Contingent beneficiaries and the annual gift tax exclusion.

• Author: Ross, Ronald S.

A longtime and basic tax-planning device for individuals making lifetime gifts is the annual exclusion.(1) With a proper gift tax strategy, an individual may make large lifetime transfers of wealth that escape the gift tax and reduce his taxable estate. As a result of this capability for facilitating large tax-free transfers of wealth, the gift tax exclusion has the potential for being abused as a tax planning technique. This article will review the traditional and intended use of the annual exclusion and examine a more recent liberal interpretation involving gifts to contingent beneficiaries. At odds with the IRS, this new interpretation may portend new, larger and vastly different tax planning techniques for transfers of wealth.

Background

Sec. 2511(a) provides that the gift tax applies to a transfer by gift whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and regardless of what kind of property is transferred. When property is transferred for less than full consideration, the amount by which the value of the property exceeds the value of the consideration will be deemed a gift.(2) Sec. 2501 imposes a tax on the transfer equal to the excess of the tax on the transferor's aggregate taxable gifts over the tax for the transferor's aggregate taxable gifts for prior calendar periods.(3) Taxable gifts here means "the total amount of gifts"(4) less the annual gift tax exclusion, i.e., the first $10,000 of these gifts to each donee is not included in the total amount of gifts made during the year.(5)

Under Regs. Sec. 25.2503-3(a), "[n]o part of the value of a gift of a future interest may be excluded in determining the total amount of gifts made during the |calendar period'." "Future interest" includes reversions, remainders and other interests, whether vested or contingent, that are limited to begin in use, possession or enjoyment at some future date or time.

Regs. Sec. 25.2503-3(b) describes those interests that qualify for the exclusion as any gift of a present interest, an interest that is "[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property...." The distinction between a future interest and a present interest focuses on the immediacy of the right to enjoyment. While the regulations seem to be fairly specific that only a present interest qualifies for the annual exclusion, an issue that keeps arising is the degree of donee ownership in the interest that must be present in order to be considered a present interest. This question was left unanswered in Crummey,(6) and in various letter rulings the IRS has taken conflicting stands. Est. of Cristofani,(7) a 1991 Tax Court case, and IRS Letter Ruling 9030005(8) address the issue of donee ownership in donated property and the impact on eligibility for the annual exclusion. Their conclusions expand on Crummey and may open the door for greater tax-free transfers of wealth.

In most situations, including Crummey, the implication is that the donee has a vested interest or, at least, a certain interest. In Crummey, the settlors established an irrevocable living trust, giving minor beneficiaries annual withdrawal rights and naming them as permissible current distributees under the trustee's power to sprinkle income. At issue was the allowance of the annual exclusion for the minor beneficiaries on the grounds that the minors, withdrawal powers were not gifts of present interests in property.

The Ninth Circuit found that the minor beneficiaries had a legal right to demand payment from the trustees that could not be legally resisted and, therefore, allowed the settlors to claim annual exclusions with respect to the minor trust beneficiaries. The court concluded that all exclusions should be allowed based on the "right to enjoy" test in Gilmore,(9) but never addressed the issue of ownership of an interest.(10)

Subsequent revenue rulings have also recognized that when a trust instrument gives a beneficiary the legal power to demand immediate possession of corpus, that power qualifies as a present interest in the property.(11) This standard, generally known as a Crummey power,(12) has become the criterion for constructing trust instruments that purport to give beneficiaries a present interest and, consequently, allow the donor to use the annual exclusion.

The IRS's Position

While Crummey helped define withdrawal powers that would be eligible for the annual gift exclusion, variations on Crummey powers required further clarification by the Treasury Department. In IRS Letter Ruling 9141008,(13) the taxpayer established a trust to benefit her three children, giving them a limited right of withdrawal. On the death of any of the children, that child's portion of the trust estate would be divided into separate trusts for the then living issue of that deceased child. In addition, the trust provided that for a period of 20 consecutive days following a contribution, but ending before December 31 of the year of the contribution, each child as well as his or her issue or spouse had the right to withdraw from the trust estate an amount that would not exceed the amount of the annual exclusion. Thus, the grandchildren had current demand rights but only a remote contingent interest in the income or the trust corpus. At the time the trust was established, the decedent had three children and 32 grandchildren and great-grandchildren.

At issue in this ruling was a question that had not been addressed in Crummey, namely, whether an annual exclusion would be permitted only for those beneficiaries who had a continuing interest in the trust or whether the exclusion also would apply to those beneficiaries with more remote, contingent interests. The IRS found it significant that none of the 32 grandchildren and great-grandchildren ever exercised any withdrawal rights and inferred that the contingent beneficiaries had reached a prior understanding with the donor that the withdrawal rights would not be exercised.(14) Consequently, naming...