Case — Crummey Illusion

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TL Case Summ

THE QUESTION

Are a trust’s Crummey provisions illusory?

THE DISPUTE

Taxpayer Says: Transfers to a trust qualify for the annual gift tax exclusion because the trust’s Crummey provisions make the gifts present interests.

Internal Revenue Service Says: The beneficiaries lacked legally enforceable rights to withdraw funds from the trust. The claimed exclusions were gifts of future, not present, interests, and the taxpayer cannot claim them.

THE LAW

From Internal Revenue Code Section 2501(a)(1): Imposes a tax “on the transfer of property by gift” during any calendar year.

From Internal Revenue Code Section 2511(a): Provides that “the tax imposed by section 2501 shall apply whether the transfer is in trust or otherwise.”

From Internal Revenue Code Section 2503(b)(1): Provides an exclusion from taxable gifts. “[I]n the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of such gifts to such person shall not * * * be included in the total amount of gifts made during such year.” Section 2503(b)(2) adjusts this annual exclusion for inflation; for gifts made during 2007, the exclusion was $12,000 per donee (Rev. Proc. 2006-53, sec. 3.32). The annual exclusion is available only for gifts of a “present interest in property.”

From Regulation 25.2503-3(b): A “present interest in property” is defined as “[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.”… “No part of the value of a gift of a future interest may be excluded” from taxable gifts.

From Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968): The demand clause in Crummey provided that whenever an addition was made to the trust, a beneficiary or guardian acting for a minor beneficiary could demand immediate withdrawal of an amount keyed to the maximum annual exclusion under section 2503(b). The court held this demand right to be a “present interest in property” even though no guardian for the minor beneficiaries had been appointed. Under the test it adopted, “all that is necessary is to find that the demand could not be resisted,” which the court understood to mean “legally resisted.” That being so, the court concluded that the trustee would have no choice “but to have a guardian appointed to take the property demanded” on the minor’s behalf. Ibid. The court rejected the IRS’ submission that “a lawsuit or the appointment of an agent is a necessary prelude to the making of a demand upon the trustee.” “The only time when the [minor’s] disability to sue would come into play,” the court noted, “would be if the trustee disregarded the demand and committed a breach of trust. That would not, however, vitiate the demand.”

THE CAUSE OF THE DISPUTE

The annual gift tax exclusion lets you give a gift to anyone without having to pay gift tax as long as the gift meets tax law requirements. One of these requirements is that the person you give the gift to must receive a “present interest” in the gift. A present interest is an unrestricted right to the immediate use, possession, or enjoyment of the gift.

When you establish a trust that restricts the beneficiaries from using or withdrawing the trust assets until some future time or event, your transfers to the trust are generally considered gifts of a future interest. That means the transfers would not be eligible for the annual gift tax exclusion.

However, the courts have allowed for a legal device, known as a “Crummey withdrawal power”, that lets you obtain the benefit of the annual gift tax exclusion. Crummey powers are named after the court case that approved them. When Crummey powers are included in a trust document, they give the beneficiaries the right to demand immediate distribution of certain amounts from the trust within a specified time period. That right effectively converts what would have been a future interest into a present interest eligible for an annual gift tax exclusion.

In this case, the taxpayer and his spouse established an irrevocable family trust in 2007 and jointly transferred property that year with a value of $3,262,000. The taxpayers each filed a gift tax return reporting these gifts in December 2011, after the IRS sent a notice. Each taxpayer claimed an annual exclusion of $720,000 based on the contention that each of their gifts included a $12,000 gift of a present interest to each of the trust’s 60 beneficiaries.

The trust granted beneficiaries the right to withdraw principal and property from the trust during the year the trust was created and during any subsequent year when property was added to the trust. The trustees were required to notify the beneficiaries of this right within a reasonable time after the trust received the property.

In 2007, after the taxpayers made the contribution to the trust, the trust’s attorney mailed the notification letters to the beneficiaries.

The IRS agrees the letters give each beneficiary an unconditional right of withdrawal. However, the IRS contends the beneficiaries did not receive a “present interest in property” because their rights of withdrawal were not “legally enforceable” in practical terms.

According to the IRS, a right of withdrawal is “legally enforceable” only if the beneficiary can “go before a state court to enforce that right.” The IRS believes this is something a beneficiary of this trust would be very reluctant to do because the trust contains a provision stating disputes must be settled before a three-person panel known as a “beth din” (a Jewish rabbinical court). If the beneficiary did not like the decision of the beth din, the beneficiary could opt to go to a state court. However, the trust document discouraged this with another provision that would revoke the beneficiary’s right to participate in the trust if they challenged discretionary acts of the trustees.

The IRS says these provisions make the withdrawal rights “illusory”, which means the beneficiaries lacked legally enforceable rights to withdraw funds from the trust. Therefore, the taxpayers’ gifts were of future, not present, interests, and the claimed exclusions were not allowable.

WHAT WOULD YOU DECIDE?

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THE COURT’S DECISION

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For the Taxpayer.

We discern two flaws in the argument of the IRS. First, if we adopt the premise that a withdrawal right must not only be “legally irresistible” under the trust instrument, but also be “legally enforceable” in an extrinsic sense, it is not obvious why the beneficiary must be able to “go before a state court to enforce that right.”

Here, if the trustees were to breach their fiduciary duties by refusing a timely withdrawal demand, the beneficiary could seek justice from a beth din, which is directed to “enforce the provisions of this Declaration * * * and give any party the rights she is entitled to under New York law.” A beneficiary would suffer no adverse consequences from submitting her claim to a beth din, and the IRS has not explained why this is not enforcement enough.

Second, if we assume our hypothetically-frustrated beneficiary must have an enforcement remedy in state court, the IRS concedes the beneficiaries of the trust have such a remedy. The IRS’s argument is not that judicial enforcement is unavailable, but that this remedy is “illusory” because the second provision would deter beneficiaries from pursuing it.

We think the IRS has misapprehended this provision’s meaning. The trust provides that a beneficiary shall forfeit her rights under the trust if she “directly or indirectly institute[s] * * * 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.”

While not a paragon of draftsmanship, this provision is evidently designed to discourage legal challenges to decisions by the trustees to make discretionary distributions of trust property, e.g., to help beneficiary A finish college, help beneficiary B enter a business, or enable beneficiary C to have a nice wedding.

The trust gives the trustees “absolute and unreviewable discretion” in such matters and states that their judgment “as to the amounts of such payments and the advisability thereof shall be final and conclusive.”

The evident purpose of this provision is to backstop the initial clause by discouraging legal actions seeking to challenge the trustees’ “absolute and unreviewable discretion” concerning discretionary distributions from the trust.

The first and third clauses of the provision explicitly track this purpose, providing that a beneficiary will forfeit her rights if she institutes a proceeding “to oppose the distribution of the Trust Estate” or “challenges any distribution * * * in any court.” A beneficiary who filed suit to compel the trustees to honor a timely withdrawal demand would not be “opposing or challenging” any distribution (discretionary or otherwise) from the trust.

Because the beneficiary’s action would not be covered by the provision, that provision logically would not dissuade her from seeking judicial enforcement of her rights.

In urging a broader construction of the provision, the IRS focuses on its second clause, “or files any action in a court of law.” But this clause cannot be read literally, otherwise, it would bar beneficiaries from participating in the trust if they filed suit to recover for mischievous behavior by their neighbor’s dog. The second clause must be given a limiting construction.

We think the most sensible limiting construction is to interpret this clause with the two clauses that surround it. The second clause thus bars a beneficiary from enjoying benefits under the trust if she files suit in any court to oppose or challenge a decision by the trustees to distribute trust property to another beneficiary.

This interpretation gives the previous provision a coherent meaning that is consistent with the provisions affording the trustees “absolute and unreviewable discretion” concerning such matters.

In sum, we conclude the beneficiaries of the trust possessed a “present interest in property” because they had, during 2007, an unconditional right to withdraw property from the trust and their withdrawal demands could not be “legally resisted” by the trustees.

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