if such Beneficiary was a descendant of the Grantor;
3. set aside and divided into per stirpital shares for the descendants then living of the Beneficiary or, if there is no descendant then living of the Beneficiary, for the descendants then living of the nearest ancestor of the Beneficiary who was a descendant of the Grantor or who is or was the Grantor, the share so set aside for a descendant to be distributed to the Trustee of the Trust for Beneficiary to be held as a separate trust to be disposed of under the terms of the Trust for Beneficiary under this Article, the descendant for whom the share is set aside to be the Beneficiary of his or her own Trust for Beneficiary.
Note that in the sample language, it is assumed that trusts were not created for children-in-law of the grantor; if such a trust were created, its remainder would pass into a trust for the benefit of the in-law’s spouse who is a descendant of the grantor (for example, the grantor’s daughter if the trust were for the grantor’s son-in-law) or, if none, other descendants of the grantor (for example, the children of the grantor’s daughter).
Trusts for Skip-persons
Unlike the withdrawal power held by a non-skip-person, the withdrawal power of the skip-person need not lapse (because the trust must be included in the skip-person’s gross estate) but may remain exercisable. But, even if the power of withdrawal does not lapse, that power will usually be made exercisable only with consent of a non-adverse person, such as an independent trustee, after a period sufficient to allow the transfer to the trust to qualify for the gift tax annual exclusion.
In any case, each skip-person, unlike each non-skip-person, must be granted a testamentary general power described in Code § 2041 to appoint the trust property at death. This grant is necessary to ensure that the trust will be included in the gross estate of the skip-person, a necessary requirement, as explained above, for a gift to the trust to qualify for the GST annual exclusion. But even so, that general power may be made exercisable only with the consent of a non-adverse party. Even if the trust is drafted so that the consent of a non-adverse person is required, the power still will be sufficient to fulfill the requirement of estate tax inclusion. See Code § 2041(b)(1)(C)(ii). In any case, to the extent the testamentary general power of appointment granted to the skip-person is not effectually exercised, the trust property usually will pass to or will remain in trust for the descendants of the skip-person, if a descendant of the transferor. If the skip-person was a spouse of a descendant of the grantor, then in default of the effectual exercise of the general power, the trust property usually will remain in trust for the spouse (being a descendant of the grantor) or, if he or she is not then living, to or in trust for his or her descendants.
Here is some sample language that may be used to describe the trust for each non-skip-beneficiary:
Trust for Skip-Beneficiary
Property that is to be held in a Trust for Skip-Beneficiary shall be held under this Article and all references to a “Trust for Skip-Beneficiary” shall be to any trust or trusts held under this Article.
A. During Skip-Beneficiary’s Life. The following provisions shall apply during the Skip-Beneficiary’s life:
1. The Trustee shall distribute to the Skip-Beneficiary as much of the net income and principal of the trust as the Trustee (excluding, however, any Interested Trustee) may at any time and from time to time determine, for any purpose.
2. Any net income not so distributed shall be accumulated and annually added to principal.
B. Upon Skip-Beneficiary’s Death. Upon the Skip-Beneficiary’s death, the property then held in his or her trust shall be:
1. distributed to such one or more persons (including the Skip-Beneficiary’s estate) on such terms as the Skip-Beneficiary may appoint by a Will or other signed writing that is acknowledged before a notary public specifically referring to this power of appointment, provided, however, that this power may be exercised only with the written consent of the Trustee (other than any person who has an adverse interest in the appointive property within the meaning of Code Sec. 2041(b)(1)(C)(ii) and Treas. Reg. § 20.2041-3(c)(2) and at all times at least one Trustee acting hereunder with respect to each Skip-Beneficiary’s Trust shall be a person who does not have such an adverse interest) and any attempted exercise without such consent shall be void and ineffectual, or, in default of appointment or insofar as an appointment is not effectual;
2. set aside and divided into per stirpital shares for the descendants then living of the Skip-Beneficiary or, if there is no descendant then living of the Skip-Beneficiary for the descendants then living of the nearest ancestor of the Skip-Beneficiary who was a descendant of the Grantor or who is or was the Grantor, the share so set aside for a descendant to be distributed to the Trustee of the Trust for Beneficiary to be held as a separate trust to be disposed of under the terms of the Trust for Beneficiary under this Article, the descendant for whom the share is set aside to be the Beneficiary of his or her own Trust for Beneficiary.
It will be noted that the property for the descendants of the skip-beneficiary (or for another descendant of the grantor) does not go into a trust for the skip-beneficiary but rather into a trust for the beneficiary. This approach in drafting is used because, on the death of the skip-beneficiary, no attempt is being made to have the property in the trust qualify for the gift tax or GST annual exclusion, and thus there is no reason or need for the property to pass into a trust described in Code § 2642(c)(2). Hence, the more flexible terms of the “Trust for Beneficiary” may be used. Also, note that in the sample language, it is assumed that trusts were not created for descendants-in-law of the grantor; if such a trust were created, its remainder would pass into a trust for the benefit of the in-law’s spouse who is a descendant of the grantor or, if none, other descendants of the grantor.
ExtraCrummeyTrust sm with Separate Shares Instead of Separate Trusts
One of the disadvantages of multiple trusts may be the necessity of having to file multiple income tax returns and to maintain separate brokerage and bank accounts for each trust. During any period that the trust is a grantor trust, no trust income tax return usually need be filed. See generally Jonathan G. Blattmachr & Bridget J. Crawford, Grantor Trusts and Income Tax Reporting Requirements: A Primer, 13 Prob. Prac. Rep. (May 2001). If the trusts are not grantor trusts, however, a separate income tax return (Form 1041) generally will have to be filed for each one. Grantor trust status will terminate no later than when the grantor dies (although each trust may be treated, in whole or in part, as a grantor trust under Code § 678 for its beneficiary).
In any case, separate trusts will necessitate, in all likelihood, separate accounts (brokerage accounts, for example) for each trust. Perhaps separate accounts could be avoided by having the trusts form a common entity (a limited partnership or limited liability company, for example) through which they separately could invest.
An alternative under the ExtraCrummeyTrust sm is to create a substantially separate and indepen-
Here is some sample language so the gifts will be held as separate shares of one trust rather than as separate trusts:
Direction to Hold as Separate Shares
Although this instrument directs the division of each contribution made to the Trustee into separate trusts and directs upon the death of a Beneficiary or a Skip-Beneficiary the division of trust property into separate trusts, any such division shall be, to the extent it would not cause any contribution made for a skip-person to fail to qualify as a nontaxable gift under Code Sec. 2642(c)(2), into separate shares within the meaning of Code Secs. 663(c) and 2654(b) rather into a separate trust or separate trusts (and any reference to a trust or trusts shall mean a separate share or shares) unless and until, but only to the extent, the Trustee exercises the authority hereby granted to the Trustee to treat any such separate share as a separate trust rather than as a separate share. One of the reasons for directing for division of contributions and trust corpus into separate shares (rather than separate trusts) is to reduce the number of income tax returns filed and reduce recordkeeping costs with respect to property held under this instrument.
Summary and Conclusions
The use of annual exclusions is important in estate planning. Outright transfers are simplest but provide no creditor protection or additional tax planning and cannot be efficiently used, as a practical matter, for transfers to minors. Although UTMA accounts and section 2503(c) trusts offer a relatively straightforward way to transfer property to minors, the requirement of payout when the minor reaches age 21 years may be problematic in some cases. Crummey trusts offer additional advantages but fail to qualify the transferred property for the GST annual exclusion. The ExtraCrummeyTrust sm seems to offer some of the best advantages of all vehicles especially if it is structured to form separate shares rather than separate trusts. The taxpayer can sign one document and then make additional gift tax annual exclusion transfers each year to cover additional beneficiaries (such as later-born or adopted grandchildren) and/or to limit the class of beneficiaries to whom he or she wishes to benefit with new annual exclusion gifts.