Section 2503(b) of the Internal Revenue Code provides the annual exclusion, which excludes from taxable gifts the first $10,000 (adjusted for inflation) of “present interest” gifts. The current annual exclusion amount is $14,000. Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968) supplies the rule for present interest gifts in trust. In order to have a present interest in a gift held in a trust, the beneficiary must have an unconditional right to withdraw upon demand. The IRS expressed its agreement with Crummey in Rev. Rul. 73-405. In Estate of Cristofani v. Comm’r, 97 T.C. 74 (1991), the Tax Court adopted the reasoning in Crummey, finding that the proper focus of the present interest test analysis is not the likelihood that beneficiaries would actually receive enjoyment of the property, but the legal right of the beneficiaries to demand payment from the trustee. The IRS acquiesced to the result in Cristofani, noting that although it will not contest annual gift tax exclusions for Crummey powers where the trust instrument gives the power holders bona fide unrestricted legal right to demand immediate possession and enjoyment of trust income corpus, it will deny Crummey exclusions where the withdrawal rights are not in substance what they purport to be in form.
In Mikel v. Comm’r, T.C. Memo 2015-64, the IRS challenged donor-grantors claims of the annual exclusion for gifts contributed to a trust where the trust granted each beneficiary (many of whom were under 18 years of age) the right to withdraw trust principal (the Crummey provision), but also contained an in terrorem (“no contest”) clause, which provided the following:
“In the event a beneficiary of the Trust directly or indirectly institute, conduct or in any manner whatever take part in or aid in any proceeding to oppose the distribution of the Trust Estate, or files any action in a court of law, or challenges any distribution set forth in this Trust in any court, arbitration panel or any other manner, then in such event the provision herein made for such beneficiary shall thereupon be revoked and such beneficiary shall be excluded from any participation in the Trust Estate.”
Each petitioner made gifts of $1,631,000 to a family trust, reported the gifts on gift tax returns and claimed annual exclusions pursuant to Section 2503(b) of $720,000. Petitioners computed their $720,000 annual exclusion amounts by multiplying $12,000 (the annual exclusion for the taxable year) by the number of beneficiaries to the trust (60). The trust also contained a provision requiring notification to all beneficiaries that the trust received property as to which the beneficiary had a demand right. Such notification must occur within a reasonable time after the contribution of property subject to a demand right. The trust complied with the notification provision after petitioners made their gifts. The trust directed mandatory distributions in response to withdrawal demands and empowered trustees to make discretionary distributions during the term of the trust for “health, education, maintenance or support” (“HEMS” provision).
The trust also provided if any disputes arose regarding the proper interpretation of the declaration the dispute shall be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith (a “beth din”). The beth din was directed to enforce the provisions of the declaration of trust and give any party the rights he is entitled to under New York law.
The IRS conceded that the trust provided each beneficiary with an unconditional right to withdraw (via the Crummey provision), but argued that regardless of the Crummey provision, the beneficiaries did not receive a present interest in property because the beneficiaries “would be reluctant” to enforce their rights in state court as a result of the no contest clause and the beth din requirement. Respondent further argued that beneficiaries’ withdrawal rights were “illusory.” Significantly, the IRS challenged the provision because the drafters did not make it clear that the in terrorem provision did not apply to the right to demand.
In finding for Petitioners, the Tax Court noted the beth din was directed to enforce the declaration of trust and give any party all rights he is entitled to under New York law. As a result, “a beneficiary would suffer no adverse consequences from submitting his claim to a beth din.” The Tax Court also noted Respondent’s concession that the beneficiaries have a state court remedy, and that the no contest clause was meant to discourage legal actions seeking to challenge the trustees discretionary (not mandatory) distributions. Therefore, the Tax Court reasoned, a suit to honor a timely withdrawal demand would not trigger the application of the no contest clause.
Since the trustee did not have discretion to deny a timely made withdrawal demand, the in terrorem provision did not apply to the demand right. Thus, the right to judicially enforce it was not illusory. Because the beneficiaries had an unconditional right to withdraw, they had present interest in the trust.
The Tax Court noted that the no contest clause was poorly drafted and devoted significant analysis to whether the no contest clause should be read narrowly. In finding for Petitioners, the Tax Court concluded a Crummey provision existed, beneficiaries’ “literally” had state court enforceable rights, and “the [no contest] provision, properly construed, would not deter beneficiaries from pursuing judicial relief.” Accordingly, although the IRS will have difficulty challenging the application of the annual exclusion to gifts to Crummey trusts, practitioners should carefully and clearly draft other trust provisions so that the Court is not in a position to consider whether other terms of the trust create present interest test issues.
KRISTA HARTWELL – For more information please contact Krista Hartwell at Hartwell@taxlitigator.com or 310.281.3200. Ms. Hartwell is a tax lawyer at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com.