Internal Revenue Code § 2503(b) allows each taxpayer to make annual exclusion gifts to any person or entity. The current amount of the annual exclusion is $14,000 annually. This means a husband and wife could give $84,000 to their three children ($14,000 x 2 x 3 children) free of gift taxes. If grandchildren were included, it could be substantially more. And these gifts are not limited to only descendants, so a taxpayer could make gifts to more distant relatives (nephews, nieces, and cousins) or even friends. The gift could be cash or other property. The purpose of the annual gift exclusion is to simplify administration of taxes by the IRS. Without it, each year taxpayers would be required to report birthday presents, Christmas gifts, graduation gifts, and paying for a daughter’s (or son’s) wedding.
In order to qualify for the annual gift tax exclusion, the gift must be a present interest gift. This means that the person receiving the gift must be able to have immediate enjoyment from the gift. A gift to a trust that distributes assets at the death of the creator of the trust would not normally qualify for one or more annual exclusions because the beneficiary would not get enjoyment of the gift until sometime in the future – like upon the death of the creator of the trust.
In 1968, the Ninth Circuit Court of Appeals ruled in favor of the taxpayer in Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968). The unfortunately named Dr. Crummey had devised a trust designed to take advantage of the gift tax annual exclusion allowed by the IRS. This was done by giving the beneficiaries the opportunity to withdraw the gift from the trust during a short window of time (typically thirty days), and if they failed to do so, the withdrawal right would lapse. This allowed the creator of the trust to make gifts to a trust and receive gift tax annual exclusions for each beneficiary who had a withdrawal right (known as Crummey power beneficiaries). As taxpayers have become more and more creative over the years, the IRS has continued to attack variations of what has become known as a Crummey Trust, with very little success.
A recent example is Mikel v. Commissioner, T.C. Memo 2015-64. Mr. and Mrs. Mikel owned three properties in New York and one in Florida valued at $3,262,000 in total. In 2007, they created an irrevocable trust and contributed the properties to the trust. The trust named sixty Crummey power beneficiaries, qualifying the trust for gift tax annual exclusions of $1,440,000 (60 x 2 x $12,000, which was the annual gift tax exclusion amount in 2007). That meant $1,440,000 of the gifts of property to the trust would have been gift tax free. The balance of the gift, or $1,822,000, would have been subject to gift tax. Presumably Mr. and Mrs. Mikel used a portion of their lifetime gift tax exemptions ($1,000,000 each back in 2007) to shelter the remainder of the gifts from gift tax. Any future growth on the properties would also pass gift and estate tax free to the remainder beneficiaries of the trust upon the death of the survivor of Mr. and Mrs. Mikel (if properly drafted, an irrevocable trust can be excluded from the estate of the creators for purposes of determining the amount of estate taxes due at death). If Mr. and Mrs. Mikel’s estate is large enough to be subject to estate tax, this strategy saved them at least $806,400 in federal and New York estate taxes (more if the properties have appreciated in value since they were contributed to the trust).
The IRS challenged the trust on various grounds, trying to disqualify it from receiving the $1,440,000 in gift tax annual exclusions and thereby recouping hundreds of thousands of dollars in gift taxes. The U.S. Tax Court heard the matter and ruled in the taxpayer’s favor, ruling that the taxpayer was entitled to annual exclusions for each of the sixty beneficiaries.
For the past several years, the Obama administration has sought to change the law to provide a cap of $50,000 per year per donor for annual exclusions, whether to trusts or outright. This would prevent the type of planning used by the Mikels, but still allow for taxpayers to engage in viable advanced estate planning strategies such as Irrevocable Life Insurance Trusts. Had the administration’s proposal been in effect in 2007, this would have limited the Mikels to gift tax annual exclusions of $100,000. Congress has yet to act on any of the Obama administration’s estate and gift tax recommendations. However, there is always the possibility that changes may occur in the future. This is a good reason to get planning done sooner rather than later.
Our law firm focuses on estate planning for clients of all levels of wealth, including those with taxable estates (single individuals with more than $5.43 million and married couples with more than $10.86 million in 2015). We also offer trust administration and probate services. As a member of the American Academy of Estate Planning Attorneys, our firm is kept up-to-date with information regarding tax cases such as the Mikel case and other developments and cutting-edge planning strategies. You can get more information about a complimentary review of your clients’ existing estate plans and our planning and administration services by calling our office at (408) 356-9200 or (831) 476-2400.