A Lapse Of Judgment And Other Gifting Nuances Involving Irrevocable Trusts

The 1968 Ninth Circuit Court of Appeals case of D. Clifford Crummey v. Commissioner of Internal Revenue established the strategy that is relied on today to permit tax free gifts to certain trusts using the donor’s annual $12,000 gift tax exclusion. Providing “Crummey Notices” to trust beneficiaries establishes the requisite rights to property or cash gifted to qualify it for the “present interest” requirement of the Internal Revenue Code. Many accountants and lawyers stop there and do not assess the gift tax consequences to the holder of the Crummey Notice, who has a temporary right to withdraw trust property. A lapse or release of that right, which almost always occurs because beneficiaries are encouraged not to withdraw the trust property contributed, often has unintended gift and generation skipping tax consequences and proper accountings should be maintained for many years to monitor these consequences.

When a holder of a Crummey Notice fails to exercise the power to withdraw property contributed to a trust or releases it, an unintended gift by the power holder is deemed to occur. For example, if in 2008 parents make a gift of $24,000 to a trust in which two children are beneficiaries and that is their only gift for the year, the gift will not be taxable if the two children are provided with a Crummey Notice, or a notice of right to withdraw the gifts for 30 days. Upon their release of the power to withdraw, or the expiration of the 30 days, the children too are deemed to be making a gift of the same amount to the trust. It is as if they received the $24,000 and then made a gift back to the trust. The problem with failure to recognize this is that the children may have future unintended gifts for which they must account and unintended generation skipping tax consequences may result to the original donor. For example, since the children are making gifts back to the trust and are also beneficiaries, an allocation of the generation skipping tax exemption to the trust would often waste that exemption because the property gifted back will be taxed in their estate. What is important to recognize is that sometimes this allocation of generation skipping tax exemption is automatic, unless a timely filed gift tax return is filed opting out of the automatic allocation. Some trusts or Crummey Notices are designed to minimize the impact of a lapse of the right to withdraw property provided by a Crummey Notice using what are called hanging powers. In general, a lapse (distinguished from a release) is not deemed a transfer of property by gift back to the trust by the Crummey power holder to the extent the amount that lapses does not exceed the greater of $5,000 or 5% of the property over which the power exists. Hanging powers are designed to provide power holders with an indefinite annual right to withdraw using this 5 & 5 rule until no gift will be made as a result of a lapse.

As hopefully can be seen from this explanation, accounting records should be kept of Crummey Notices and hanging powers. This should be done as part of annual gift tax compliance, as more often than not gift tax returns should be filed. Many are unaware of this, which complicates future planning and tax compliance for both senior family members, as donors, and junior family members, as beneficiaries. Both are potentially adversely impacted by relatively small gifts to irrevocable insurance or gifting trusts, and this oversight or “lapse in judgment” should be cured.

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