Importantly, the test for a present interest is not when title in the gifted property vests in the donee, but when substantial enjoyment begins for the donee. [8] Even though a postponement may be of a relatively short duration, it will be fatal to the qualification for the annual exclusion. [9]   Further, it is the certainty of the postponement, not the certainty of duration that will disqualify a gift for the exclusion. [10]  

A gift will not be one of a future interest simply because it involves a gift of a contractual right such as a bond, a promissory note (even if no interest will be paid until maturity), or a policy of life insurance, the obligations of which are to be discharged by payments in the future. [11]   A gift of all of the incidents of ownership in an unmatured insurance policy is a gift of a present interest for which the exclusion applies, even though the policy has no cash surrender value and will lapse unless future premium payments are made.   Similarly, a gift in the form of premium payments on such a life insurance policy is a gift of a present interest to the policy owner. [12]  

  (3)  A Gift May Be a Present Interest as to Income and a Future Interest as to Corpus.  For purposes of applying the gift tax annual exclusion, a gift may be separated into its component parts, less than all of which will qualify as gifts of present interests for purposes of the annual exclusion. [13] Thus, if the component comprising corpus or capital of the gift does not satisfy the present interest requirements, but the element comprising the income rights does so qualify, an annual exclusion may be allowed for the income rights. [14] A right to income will not be a present interest, however, unless, at the time of the gift, there is a requirement for a steady and ascertainable flow of income to the donee. [15]  

(4)  Substantial Enjoyment that Requires Action by Others Creates a Future Interest.  If a donee can secure substantial enjoyment of gifted property only by joint action with others, or only with the consent of others, the gift will be a contingent gift that will be regarded as a future interest. [16] For example, the requirement that donees of a life insurance policy must act jointly to exercise certain incidents of ownership over the policy will cause a gift of an interest in the policy to fail to qualify for the annual exclusion. [17]   Further, the requirement that other partners must consent to transfers of partnership interests or to the liquidation of the partnership, absent other indications of substantial immediate enjoyment, can cause a gift of a partnership interest to be a gift of a future interest that does not qualify for the exclusion. [18]

(5) The Burden of Proving Qualification for the Exclusion is on the Taxpayer.  Exclusions, deductions and exemptions are matters of “legislative grace,” [19] and, as such, will be construed narrowly. The burden will therefore fall upon the taxpayer to demonstrate that a particular gift qualifies for the gift tax annual exclusion. [20]

 

            C.  Business Entities as Donors and Donees

(1)  Business Entities as Donors.  Corporations, partnerships, limited liability companies and other entities formed to operate a business for profit (or for collective investment to increase the wealth of the owners) do not generally make gratuitous transfers to individuals. However, if a business entity does give cash or property to an individual or to another entity that is not a shareholder, partner or member without receiving full and adequate consideration in return, the transaction will in most circumstances be treated as a dividend or a distribution to the shareholders, partners or members of the entity followed by deemed gifts by those individuals to the ultimate recipients. [21] If the asset gratuitously transferred by the entity satisfies the requirements for a present interest, then the annual exclusion will be available as between the deemed donors and the deemed donees.

(2) Business Entities as Donees

(a) Gifts to For-Profit Corporations.  A gift from an individual to a corporation that is operated for profit is generally classified as an indirect gift to the corporation’s shareholders. [22] Because shareholders do not unilaterally have the power to liquidate the corporation or to declare a dividend in order to obtain the immediate use and enjoyment of the gift, such gifts are generally gifts of future interests that do not qualify for the annual exclusion. [23]   On the other hand, a gift to a corporation with a single shareholder should be a gift of a present interest to that shareholder since the sole shareholder can liquidate the corporation at will.  There is, however, no authority to support this outcome.  Therefore, the better strategy to insure the availability of the annual exclusion is to make a gift to the individual shareholder, who can in turn contribute the gifted cash or property to the capital of the corporation.

(b) Gifts to Non-Profit Corporations.  Whether a gift to a non-profit corporation operated for charitable, public, political, or similar purposes is a gift to the corporation or to the individual shareholders or members depends upon the facts and circumstances surrounding the gift. [24]   Because the annual exclusion is not required to shelter gifts to qualified charitable organizations from taxation, this issue most typically arises in the context of 501(c)(7) social clubs and other forms of non-charitable tax exempt organizations.

Unfortunately, there is no apparent bright line test for determining when a gift to a non-profit is a gift to the members of the non-profit or a gift to the entity itself.  For example, in PLR 9323020, contributions by certain members of a Section 501(c)(7) social club to pay for new facilities were treated as indirect gifts to the non-contributing members. Because the non-contributing members would have the use and enjoyment of the new facilities, the gifts were gifts of present interests to which the annual exclusion applied.  Similarly, in PLR 9104024, funds donated to a 501(c)(7) social club to build a clubhouse for the exclusive benefit of the members were treated as gifts to each of the members.  Because club members had the immediate and exclusive benefit and enjoyment of the transferred property, the annual gift tax exclusion applied as to each of them.

Contrast, however, the Service’s ruling under similar facts in PLR 9818042.  In this ruling, a gift to a Section 501(c)(7) social club for the purpose of making building improvements was deemed a gift to the corporation rather than a gift to its members because the members did not have the right to withdraw the contributed capital.  However, since the corporation itself would have the immediate and unrestricted use of gift, the gift constituted a gift of a present interest to which the annual exclusion applied. 

(c) Gifts to Partnerships and LLCs.  A gift of cash or property to a partnership or LLC is a gift to the individual partners or members in the same proportions that the gifted cash or property is allocated to the partners’ or members’ respective capital accounts. [25]   Such gifts will be gifts of present interests in the contributed cash or property so long as the donee partners have the unrestricted right to withdraw their capital. [26]   

 

II. Gifts of Partial Interests in Property  

The value of a gift of a life estate in property will qualify as a gift of a present interest, so long as the donee will have substantial immediate use and enjoyment of the property (such as by producing current income to the donee or by serving as the donee’s personal residence). [27]   Similarly, gifts of fractional interests in property are gifts of a present interest, but only if the donee has substantial and immediate use and enjoyment of that property. [28]   If, however, the donee’s ability to use and enjoy the gifted fractional property interest is restricted, the gift may be a gift of a future interest. For example, a gift of a fractional interest in real estate subject to an unexpired, prepaid leasehold interest that resulted in delaying the donee’s use of the property by three months was a gift of a future interest in the gifted property that did not qualify for the annual exclusion. [29]

 

III. Gifts in Trust

It is well settled that gifts in trust are to be regarded for gift tax purposes as gifts to the beneficiaries rather than to the trustees. [30]   Such gifts will therefore be considered gifts of future interests unless the beneficiaries have the immediate right to the substantial use and enjoyment of the gifted property or to the income from the property, or if certain statutory exceptions to the present interest requirement are met.  The most commonly recognized means for qualifying gifts in trust as gifts of a present interest is, of course, by providing one or more individual trust beneficiaries a “Crummey” power; that is, the power to immediately withdraw cash or property gifted to the trust up to the amount of gift tax annual exclusion. Crummey powers, however, have their disadvantages, including potential gift, income and estate tax consequences to the power holder, the risk of subjecting trust assets to claims of the power holder’s creditors, as well as the actual risk to the donor that the power holder (or the guardian acting for a minor power holder) will exercise his or her withdrawal rights.  It is therefore important to be aware of other means pursuant to which gifts in trust may qualify, in whole or part, for the gift tax annual exclusion. 

A.       Beneficiary’s Income Interest Can Qualify for the Annual Exclusion.  It is possible to create a trust in which the beneficiary’s income interest qualifies for the annual exclusion although the principal interest does not so qualify. [31]   For gifts made after April 30, 1989, the value of such a qualifying income interest is determined under the valuation rules of §7520.  The valuation tables are contained in IRS Pubs. 1457 and 1458, which are revised every 10 years.  Under these tables, if the income interest is for a substantial period of time (such as for the life of a younger income beneficiary), the value of the income interest in the gifted property could represent a substantial portion of the entire gift, and this portion of the gift will qualify for the annual exclusion even if the beneficiary’s right to principal is limited or even non-existent.   

(1) Elements of a Present Interest in Trust Income.  In order for a gift of an income interest in a trust to qualify as a present interest, three elements must be satisfied. These elements are: (a) the trust will receive income; (b) some portion of that income will flow steadily to the beneficiary; and (c) the portion of the income flowing out to the beneficiary can be ascertained. [32]   On this basis, if a gift of income-producing property is made to a trust that provides for the payment of all of the net income annually to the beneficiary for a term of years, and if principal can be paid to no person other than the income beneficiary during that term, the income interest will be a present interest for purposes of the gift tax annual exclusion. [33]   If the foregoing requirements are met, the presence of a spendthrift clause will not cause an otherwise qualifying income interest to fail to qualify as a present interest. [34]  

(2) Trustee with Discretion to Distribute Income.  If income is payable to the beneficiary only in the event of a contingency, such as when the trustee deems necessary, the income interest will not be a present interest. [35] Similarly, if a trust agreement gives the trustee the discretion to allocate receipts to income or principal or to charge expenses to income or principal, [36] or if the trustee has the discretion to credit income with capital gains or charge income with capital losses, [37] the value of the income interest will be unascertainable and, therefore, it will not qualify as a present interest.  Further, if a trustee has the discretion to allocate trust income among several beneficiaries, the value of the income interest as to any one of the beneficiaries is unascertainable and therefore fails to qualify as a present interest. [38]   If the trust requires the payment of income to a beneficiary, but there is a clause in the trust permitting the trustee to withhold income distributions to a beneficiary who is suffering from a substance abuse or other negative or self- destructive behaviors, the income interest likely will not qualify as a present interest.

(3) Trustee with Discretion to Distribute Principal. If a beneficiary’s income interest in a trust otherwise qualifies as a present interest, it will not fail to so qualify because the trustee has the power to distribute principal to that beneficiary, even though such a distribution will in effect, reduce the amount of income generated by the trust.  If, however, during the term of a beneficiary’s income interest, the trustee can distribute principal to another beneficiary, the value of the income interest will indeterminable to the extent of that power. [39]   On the other hand, at least one court has held that where a trustee’s discretion to invade principal for beneficiaries other than the income beneficiary is limited by an ascertainable standard, and if by applying that standard, the possibility of a principal invasion is so remote as to be negligible, the value of the income interest is not necessarily indeterminable. [40]

(4) Delay in Distribution of Income. As a general rule, any delay imposed by a trust instrument upon the distribution of trust income to the income beneficiary will cause the income interest to fail to qualify as a present interest. [41]   However, the requirement that income be distributed at such times as the trustee deems practical, but in all events at least annually, will not cause the beneficiary’s income interest to fail to qualify as a present interest because income is not paid by the trustee as received. [42]   Delaying the distribution of trust income until all trust liabilities have been paid by the trustee will, however, cause the income interest to be treated as a future interest. [43]  

(5) Trust Holding Unproductive Property. The Treasury Regulations under Section 7520 provide that the valuation of an income interest in a trust holding unproductive property may not be based upon standard valuation principles unless the trustee may be required to make the property productive. [44]   On this basis, the IRS may challenge the characterization of a beneficiary’s income interest in a trust as a present interest that is susceptible of valuation if the gift to the trust involves non-income producing property, [45] particularly if that property is not easily converted into productive property or if the trust agreement restricts either the trustee’s ability to sell the gifted property or the beneficiary’s right to require the trustee to make the trust property productive.

B. 2503(c) Trusts. A gift to a trust that meets the requirements of Section 2503(c) of the Code will be a gift of a present interest for which the annual exclusion applies.  Section 2503(c) provides as follows:

  “(c) Transfer for the Benefit of Minor.  No part of a gift to an individual who has not attained the age of 21 years on the date of such transfer shall be considered a gift of a future interest in property for purposes of subsection (b) if the property and the income therefrom

(1) may be expended by, or for the benefit of, the donee before his attaining the age of 21 years, and

(2) will to the extent not so expended

(A) pass to the donee on his attaining the age of 21 years, and

(B) in the event the donee dies before attaining the age of 21 years, be payable to the estate of the donee or as he may appoint under a general power of appointment as defined in Section 2514(c).”

(1) Requirement that Property and Income Be Expended for the Beneficiary. The first requirement of Section 2503(c) is that trust property and the income therefrom may be expended by the trustee, or applied by the trustee for the benefit of, the beneficiary before his attaining the age of 21 years. To satisfy this requirement, the trust instrument must not impose any substantial restriction upon the exercise of the trustee’s discretion to make distributions to or for the benefit of the beneficiary while he or she is a minor.[46] Any limitation upon the trustee’s distribution powers could result in the loss of the annual exclusion if that limitation is deemed to exceed that imposed upon a guardian under applicable state law.[47] Trust provisions that limit distributions to those necessary in the event of an accident, illness, infirmity, disability or other emergency affecting the trust beneficiary are substantial restrictions on the trustee’s discretion to make distributions and will cause a gift to the trust to fail to qualify as a present interest under Section 2503(c).[48] Further, if the trustee may only make distributions upon the demand of another person on the beneficiary’s behalf, the trustee’s discretion to make distributions is subject to a substantial restriction.[49]

Not all distribution standards will be deemed substantial restrictions upon the trustee’s discretion to make distributions for purposes of 2503(c).  A general standard that is reflective of need is not so restrictive as to cause a gift to the trust to be a gift of a future interest. [50] The Service has ruled that a trustee's discretionary power to use principal and income for the beneficiary’s support, care, education, comfort and welfare is not a substantial restriction upon the trustee’s discretionary powers and will not cause the trust to fail to qualify under Section 2503(c). [51]   Similarly, gifts to trusts have qualified as a gifts of present interests under Section 2503(c) where a trust instrument directed the trustee to make distributions as may be necessary for the education, comfort and support of the beneficiary, and to accumulate any income not so needed under this standard, [52] and also where a trust instrument authorized the trustee to make distributions in such amounts and at such times as the trustee in his or her sole discretion deemed necessary for the proper care, support, maintenance and education of the beneficiary. [53]   The fact that the trustee may not make such distributions in a manner that will serve to discharge the grantor’s legal obligation to support the trust beneficiary will not be considered a substantial restriction, as such a statement merely duplicates the rights of the minor under state law. [54]   On the other hand, limiting distributions based upon the beneficiary’s other financial resource may create a future interest. [55]

(2)        Requirement that Property Pass to Donee at Age 21. The second requirement of Section 2503(c) is that trust property and the income therefrom that is not expended by, or for the benefit of, the beneficiary before he or she attains the age of 21 years must pass to the beneficiary upon attaining that age. To satisfy this requirement, the trust estate must either be distributed to the beneficiary, or distributable in the beneficiary’s discretion, no later than when the beneficiary is age 21. 

Initially, the IRS interpreted this requirement to prohibit any trust provision that would cause a trust to continue after the beneficiary’s 21^st birthday, even if the beneficiary possessed the power to withdraw the trust property or to elect to have it continue in trust for distribution at a later date. [56]   This position was not followed by the Tax Court, however, [57] and the IRS subsequently adopted and broadened the Tax Court’s position, ruling in Rev. Rul. 74-43 [58] that a trust would qualify under Section 2503(c) so long as, upon reaching the age of 21, a beneficiary has the right to compel distribution from the trust, even if that right is limited to a specific period of time and must be exercised in writing, and, if not exercised, the trust property will remain in trust subject to the terms of the trust agreement. [59]  

As with Crummey withdrawal powers (which are touched on but not discussed at length in this Outline), there should be a reasonable time frame during which the beneficiary can exercise his or her right to withdraw trust property from a 2503(c) trust.  Although there is no clear indication of what would constitute a reasonable time frame, in private rulings the IRS has approved time periods of 30 and 60 days. [60]

(3) Requirement that Undistributed Property Be Paid to Donee’s Estate or Be Subject to Donee’s General Power of Appointment.  The third and final requirement of Section 2503(c) is, in the event of the beneficiary’s death before attaining age 21, trust property and the income therefrom that has not been expended by, or for the benefit of, the beneficiary must be payable to the estate of the beneficiary or as he may appoint under a general power of appointment as defined in section 2514(c) of the Code.  A beneficiary’s general power of appointment will be effective for this purpose even if, under local law, the donee lacks testamentary capacity or the capacity to exercise a power of appointment. [61]   Care must be taken, however, to be certain that the trust instrument does not define capacity in a manner that exceeds state law definitions.  For example, a trust which limited a minor’s ability to exercise her power of appointment before the age of 19, the normal age of testamentary capacity under applicable state law (Texas), nevertheless failed to qualify under Section 2503(c) because applicable state law granted testamentary capacity to a married beneficiary who is at least 18 years of age. [62]  Similarly, the requirement that trust property be paid to a beneficiary’s estate is strictly construed.  For example, where a trust agreement provided for the distribution of trust property at the beneficiary’s death to his heirs at law, the trust failed to qualify under Section 2503(c). [63]

Although the language of Section 2503(c) is unclear on this issue, the Service has interpreted the requirement for disposition at death to be read in the alternative; that is, the beneficiary must either have a general power of appointment or the trust property must be payable to the beneficiary’s estate, the goal being to ensure estate tax inclusion for property that received the benefit of the gift tax annual exclusion.  For example, the IRS has allowed a gift to a trust to qualify for the annual exclusion under Section 2503(c) where the beneficiary held a special power of appointment rather than a general power of appointment, but in the absence of a valid exercise of that power, the trust property would be payable to the beneficiary’s estate. [64]   Similarly, if a beneficiary holds a general power of appointment over the trust, the trust agreement may provide for the disposition of the remainder to alternate beneficiaries in the event that the beneficiary does not validly exercise his general power of appointment. [65]

(4) A Trust Can Qualify Under 2503(c) as to Income Only.  Consistent with the general principles discussed earlier in this Outline, a gift in trust can qualify for the annual exclusion under Section 2503(c) as to a portion or all of the beneficiary’s income interest even if it does not so qualify as to the beneficiary’s interest in trust corpus. [66]   In order for a beneficiary’s income interest in a trust to qualify as a present interest under Section 2503(c), the requirements of Section 2503(c) must be met as to trust income; that is, (a) all of the income generated by the trust property may be expended by the trustee, or applied by the trustee for the benefit of, the beneficiary before his attaining the age of 21 years; (b) any accumulated trust income must pass to the beneficiary upon attaining the age of 21; and (c) in the event of the beneficiary’s death before attaining age 21, any accumulated trust income must be payable to the estate of the beneficiary or as he may appoint under a general power of appointment as defined in section 2514(c) of the Code.  If these requirements are met as to income but not as to principal (as, for example, where trust principal is not fully distributable at age 21), the beneficiary’s income interest will be a present interest that qualifies for the gift tax annual exclusion, but the gift of trust principal will be a gift of a future interest that does not so qualify. [67]

 

IV. Gifts of Interests in Entities

A. Gifts of Corporate Stock.  Gifts of corporate stock will, in most cases, qualify as gifts of present interests. However, agreements that place substantial restrictions upon the donees’ use and enjoyment of gifted stock can transform that stock into a gift of a future interest that does not qualify for the annual exclusion, particularly where the stock is not income producing.  It is irrelevant that a restrictive agreement existed before the gift or that the same restrictions were imposed upon the donor before the transfer.  For example, the IRS has ruled that gifts of corporate stock were gifts of future interests where the stock was subject to a restrictive agreement both before and after the transfer which, for a two year period, (i) limited transfers to certain gifts to a small group of the donor’s family members and (ii) limited the donee’s ability to pledge the stock to a single specified trust company.  Such limited rights did not, in the view of the Service, afford the donees the right to any substantial present economic benefit from the gifted stock and therefore constituted a gift of a future interest as to the donees’ capital interest in the stock.  Further, because the corporation had never paid dividends, and because a recent corporate prospectus indicated that no dividends were anticipated for the foreseeable future,  the donees did not receive a gift of a present interest as to income from the gifted stock.  As a result, no portion of the gift qualified for the annual exclusion. [68]  

B. Gifts of Interests in Partnerships and LLCs.  In July of 2003, the Court of Appeals for the Seventh Circuit affirmed the decision of the Tax Court in Hackl v. Comm’r., [69] denying the annual exclusion for gifts of  membership interests in a limited liability company.  A great deal of commentary subsequently ensued concerning whether the annual exclusion had been rendered unavailable for gifts in partnerships and LLCs.  However, based upon existing law and an examination of the facts in Hackl, the annual exclusion should be available for all or a portion of such gifts so long the donees have the unconditional right to the present use, possession or enjoyment of the transferred interest or the income therefrom.

(1) The Law Before Hackl. Prior to the Hackl decision, the IRS issued several Technical Advice Memoranda concerning circumstances under which gifts of interests in limited partnerships and similar entities would be treated as gifts of present  interests that qualified for the annual exclusion.  For example, in TAM 9131006, the IRS examined gifts of interests in a limited partnership formed under Washington state law.  The sole asset of the partnership was a 50% interest in farm property that was no longer being actively farmed and did not produce current income.  Distributions, if any, would be made to the partners proportionately, but the timing and method of such distributions was in the general partners’ sole discretion.  The Service noted that the general partners’ control over distributions was (i) similar to that of a corporate board of directors; (ii) no different from those found in agreements between unrelated partners; and (iii) subject to state law fiduciary duties.  Limited partners could transfer their interests to third parties, although the other partners had a right of first refusal to purchase the transferring partner’s interest.  The Service ruled that, under these facts, the donees of the partnership interests had the immediate use, possession and enjoyment of their partnership interests and therefore the gifts qualified for the annual exclusion.  Similarly, in PLR 9415007, the Service allowed the annual exclusion for gifts of interests in a limited partnership where (i) the general partner had the sole discretion, subject to state law fiduciary duties, to determine the timing and amount of distributions; (ii) distributions, if made, would be made to the partners pro rata; and (iii) the donee partners, though unable to withdraw their capital from the partnership, could freely transfer their partnership interests subject to a right of first refusal by the other partners. [70]  

On the other hand, the IRS ruled in TAM 9751003 that gifts of partnership interests would be gifts of future interests that did not qualify for the annual exclusion.  The Service interpreted the partnership agreement to limit transfers or assignments by any partner other than the donor, and to prevent any partner from withdrawing his or her capital from the partnership, for a period of 30 years without the consent of all of the partners.  Thus, although title to the transferred interests vested in the donees, the donees received no tangible and immediate economic benefit as to the capital of the partnership that would qualify for the annual exclusion. In addition, under the terms of the partnership agreement, the general partner could, in her complete discretion, withhold distributions to the partners for any reason whatsoever. The Service concluded such discretion was extraordinary, that it effectively obviated the general partner’s fiduciary duties to the partners, and that it was outside of the scope of a business purpose restriction.  Therefore, the income component of the gift also failed to qualify for the annual exclusion. 

(2) The Hackl Decision. Albert Hackl retired in 1995. He subsequently established a tree farming business through a limited liability company that he and his wife, Christine, appropriately named, “Treeco LLC.”  Treeco LLC was formed under the laws of the state of Indiana and was subject to an operating agreement which contained the following terms:

Management:  The Management of Treeco was vested exclusively in Mr. Hackl, who was appointed manager for life or until his earlier resignation, removal, or incapacity.  Mr. Hackl was granted the right to appoint a successor manager, either during his lifetime or through his will at his death.

Withdrawal of Capital:  Prior to the dissolution of Treeco, no member had the right to withdraw his or her capital or to demand a distribution in return for his or her capital contribution except with the manager’s approval.  Dissolution would occur upon the earlier of: (1) Mr. Hackl’s written determination that the company should be dissolved; (2) a vote of 80 percent of the voting members; (3) the resignation, expulsion, or death of a manager; or (4) at such earlier time as may be provided by applicable law.

Transfers:  The only opportunity for a member to transfer his or her company interest was to offer it back to Treeco, and the manager had the exclusive authority  to accept or reject the offer, and to negotiate the terms of a purchase, on Treeco’s behalf.  Any other transfers required the manager’s consent.  Without such consent, a transferee would receive a mere assignee interest.

Distributions:  The manager of Treeco could direct the distribution of available cash, if any, to the members in accordance with their respective percentage interests.  For this purpose, available cash meant cash on hand after payment of operating expenses and current debts, and after providing for a working capital reserve.  However, the nature of the business was such that Mr. Hackl did not anticipate substantial, if any, current income production, but did hope for significant capital appreciation over time.

In 1995 and 1996, Mr. and Mrs. Hackl made gifts of membership interests in Treeco to their children, their children’s spouses, and grandchildren, and to trusts for their benefit, for which they claimed the benefit of the gift tax annual exclusion.  The IRS denied the exclusion on the basis that the gifts were gifts of future interests in capital and income.  The Hackls responded that the annual exclusion should apply because the transferred interests were fully vested in the donees and because they had transferred to the donees all of the rights and interests that they had possessed in the transferred LLC interests.

The Tax Court agreed with the IRS that the transfer of interests in Treeco did not qualify as transfers of a present interest.  The Tax Court found irrelevant that the interests vested immediately in the donees or that their interests were identical to those of the donors, as neither of these facts established a substantial economic benefit in the donees from the possession, use or enjoyment of the transferred LLC interests.  The Court noted that the donees (1) could not demand or receive their capital without the manager’s consent; (2) could only withdraw from the LLC by offering their units for sale to the company, and then the manager could unilaterally accept or reject the offer and negotiate terms; (3) could not dissolve the LLC without the participation of 80% of the members; and (4) could not transfer or sell their units to third parties without the manager’s consent, which could be withheld in the manager’s sole discretion.  The fact that the donees had the right to share in the future appreciation in Treeco’s business and assets did not create a substantial present economic benefit in the capital of the partnership that qualified for the annual exclusion.  Further, the Court stated that the right to income creates a present interest only if that income will be produced, some portion of that income will flow steadily to the donee, and that portion can be ascertained.  In this case, because Treeco held non-income producing assets, and because there was no reasonable expectation of future income production, the gifts of income interests in Treeco also did not qualify for the annual exclusion. 

In a relatively brief opinion, the Seventh Circuit affirmed the Tax Court’s decision, stating that merely making an outright transfer of a donor’s entire interest in property does not create a present interest.  Rather, there must be a transfer of the right to immediate use, possession or enjoyment of the property or the income therefrom.  Because the restrictions in Treeco’s operating agreement rendered the transferred LLC interests “essentially without immediate value” to the donees, the annual exclusion was denied. [71]         

(3) Strategies to Insure a Gift of an Interest in a Limited Partnership or LLC Is a Gift of Present Interest.  Hackl is a strong reminder that, when making annual exclusion gifts of interests in LLCs, limited partnerships or other similar entities, the taxpayer must be able to prove, from all of the facts and circumstances, that the donee can derive substantial current economic benefit from the gift. Practitioners who are drafting the operative agreements for family limited partnerships and LLCs should consider utilizing one or more of the following techniques to tip the balance of the facts and circumstances in the taxpayer’s favor:

(a) Transferability with Right of First Refusal.  The operative agreement should not completely restrict transfers of interests in the entity without the consent of the manager or other members or partners.  The operative agreement should, at the very least, provide the members or partners a right to transfer interests in the entity subject to a right of first refusal by the other partners or members.

Importantly, most state laws as well as the terms of most operative agreements will not permit a transferee to acquire anything more than an assignee interest unless admitted as a substitute partner or member by a vote of the other partners or members. While the operating agreement in Hackl purported to prohibit transfers without the consent of the Manager, transfers made in violation of this provision were, in fact, effective to transfer economic rights to the transferee, but not voting rights (that is, an assignee interest).  The Court did not deem this sufficient to create a present substantial economic interest.  Thus, providing free transferability subject to a right of first refusal may not be enough to create a present interest.

(b)  A Window for Unrestricted Transfers.  Taking advantage of well established law concerning the use of Crummey powers to create a present interest for gifts in trust, the operative agreement could provide partners or members who acquire their interests by gift from designated donors a reasonable period of time (such as 60 days) after acquiring their entity interests to freely transfer those interests, including all economic and voting rights, to any person without restriction.  The disadvantage of this approach is that a donee could in fact transfer his or her interest to a third party, such as a spouse or creditor.  It is therefore imperative that agreements containing such transfer windows have corollary provisions that would permit family members to elect to buy out the interests of non-family members.

(c) Put Right.  A preferred approach to securing present interest treatment for gifts of entity interests may be to provide partners or members who acquire their interests by gift from designated donors a reasonable period of time (such as 60 days) after acquiring their interests to require the partnership or LLC to buy them out (a “put right”) for the full fair market value of the gifted entity interest, determined with all of the relevant discounts applied for purposes of determining the value of the gifted interest for federal gift tax purposes.  The operative agreement should authorize the entity to satisfy the exercise of any such put right by making distributions in cash or kind, or by borrowing funds on its own credit and by encumbrances on the property of the entity.

 Comment: Whether a present interest is to be created through free transferability of a donee’s interest or by providing the donee a put right, it is important that donors are mindful of IRS challenges to similar rights and powers with regard to trusts.  Specifically, the IRS has sought to deny the annual exclusion for gifts in trust subject to withdrawal powers by the beneficiaries where there is an actual agreement or an implied understanding between the donor and the beneficiary that the beneficiary will not actually exercise these powers.  For a more detailed discussion of this issue in the context of “Cristofani”-type Crummey powers, see Section VII.C of this Outline below.

(d) Annual Distributions.  The operative agreement should require (a) the distribution of available cash and (b) a requirement that the determination of whether there is any available cash be made at least annually and subject to criteria that is not entirely subjective.  If at all possible in light of the nature of the property or business of the entity, the operative agreement should require some minimum amount of income be distributed annually to the partners or members.  Importantly, the general partner or manager should not be absolved from his, her or its fiduciary duties in the determination of the timing and amount of distributions.  In addition, partners, members and assignees should be entitled to sufficient information about the operations of the entity and the actions of the general partner or manager so that they will be in a position to evaluate whether these fiduciary duties are being carried out.  Finally, care needs to be exercised in the drafting of the operative agreement to insure that such fiduciary duties are not obviated by overly broad and generous indemnification and hold harmless clauses that will essentially forgive all but the most egregious breaches of duty by the general partner or manager.

 

V. Gifts Under the UTMA and the UGMA 

Uniform laws have been adopted in every state and the District of Columbia to facilitate gifts to minors.  These laws are generally either a complete adoption, or an adaptation, of the Uniform Transfers to Minors Act, or its ancestors, the Uniform Gifts to Minors Act and the Model Gifts of Securities to Minors Act.  Gifts that are made to a custodian for the benefit of a minor (which is considered to be a person under age 21 for purposes of the UTMA and under 18 for the purposes of the UGMA and the MGSMA) under any of these Acts generally qualify as gifts of present interests. [72]

The advantage of such custodial arrangements as compared to 2503(c) trusts or other trust structures is simplicity, cost effectiveness, and the ability to act quickly when time is of the essence to complete a transfer (such as a deathbed transfer, discussed later in this Outline, or a last minute annual exclusion gift made at year end).  There are several disadvantages of gifts under the UTMA or UGMA, however. 

First, because the custodian’s power to make distributions to the minor or for the minor’s benefit is not limited to a reasonably definite standard for purposes of Section 2038 of the Code, if the donor serves as custodian and dies while in that capacity, the assets in the account will be includible in the donor’s estate. [73] On the other hand, the IRS has ruled that where a donor makes a gift to a UTMA or UGMA account with his or her separate property, his or her spouse can serve as custodian without risk of estate tax inclusion, even if the spouse makes a gift splitting election under Section 2513 of the Code. [74]   

Naming the parent of the beneficiary (such a donor’s child as custodian of the donor’s grandchild) can also be problematic.  Under the UTMA and the UGMA, the custodian can make distributions that would serve to discharge the parent’s support obligation to the beneficiary.  As a result, it is the position of the Service that a parent acting as custodian for his or her minor child holds a general power of appointment over the account. [75]   

A significant non-tax disadvantage of custodial arrangements, however, is that the assets in the account are distributable to the beneficiary at age 18 (or, under the UTMA only, as late as age 21 if so specified in the original instrument of transfer).  When annual exclusion gifts are made to a custodial account on a regular and continuous basis, particularly if they start when the beneficiary is an infant, the combination of $12,000 annual gifts and good investing can result in the accumulation of several hundred thousand dollars in a minor’s account by the time he or she is age 18 or 21.  As discussed above, when such gifts are made to a 2503(c) trust, the trust agreement can require the beneficiary to take some affirmative action to withdraw the trust assets within a relatively short period of time after reaching the age of 21 (commonly within 30-60 days), after which time those assets will be irrevocably transferred to a trust that will continue until the beneficiary is substantially older and more financially mature.  A beneficiary of a UTMA or UGMA account, however, has the absolute right to withdraw the assets from the account at anytime after the age specified for termination (age 18 or 21).  Further, if the beneficiary is disabled when the account terminates, a guardianship or custodianship may be required in order to access the funds for the beneficiary’s benefit. 

To replicate the benefits of a 2503(c) trust, in advance of the beneficiary’s reaching the age of majority, donors and their attorneys will often prepare an irrevocable trust to which the beneficiary will be asked by the donor to transfer the assets in the custodial account.  However, unlike the 2503(c) trust, where an affirmative act is required by the beneficiary within a relatively short time frame to withdraw the trust assets, the beneficiary of a custodial account must take an affirmative action for the assets to be placed in a trust.  Where there are several hundred thousand dollars accumulated in a custodial account, the minor may not be a willing participant in this plan and, unlike a 2503(c) trust, he or she will have an unlimited time to consider the alternatives.  In addition, whereas the donor/client is the settlor of a 2503(c) trust, and the attorney who prepared the trust is rarely consulted by the beneficiary upon reaching the age of majority, the beneficiary of the custodial account will be the settlor of the continuation trust.  Typically, the donor’s lawyer is asked by the donor to draft the trust that will receive the custodial assets.  A lawyer in this situation needs to exercise great care to address the inherent conflict of interest between the donor on the one hand and the beneficiary on the other.  It should come as no surprise that beneficiaries who are advised by the donor’s attorney to place custodial assets in an irrevocable trust could later question the wisdom having voluntarily taken hundreds of thousands of dollars out of his or her control.  This could result in unfortunate backlash to the drafting attorney, particularly if the term of the continuation trust is very long or there is a loss to the trust fund due to mismanagement or self-dealing by the trustees.  The donor’s lawyer might therefore be well advised to instruct the minor to seek his or her own legal counsel to explain the benefits and burdens of an irrevocable transfer of assets to the proposed trust before committing to such a transfer.

 

VI. Gifts to Fund IRC Section 529 Plans

Qualified tuition programs (also known as 529 Plans) are statutorily created savings accounts that offer significant tax advantages designed to encourage taxpayers to save for expenses of higher education.  Under Section 529 of the Code, there are two types of qualified tuition programs.  The first type of program allows a person to purchase tuition credits or certificates on behalf of a designated beneficiary which entitle the beneficiary to the waiver or payment of qualified higher education expenses.[76]  The second type of program is a state program under which a person can make contributions of cash to an account that is designed to meet the qualified higher education expenses of the designated beneficiary of the account.[77] 

One advantage of 529 Plans is that there are no income thresholds or phase-outs that limit the ability of high-income contributors to participate in such plans.  Another attractive feature of 529 Plans is that the 529 Plan account owner retains significant control over the account, including the ability to unilaterally take back the contribution or to change the designated beneficiary to another family member. [78]   Perhaps the most significant advantage to 529 Plans is that the earnings on the cash contributed to a 529 Plan generally accumulate tax-free, and no income tax is incurred on distributions that are made for a beneficiary’s qualified higher education expenses. [79] Qualified higher education expenses include “tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution; and expenses for special needs services in the case of a special needs beneficiary which are incurred in connection with such enrollment or attendance.” [80]

A.  Gifts to a 529 Plan Qualify for the Gift Tax Annual Exclusion.  Under most 529 Plans, the account owner retains the right to change the beneficiary of the account, to designate any person other than the designated beneficiary to whom account funds may be paid, or to receive distributions from the account if no other person is designated. [81]   In addition, most 529 Plans allow the account owner to revoke the account and withdraw the funds contributed to the account.  Under normal gift tax rules, such a gift would not qualify for the gift tax annual exclusion. [82] However, a transfer to a 529 Plan is by statute treated as a completed gift to the designated beneficiary of a present interest. [83]   As a result, such a transfer qualifies for the gift tax annual exclusion. [84] In addition, a donor can elect to split gifts to a 529 Plan with his or her spouse. [85]  

If a donor’s contribution to a 529 Plan exceeds the annual exclusion amount, he or she can elect to prorate the aggregate amount contributed to the 529 Plan over a five-year period. [86]   Thus, a donor can contribute up to five times the annual exclusion amount (currently $60,000 for an individual donor, $120,000 for a couple) in a given year to a 529 Plan without incurring any gift tax. [87]   Any excess over the five-year amount will be treated as a taxable gift in the year of the contribution. [88]   If the donor chooses to front-load the 529 Plan with the entire allowable amount, he or she will then be unable to make gifts to the individual who is the designated beneficiary of the 529 Plan, without incurring gift tax, for a period of five years. If, however, the annual exclusion amount is increased for inflation at any time after the first year of the five-year period, the donor may make an additional contribution in any one or more of the remaining four years up to the difference between the annual exclusion amount as increased and the original exclusion amount. [89]   

B. Gift Tax Consequences of a Rollover or Change in Beneficiary.  If a 529 Plan is rolled over to a new account for the designated beneficiary or a member of the family of the designated beneficiary who is assigned to the same generation as (or a higher generation than) the designated beneficiary, as defined in Section 2651 of the Code, no taxable gift will have occurred. [90]   Similarly, if the designated beneficiary of a 529 Plan is changed to a new designated beneficiary who is a member of the old designated beneficiary’s family and is assigned to the same generation as (or a higher generation than) the designated beneficiary for purposes of Section 2651 of the Code, no taxable gift will have occurred. [91]   For purposes of these rules, the designated beneficiary’s family members are his or her descendants, step-children, siblings and step-siblings, ancestors, step-parents, nephews and nieces, aunts and uncles, children-in-law, parents-in-law, and siblings-in-law, the spouse of any of the foregoing persons, the designated beneficiary’s spouse, or first cousins. [92]   

An interesting planning opportunity is presented by the fact that a change in beneficiaries that satisfies the above rule is not a taxable transfer.  It is possible for an account owner to make annual exclusion gifts to a niece or nephew, for example, in the form of contributions to a 529 Plan.  At the same time, he or she may make other annual exclusion gifts to his or her own children.  The account owner could, in a later year, change the beneficiary of the 529 Plan from his or her niece or nephew to his or her own child or children. [93] Because the account owner’s niece or nephew and his or her children are members of the same family, and are assigned to the same generation, the change in beneficiaries would not result in a taxable gift.  The net result would be that the account owner could double the annual exclusion gifts to his or her children.  Note, however, that the Pension Protection Act of 2006 authorizes the Secretary to “prescribe such regulations as may be necessary or appropriate to carry out the purposes of this Section and to prevent abuse of such purposes, including regulations under Chapters 11, 12 and 13 of this title. [94]   The technical explanation of the Act specifically describes the foregoing opportunities as susceptible to “abuse of qualified tuition programs.”  Therefore, it should be expected that, in the future, regulations will be issued that will prevent donors from optimizing their gift and GST tax annual exclusions by changing the beneficiaries on their 529 Plans.   

The proposed Treasury Regulations do not specifically address the consequences of a rollover or change of beneficiary to a new beneficiary  who is not a member of the designated beneficiary’s family, but who is assigned to the same generation as (or a higher generation than) the designated beneficiary.  Because such a transfer would not fall into the exception stated above, it will be treated as a taxable gift.  Presumably, it will be treated as a transfer from the account owner to the new beneficiary.  The gift will qualify for the gift tax annual exclusion, to the extent that the account owner has not already made gifts to the new beneficiary in the same calendar year.  The account owner could also elect the five-year averaging method discussed in paragraph 1 above to shelter the maximum amount possible from gift tax. 

The gift tax consequences of a rollover or change of beneficiary become more complicated if the new beneficiary is assigned to a generation below that of the designated beneficiary, as defined in Section 2651 of the Code.  In that case, regardless of whether the new beneficiary is a member of the family of the designated beneficiary, the rollover or change in beneficiary will be treated as a gift from the designated beneficiary to the new beneficiary, subject to gift tax. [95]   Whether the designated beneficiary is responsible for personally paying any resulting gift tax, or if the tax will be payable from the account itself, remains to be seen.  Some authors are of the opinion that the only result that will not offend constitutional principles is to have the tax payable out of the 529 account itself. [96]   Regardless of the source of payment of the gift tax, the gift will be eligible for the gift tax annual exclusion.  In addition, the designated beneficiary can elect the five-year averaging method discussed in paragraph 1 above to shelter the maximum amount possible from gift tax.

C. Generation-Skipping Transfer Tax Consequences.  Section 2642(c)(2) of the Code provides an annual exclusion from the GST tax.  This exclusion is discussed at Section X of this Outline below.  To the extent that an initial transfer to a 529 Plan for the benefit of a “skip-person” for GST tax purposes qualifies for gift tax annual exclusion, it will also qualify for the GST annual exclusion. [97]   If the transfer to the 529 Plan does not qualify for the gift tax annual exclusion (for example, if prior gifts during the calendar year have utilized the available exclusion), then the transfer will not qualify for the GST tax annual exclusion either. [98] If, either due to a rollover or change of beneficiaries, the new beneficiary is assigned to a generation two or more generations below that of the designated beneficiary, the rollover or change in beneficiary will be treated as a gift from the designated beneficiary to the new beneficiary, and will be subject not only to gift tax, but to GST tax as well. [99]   Because the rollover or change in beneficiaries is completely in the control of the account holder, and the designated beneficiary has no say in the matter, it seems particularly unfair (perhaps unconstitutional) to require that he or she pay the resulting GST tax.  However, as discussed above in relation to the gift tax, it is unclear whether the designated beneficiary himself or herself will be responsible for paying the GST tax, or if the tax will be paid from the account. Presumably, if the designated beneficiary has available GST exemption, his or her exemption will be automatically applied to the transfer as a direct skip.

 

VII. Attempts to Multiply Available Annual Exclusion Gifts

The annual exclusion is an alluring tax benefit because it is virtually unlimited.  In theory, by merely using the gift tax annual exclusion, a billionaire could give away his entire estate in a single day, tax-free and without the need to file a gift tax return, so long as he can identify a mere 83,334 donees.  He could cut the number of required donees in half to 41,667 if his wife makes a gift splitting election, and in half again to a mere 20,834 donees if he can make gifts in two separate rounds on December 31 of one year and January 1 of the next.  To decrease the number of donees even further, before making these gifts, he could contribute his billion dollars worth of assets to a family partnership, obtain an appraisal of the gifted interests, and likely cut the number of donees down to under 15,000.

This math is just too simple for donors to miss, and there have been many attempts to manufacture more donees and/or donors for the purpose of passing wealth tax-free to the natural objects of the donor’s bounty.  Three of the most common strategies (constituting two failures and one success) are highlighted below.

A. Gifts Intended to Be Passed On to Others.  Not unexpectedly, many attempts have been made by taxpayers to “leverage” the gift tax annual exclusion by making a gift to one person with the actual or implied understanding that the first donee will give, or apply the gift for the benefit of, another person, who is the true and intended donee of the original gift.  This technique, however, does not work, as the series of gifts will be collapsed into a single, albeit indirect, transfer from the original donor to the ultimate donee.  For example, in Heyen v. U.S., [100] the decedent had made over two dozen gifts of corporate stock to individuals who immediately conveyed their stock certificates over to members of the decedent’s family.  Not only was the gift tax annual exclusion denied for these gifts, but a fraud penalty was imposed upon the executrix of the decedent’s estate for failing to report them. 

Without giving it much thought, donors will often make gifts to a married couple with the expectation and belief that the couple will recognize this gift as being for the benefit of the spouse who is the child or other natural object of the donor’s bounty.  If the gift is in fact treated by the couple as made to only one of them, even this more benign attempt to maximize the benefits of the annual exclusion will fail.  For example, in Cidulka v. Comm’r., [101] the decedent, for many years prior to his death, made gifts of stock in a family corporation to his son and daughter-in-law using the annual exclusion. With respect to each such gift, the daughter-in-law dutifully turned the gifted stock over to her husband.  Although the Service offered no direct proof of an agreement that the daughter-in-law would make these subsequent transfers to her husband, the Tax Court had no trouble inferring such an agreement from that the simple fact that she did so with regard to each and every gift.  Therefore, the Court disallowed the annual exclusion as to each gift from the decedent to his daughter-in-law. [102]

B.  Reciprocal Gifts (or, “You Scratch My Back, I’ll Scratch Yours”).  A group of friends are having their regular Saturday night dinner at the Country Club, where they are complaining that despite all the money they pay to their fancy and high priced estate and trust lawyers, that dang “death tax” that Mr. Bush claims to have repealed just won’t seem to go away.  Two of them discover while taking a powder room break that they each make maximum annual exclusion gifts to their children every year, and, conveniently, they each have three children.  One of them comes up with a bright idea: How about next Saturday they bring their check books to dinner and each of them can make annual exclusion gifts to other’s children?  Maybe when they get back to the table, they can convince some of their other friends to join in, and they can really beat Uncle Sam at his game. 

Unfortunately for our dinner guests, the IRS and the courts have a way of looking through these gifts by leveraging off of the reasoning behind the reciprocal trust doctrine. [103] The reciprocal trust doctrine describes cross transfers of property in trust by two settlors, each creating a trust to accomplish the goals of the other, made pursuant to an interrelated scheme that leaves each of the settlors in approximately the same economic position they would have been in had they created trusts and named themselves as beneficiaries. [104]   With regard to reciprocal gifts, the courts have been willing to apply the principles of the reciprocal trust doctrine to determine the actual transferor based upon all of the fats and circumstances surrounding the gifts involved.  The focus of the analysis is the extent of reciprocity and who the persons are who should be the natural objects of each transferor’s bounty.  To the extent that such gifts provide equal benefit to the respective donee pools, the annual exclusion will be disallowed. [105]

C. Gifts to “Cristofani” Trusts 

(1) Overview of the Technique.  Although gifts in trust are generally considered gifts of a future interest to the trust beneficiaries for which the annual gift tax exclusion is unavailable, the annual exclusion will be allowed so long as an individual beneficiary has a reasonable opportunity to withdraw amounts contributed to the trust at least up to the annual exclusion amount (a Crummey power). [106]   Most typically, a beneficiary holding a Crummey power has between 15 and 60 days after receiving notice of a gift to the trust to withdraw the amount of the gift (or such beneficiary’s pro rata share) up to the annual exclusion amount or the gifted asset will remain in the trust, possibly for the remainder of the beneficiary’s lifetime.  Importantly, there are no immediate gift tax consequences to a beneficiary who allows his or her withdrawal power to lapse, so long as the beneficiary either has a power of appointment over the lapsed amount or the withdrawal right (or its lapse) is limited to $5,000 or 5% of the value of the trust assets from which the right could be satisfied on the date it lapses (a “5 or 5 power”).  With this in mind, trusts are frequently created for the current or long term benefit of a small number of primary beneficiaries (or even a single beneficiary), yet multiple individuals with no significant interest, or a mere contingent interest, in the trust are provided rights of withdrawal, often limited to the 5 or 5 power, in order to increase the amount that can be given to the trust each year under the gift tax annual exclusion.

  (2)  Score:  Taxpayers 2, IRS 1/2.  The IRS has been consistently hostile toward the use of contingent beneficiaries or worse, persons with no interest in a trust at all other than a Crummey withdrawal right, to increase the number of annual exclusions that can be used to fund a trust.  For example:

In TAM 8727003, the Service considered a trust for the primary benefit of the grantors’ two sons, but over which 16 other family members held withdrawal powers.  The Service ruled that it would only allow annual exclusions for the primary beneficiaries and for the small number of additional beneficiaries who actually exercised their withdrawal rights. 

In TAM 9045002, the Service disallowed annual exclusions for 12 family members who either held no interest at all in the subject trusts or who held a contingent interest.   

In TAM 9141008, a trust was created for the benefit of the grantor’s three children, who, along with the grantor’s 32 grandchildren and great-grandchildren, held Crummey withdrawal powers.  The IRS disallowed annual exclusions as to grantor’s 32  grandchildren and great-grandchildren.

In the 1991 case of Cristofani v. Comm’r. [107] the Tax Court addressed the question of whether a Crummey power held by a contingent beneficiary would be respected for purposes of the gift tax annual exclusion.  In that case, a mother had in two consecutive years prior to her death transferred 1/3 fractional interests in commercial real estate to a trust for the primary benefit of her two adult children.  The trust agreement provided that all of the trust income would be paid to the children and principal would be paid to them for their health, maintenance, support and education.  If the children, who were in good health, survived their mother, they would each receive ½ of the trust outright.  If either of them did not so survive, the deceased child’s trust share would be divided equally among his or her surviving children.

The two children and the decedent’s five grandchildren each possessed Crummey withdrawal rights. It was stipulated that there was no agreement or understanding that these rights would not be exercised.  Under these facts the Service sought to disallow annual exclusions for the five grandchildren.  The Tax Court, however, noted that the Court of Appeals for the Ninth Circuit in Crummey rejected any test for a present interest that is based upon the likelihood that beneficiaries would actually receive present enjoyment of the trust property or whether a demand right would actually be exercised.  Nor, stated the Tax Court, should the test be whether a beneficiary with a withdrawal power has a vested present interest in the trust or a contingent remainder interest. Rather, the test should simply be whether the beneficiary had an enforceable right to demand payment from the trustee which the trustee would be unable to legally resist. [108]  

Despite the fairly resounding taxpayer victory in Cristofani, not long after the Tax Court issued its opinion, the Service issued AOD 1992-09 in which it stated its intention to continue to litigate cases where there are abuses of Crummey powers, particularly if they are under facts more egregious than those in Cristofani and if they arise outside of the Ninth Circuit. The IRS subsequently published PLR 9628004, in which it acknowledged the holding in Cristofani and stated that its position generally is not to contest Crummey powers held by current income and vested remainder beneficiaries.  However, the IRS stated that, where withdrawal rights are held by discretionary beneficiaries or beneficiaries with remote contingent interests in the trust, their failure to exercise their withdrawal rights, which is contrary to their economic interests, must indicate that there is a prearranged plan that they will not exercise those rights. [109]   Citing the principles set forth Heyen v. U.S., [110] discussed in above in the context of gifts that are made to one person but immediately conveyed to another, the Service in PLR 9628004 disallowed 13 annual gift tax exclusions that were attributable to unexercised Crummey powers held by remote contingent beneficiaries or by individuals who had no other interest in the trusts in question other than their withdrawal rights. [111]

Again, however, when this issue came up in a litigated case, this time from the Third Circuit, the IRS was unsuccessful.  In Kohlsaat v. Comm’r., [112] the decedent had created a trust and transferred to it a commercial building valued at $155,000.  The decedent’s two children were co-trustees and the sole current income and principal beneficiaries.  The two children also each held special powers of appointment over their respective one-half interests in the trust.  The two children and 16 contingent remainder beneficiaries (consisting of grandchildren, great grandchildren and certain in-laws), all held Crummey withdrawal powers over the trust.  All of the beneficiaries were timely notified of their withdrawal rights, but none were exercised.  The IRS argued that the only rational explanation for the failure of the 16 contingent beneficiaries to exercise their withdrawal powers was an implied agreement that they would not do so. 

The Tax Court in Kohlsaat disagreed with the IRS that there was an implied agreement, noting that at trial other credible reasons were offered for why the contingent beneficiaries did not exercise their withdrawal rights.  Although the opinion does not set forth these reasons, one could hypothesize that, given the nature of the trust asset, the beneficiaries did not exercise their withdrawal rights because they wanted to insure a clean chain of title, they did not want to incur the person liability associated with ownership of real property, they wanted to retain the property under centralized management without the necessity of creating a partnership or other entity, or they might simply have wanted to keep the property in trust for creditor protection purposes and to maximize the benefit of the property for the family as a group.  Whatever the reasons offered, the Tax Court found them no less compelling than the Service’s explanation of an implied agreement.  As a result, annual exclusions were allowed with respect to the Crummey powers held by all 16 contingent beneficiaries. 

In one rare and unique Tax Court case, the IRS did secure a minor victory on the issue of implied agreements with regard to Crummey powers, which it might be expected to try to leverage into other situations.  In Trotter v. U.S., [113] an elderly grandmother made a gift of her condominium to a trust for the benefit of her grandchildren.  The grandmother, who was suffering from recurring cancer when she created the trust, continued to live in the condominium.  In lieu of paying rent, she paid utilities, insurance and taxes.  Upon her death, the IRS included the residence in her estate under Section 2036(a)(1).  Accepting the position of the Service, the Tax Court noted that, not only did the facts presented suggest there was an implied agreement between the grandmother and her grandchildren that she would have the right to continued rent-free occupancy of the condominium for her lifetime (this alone would have been sufficient for estate tax inclusion), but there was also an implied agreement that the grandchildren would not exercise their Crummey withdrawal rights.

Stories have been circulating among practitioners since the Trotter case that the IRS is not beyond deposing trust beneficiaries after the death of the settlor of a Crummey trust to ask them, under oath, whether there was any agreement with the decedent that they would not exercise their withdrawal rights and whether they were threatened with penalties, such as disinheritance, if they did exercise those rights.  It is therefore extremely important that this not be the message conveyed to the beneficiaries, whether direct or implied.

(3) Practical Considerations.  Despite the benefits of a Cristofani type trust for purposes of increasing the amount of annual exclusions, there are important practical considerations.  In particular, the more minor, remote or contingent the beneficiaries’ interests are in the trust (and the more distant their relationship is to the donor), the more likely that, over the course of time, some of these beneficiaries’ Crummey powers will in fact be exercised.  This is a particularly important consideration where a large class of beneficiaries will be needed to hold withdrawal powers over a sustained period of time, such as to fund the annual premiums on a large life insurance policy.  On the bright side, the actual exercise of withdrawal powers may be helpful in the future to prove that these powers are real and enforceable and not entirely illusory. 

Attorneys who create Cristofani trusts where there is a risk of actual exercise of Crummey powers need to consider available pre-emptive measures.  First, if the trust has a substantial long-term cash flow need that must be funded annually (such as the need to fund large annual insurance premiums), it is advisable to have well more Crummey power holders than strictly necessary so that additional contributions can be made to make up for the withdrawn amounts.  Donors should also have the ability to determine which beneficiaries should have the right to withdraw with regard to each contribution so that withdrawing beneficiaries can be excluded as to future contributions.  It is also important in such trusts to charge the ultimate beneficial interests (if any) of the withdrawing beneficiary with the amount of any actual withdrawal so that beneficiaries who do not exercise their withdrawal rights will not feel penalized (and therefore may feel less inclined to withdraw in the future).

 

VIII. "Last Minute" Annual Exclusion Gifts

The call comes in from your client’s daughter telling you that the client has had a stroke and her prognosis is not good.  The daughter wants to know if there are any last minute actions that her family can take to reduce taxes before it is too late. 

One question that should come to mind under these circumstances is whether your client has fully utilized her gift tax annual exclusions for the current year and whether it might be possible to make some last minute gifts to children, grandchildren or others to reduce the value of the client’s taxable estate.

A. Gifts by Incompetent Donors  

(1) Someone Must Have the Legal Authority to Make Gifts.  It is well established that gifts made on an incompetent donor’s behalf without proper authority are void and, because a void gift can be revoked by or on behalf of the donor, such gifts are includible in the donor’s taxable estate under Section 2038 of the Code. [114]   Therefore, when contemplating last minute annual exclusion gifts for an incompetent client, the first question that must be answered is whether anyone has the legal authority to make gifts on the client’s behalf.

State law is determinative of whether anyone is in possession of the legal authority to give away an incompetent person’s property. [115]   For example, the California Probate Code provides that a power of attorney may not be construed to grant authority to an attorney-in-fact to make gifts of the principal’s property in trust or otherwise unless expressly authorized in the power of attorney.  Thus, in Swanson v. Comm’r., a California power of attorney that authorized Mrs. Swanson’s agent “to manage and dispose of Mrs. Swanson's property, and to conduct business on her behalf” was insufficient to constitute express authorization to make gifts under California law.  As a result, 38 last minute annual exclusion gifts were brought back into Mrs. Swanson’s estate under Section 2038.  On the other hand, in Frank v. Comm’r., [116] an agent acting under a New Jersey power of attorney for an incompetent principal was given the power “to make gifts, without consideration in any amount to anyone” as well as the power “to withdraw and receive income or corpus of a trust.”  Under this combination of powers, the agent was able to withdraw shares in a family owned corporation from the principal’s trust, place those shares in the principal’s name, and then immediately transfer those shares to the principal’s wife, all for the purpose of securing a minority discount for the value of those shares in the estates of both spouses.  Because the agent had the legal authority under New Jersey law to take these actions on the decedent’s behalf, and because the proper steps were followed, the Court held that the gift should be respected and upheld.

In some states, specific reference to the power to make gifts is not required for an agent acting under a power of attorney to make gifts.  In some respects, life for the last minute estate planner can be more treacherous in these states as it may not be clear whether anyone has the power to make gifts.  For example, two separate cases, both decided on the basis of Virginia law, produced different results under similar circumstances.  In the first case, Casey v. Commissioner, [117] the Court noted that while neither Virginia statutory law nor existing case law demonstrated any requirement that a broad durable general power of attorney must specifically authorize donative transfers of the principal’s property for the agent to possess that power, it was highly likely that, should the issue be brought before the highest court in the state, it would adopt that requirement as a matter of public policy.  As a result, despite the fact that the agent had a broad general power of attorney and simply continued the pattern of past giving by the principal, the Court concluded the gifts made by the agent should be included in the decedent’s estate because the agent was not expressly authorized to make gifts.  

Two years later, in Ridenour v. Commissioner, [118] the Tax Court reached an entirely different conclusion when applying Virginia law to similar facts.  In that case, the decedent had a strong pattern of regular gifting to certain individuals.  Three weeks before his death from renal failure and while the decedent was incompetent, his agent acting under a broad general power of attorney without specific gifting authority made just under $100,000 of gifts to nine different donees, most of whom were past recipients of gifts from the principal, but some of whom were not.  The Service argued that the holding in Casey was directly on point and that all of these gifts should be declared void.  However, between the issuance of the ruling in Casey and the rendering of the Court’s opinion in Ridenour, the Virginia legislature enacted an amendment to state law clarifying that an agent under a durable power of attorney that is given “full power to handle the principal’s affair or to deal with the principal’s property” had the inherent power to make gifts.  This law was enacted after the gifts had been made in Ridenour.  Nevertheless, the Court in Ridenour viewed the new law as evidence that the Casey court had made an erroneous assumption about the public policy of the State of Virginia.  Consequently, the gifts in Ridenour were upheld, including gifts to those donees who were not past recipients of gifts from the decedent.

(2) Transfers Directly from Revocable Trusts.  A frequent problem for last minute gifting is trying to identify who actually has access to assets for purposes of making these gifts: the agent or the successor trustee of the incompetent person’s trust?  Once this is ascertained, the next question is whether the fiduciary with access to the assets is also the fiduciary with the power to make gifts.  The most common quandary is that the agent acting under a durable power of attorney or a court appointed guardian or conservator has been given the authority to make gifts for the incompetent person, but the incompetent person’s assets are tied up in a revocable trust that does not authorize the trustee to make gifts or distributions to anyone other than the grantor during his or her lifetime. [119]   The best solution under these circumstances is for the agent, guardian or conservator to withdraw assets from the trust, take them into the incompetent grantor’s name, and then make the desired gifts.  Sometimes, however, the agent or guardian does not have the power to withdraw trust property, or time is of the essence and it is simply more efficient and effective to make gift transfers directly from the incompetent person’s revocable trust. [120]  

In TAM 9309003, the Service considered a situation where gifts were made directly from a decedent’s revocable trust at his guardian’s direction.  In that TAM, the decedent’s revocable trust agreement reserved in the decedent as grantor the power to withdraw trust assets at anytime.  In the event that the decedent became incompetent, the trust directed the trustee to make distributions to the decedent or for her benefit, but to no other person.  When the decedent became incompetent, the Court appointed a guardian of her estate and authorized the guardian to continue to make gifts consistent with the decedent’s past giving practices.  Using this authority, the guardian directed the trustee to make transfers to a number of the decedent’s family members.  In reviewing the facts after the decedent’s death, the Service concluded that although distributions were not authorized from the trust to any person but the decedent, they were in substance withdrawals by the guardian on the decedent’s behalf followed by gifts to the ultimate donees. [121]

B. Deathbed Gifts: No Relation-Back of Uncashed Checks.  A final issue when making last minute gifts is whether the gift will be deemed completed before the client takes his or her last breath. Generally, the gift must be delivered, accepted and beyond any right of revocation by the decedent or an agent or other personal representative acting on his or her behalf.  The most sticky problem in this regard involves the use of checks to make last minute annual exclusion gifts.  It is a well established rule that a non-charitable gift is not complete for transfer tax purposes until the donor has parted with dominion and control such that he has no power to change the disposition, whether for his own benefit of the benefit of another. [122] Whether such control has been relinquished is a matter of state law.  Under the laws of most, if not all states, a person who drafts a personal check can stop payment on that check at any time before it clears his or her bank.  As a result, unless and until gift checks have actually been paid by the donor’s bank, the gift is incomplete. [123]   If the donor dies before the gift is complete, the gift will be included in the decedent’s estate under Section 2038 of the Code.  Therefore, to improve the chances of making successful last minute cash gifts, it is always preferable to use a non-cancelable means of transferring funds, such as cashiers checks, money orders or wire transfers, particularly if time is running out and it is not possible for the intended donees to present their checks personally to the donor’s bank for payment before the donor’s death.

 

IX. Annual Exclusion Gifts Involving Debt  

A. Gifts of Debt Relief - Debt Owed by a Natural Person.  Relief of individual indebtedness that is provided with donative intent is a gift of a present interest in the amount of the debt relief. [124]  The legal issue in most such cases is therefore not whether the gift is one for which the annual exclusion applies, but rather the timing of the gift; in other words, whether the gift was completed when the debt was relieved or when the original loan was made.  The answer to this question turns on whether the original transfer created a bona fide debt. [125]

A loan made to a family member will be subject to special scrutiny, and the presumption will be that the transfer is a gift. [126]   To rebut this presumption, the transferor must show that, at the time of the loan, he or she had a reasonable expectation of being repaid. [127] Further, the transferor must demonstrate he or she possessed the intention to enforce the loan if it was not timely paid. [128] Whether there was a reasonable expectation of repayment and an intention to enforce the loan is based upon all of the relevant fact and circumstances, no one of which is necessarily determinative. [129] These include (a) whether there is a promissory note or other written evidence of the debt; (b) whether the obligation bears interest; (c) whether the debt is secured; (d) whether there is a fixed maturity date; (e) whether records were maintained by the transferor and/or the transferee (such as a personal financial statement) that reflect the transaction as loan; (f) whether federal income tax reporting was consistent with the treatment of the transfer as a loan; (g) whether any actual payments were made on the loan; and (h) in the event of default, whether there was a demand for payment. [130]

A common gifting strategy is to loan money to children, grandchildren or others and then to forgive the loan incrementally from year to year using the gift tax annual exclusion.  So long as the facts do not suggest that the incremental debt forgiveness is part of a prearranged plan to forgive the debt payments as (or before) they become due, a gift will be made at the time of the forgiveness, and such gift will take into account both principal and accrued but unpaid interest. [131]   On the other hand, it is the position of the Service that, if there is a pre-arranged plan to forgive the debt, the initial transfer is not a loan but a gift and, therefore, the annual exclusion is not available to shelter the amount of that gift from immediate taxation as payments are forgiven in later years. [132]  

The courts have not consistently supported the Service with regard to the tax treatment of prearranged plans of debt forgiveness.  For example, in Haygood v. Comm’r., [133] the Court agreed that it was the intent of the seller of real property to forgive payments due on a purchase money note as they came due.  This intent, however, did not override the validity of the original note as an enforceable obligation under state law, which represented adequate consideration for the property sold.  Therefore, the Court determined there was no gift at the time of the initial transfer and that the gift tax annual exclusion applied each time a note payment was canceled. [134]   The IRS has not acquiesced to the decision on Haygood, however, and taxpayers should anticipate that any pre-arranged plan of debt forgiveness will be subject to challenge.  To avoid such a challenge, a preferred approach may be to make cash gifts to a debtor family member, which the debtor family member may, in his or her discretion, apply to pay down a debt to the donor.  Regardless of whether debt is reduced by gifts of cash or by gifts of debt relief, however, it is imperative that all the necessary documentation is in place to show that the debt is a bona fide obligation that the transferor intends to be repaid, that payments are actually made as scheduled, that the transaction is reported as debt on the books of the transferor, that interest payments (or imputed interest, as discussed below) are properly reported for federal income tax purposes, and that action is taken to collect the debt in the event of a default.

B. Gifts of Debt Relief - Debt Owed by a Corporation.  As noted earlier in this Outline, a gift from an individual to a corporation that is operated for profit is usually treated as an indirect gift to the corporation’s shareholders.  Similarly, a gift of forgiveness of a corporate debt is a gift to the shareholders of the debtor corporation. [135]

The leading case on the tax consequences of gifts of corporate debt relief is Stinson v. Comm’r., [136] issued by the Seventh Circuit Court of Appeals in May, 2000.  In a relatively short opinion affirming the decision of the District Court, the Court in Stinson held that because (a) donative relief of a corporate debt is an indirect gift to the corporation’s shareholders, and (b) no one shareholder in that case could secure the benefit of corporate debt relief by liquidating the corporation or declaring a dividend, the deemed donees did not have the present use and enjoyment of the gift and, therefore, the gift was a gift of a future interest. [137]    

Two important points deserve special note in connection with the Stinson case.  First, at the District Court level, the taxpayer had argued that the shareholders received a present interest when the debt was relieved because they could sell their stock in the corporation for greater value, providing immediate use and enjoyment of the gift.  Neither the District Court nor the Seventh Circuit found this argument persuasive, noting that virtually any property right has value, and the mere fact that a future interest received as a gift could be sold to a third party does not transform that future interest into a present interest.  Of additional importance, the Seventh Circuit upheld the District Court’s holding that, although the gift of debt forgiveness to the corporation was deemed to have been made to each of the shareholders, the gift was of the full amount of the forgiven debt ($147,000 in that case) and not the increase in the value of each of the shareholder’s shares in the corporation, which would be affected by the lack of marketability and minority status of those shares. 

C. Gifts Involving Below-Market Interest or No-Interest Loans.  As to term loans entered into, and demand loans outstanding after, June 6, 1984, if such loans are gift loans and are either interest-free or bear below-market interest, interest will be imputed for federal gift and income tax purposes under Section 7872 of the Code.  A loan is deemed a “gift loan” under Section 7872 if the foregone interest is in the nature of a gift.  In such case, the lender is deemed for gift tax purposes as having made a gift to the borrower of the amount of the foregone interest, and the borrower is deemed for income tax purposes as having paid that amount back to the lender.  Where such loans are between natural persons, the deemed gift of forgone interest is a gift of a present interest for which the annual exclusion applies.

The determination of whether a gift loan bears below-market interest, the amount of the imputed interest, the timing of the deemed gift from the lender to the borrower, and the timing of the deemed interest payment from the borrower to the lender, differs depending upon whether  the loan is treated as a loan with a definite maturity date or a demand loan.  

(1) Gift of Imputed Interest on a Loan With a Definite Maturity Date.  A loan has a definite maturity date if it is payable on a date certain, including a date that is determined actuarially (such as on the basis of a person’s life expectancy). [138]   A gift loan with a definite maturity date is deemed to bear below-market interest if the value of all payments to be received under the loan on a present value basis is less than the amount of the loan, the discount rate for this purpose being the applicable federal rate in effect on the date of the loan. [139] The difference is deemed a gift by the lender on the date of the loan. [140]   Although the gift is deemed to be made on the date of the loan, for income tax purposes, the lender is treated as receiving from the borrower a payment equal to the imputed interest element each year on the last day of the borrower’s taxable year. [141]  

(2) Gift of Imputed Interest on Demand Loans.  A loan is a demand loan if it is payable upon demand of the lender or if the maturity date is otherwise indefinite. [142]   A gift loan that is a demand loan is deemed to bear below market interest if the interest rate payable is less than the applicable federal rate. [143]   For this purpose, the applicable federal rate is the rate published pursuant to Section 1274(d) of the Code, compounded semi-annually.  The gift is the amount of the foregone interest and is computed using a “blended rate” that is published under Section 7872(e)(2) of the Code and which is the average of the short term rates published on January 1 and July 1 of each calendar year in which amounts are outstanding under the loan. [144]   The date of the deemed gift and deemed interest payment is the last day of the borrower’s taxable year. [145]

(3) Forgiving Interest as It Comes Due.  As discussed above, a lender may choose to make an annual exclusion gift to a borrower in the form of a forgiven payment.  This will not serve to avoid the tax consequences of the imputed interest element of a below-market loan unless a substantial part of the gift involves the forgiveness of principal as well as accrued interest and principal purpose of the forgiveness is to confer a benefit upon the borrower. [146]

(4) Exceptions to Imputed Interest

(a) Aggregate of Below-Market Loans Do Not Exceed $10,000.  The imputed interest rules do not apply to below-market rate loans between two taxpayers who are natural persons which, in the aggregate, do not exceed $10,000 and which are not made for the purpose of purchasing income-producing assets.  For this purpose, a UTMA account for a minor is treated as a natural person but a trust is not. [147]

(b) Aggregate of Below-Market Loans Do Not Exceed $100,000.  If the aggregate amount of all below-market rate loans does not exceed $100,000 as between two taxpayers who are natural persons, and if federal tax avoidance is not one of the principal purposes of these loans, then the amount of imputed interest will be limited to the amount of the borrower’s net investment income determined in accordance with Section 163(d)(4) of the Code. [148]   If the borrower’s net investment income does not exceed $1,000, it is disregarded for this purpose. [149]   Net investment income is computed for the entire year regardless of whether the loan or loans were outstanding for the whole year.