Under current tax law, an individual is entitled to make gifts of up to $13,000 per donee per year without being subject to gift tax. This $13,000 is commonly referred to as the "annual exclusion amount" because it refers to the amount a donor can give annually to a person that is excluded from the donor's taxable gifts. Gifts in trust are not eligible to be annual exclusion gifts – the gift must be outright.
However, to take advantage of this annual exclusion amount, irrevocable trust agreements frequently contain provisions that allow one or more trust beneficiaries to exercise withdrawal rights over a portion of the donor's contributions to the trust (generally the right to withdraw up to $13,000 per beneficiary). These withdrawal rights allow the trust donor to utilize his or her annual exclusion amount with respect to each beneficiary holding a withdrawal right in the trust since the right to withdraw the funds is the same as the right to get the funds outright, thereby minimizing the taxable gifts transferred to the trust. These withdrawal rights, which are frequently contained in insurance trusts, are commonly called Crummey withdrawal rights.
A trust agreement with a typical "withdrawal right" provides that, whenever property is contributed to the trust, one or more trust beneficiaries (or a guardian or other person on behalf of a minor or incapacitated beneficiary) has a right to withdraw a portion of such contribution for a certain period of time. The trust agreement usually provides that the trustee of the trust must give the beneficiary timely notice of each contribution and notify the beneficiary of the amount subject to his or her withdrawal right. The amount subject to withdrawal by each beneficiary is generally capped at the annual exclusion amount reduced by any previous gifts to that beneficiary by the donor within the same calendar year. If the beneficiary does not notify the trustee of his or her election to exercise the withdrawal right, the right to withdraw usually lapses after a period of time or at the end of the calendar year.
Trust beneficiaries rarely exercise their withdrawal rights. However, donors and beneficiaries must never have an express or implied agreement that the withdrawal rights will never be exercised. The IRS views any advance agreement between donors and beneficiaries not to exercise withdrawal rights as though the withdrawal rights were illusory, and will deny treatment of such gifts as gifts of present interests that qualify for the annual exclusion.
Tax law states that a donee has a "present interest" in gifted property if he or she has an unrestricted right to the immediate use, possession, or enjoyment of such property or the income from such property. If a trust beneficiary does not have a right to withdraw assets contributed to an irrevocable trust, the gift is generally treated as a gift of a "future interest." The withdrawal right converts that "future interest" to a "present interest," and makes the annual gift tax exclusion available to the donor.
The landmark case approving the above arrangement is a 1968 Ninth Circuit decision, Crummey v. Commissioner. This case is the reason that the beneficiaries holding withdrawal rights are often referred to as "Crummey beneficiaries" and the rights as "Crummey withdrawal rights." To have a present interest under Crummey, a trust beneficiary must be legally and technically capable of immediately possessing the gifted property, and have a reasonable opportunity to do so. So long as a beneficiary can legally exercise his or her withdrawal rights, this requirement is easily met. It is therefore, necessary for trustees in the administration of these trusts to provide beneficiaries with a reasonable opportunity to exercise the withdrawal rights.
In order for a beneficiary to have a reasonable opportunity to exercise a right of withdrawal, the beneficiary must be (i) aware that the right exists and (ii) given enough time to exercise the right before it lapses. All of the circumstances surrounding the making of the gift, the timing of notice, and the length of the exercise period are taken into account in assessing whether a beneficiary has a reasonable opportunity to exercise his or her withdrawal right.
Requirement (ii) noted above can be easily met. As long as a beneficiary (or guardian) is given at least 30 days after receiving notice to exercise his or her withdrawal right prior to any lapse, the period is sufficient. Therefore, it is recommended that the withdrawal period specified in the trust agreement start on the date upon which the property was contributed to the trust and continue until at least 30 days after the date of notice before it lapses.
Requirement (i) noted above – ensuring that the beneficiary is "aware" of his or her withdrawal right – is of greater concern and the authority is clear: so long as actual notice is provided to the beneficiary, requirement (i) is satisfied.
Notice May Be Required in the Trust Agreement
A trust agreement itself frequently includes guidance regarding the steps that the trustee must take whenever a withdrawable contribution is made. The trust agreement will likely require the trustee to provide to each beneficiary a notice of withdrawal rights within a reasonable time after any gift subject to a withdrawal right is made to the trust. The precise manner, timing and contents of this notice (discussed in greater detail below) may not be specified in the trust agreement, but if the trustee provides notice to the beneficiaries in a manner that differs from what the agreement requires, the trustee will be in violation of the terms of the agreement, and potentially liable to the beneficiaries, even if the trustee has met the legal requirements regarding notice. Ideally the trust agreement will include a nonexclusive list of several manners by which notification may be provided, such as written, verbal, or electronic notification, in order support a trustee's assertion upon audit that notice was provided via a method sanctioned by the agreement.
From an evidentiary perspective in the event of an audit, the optimal way for a trustee to notify a beneficiary that he or she has a withdrawal right with respect to a trust contribution, is for the trustee to give the beneficiary written notice. A copy of the notice, signed by the trustee, along with a statement affirming that the notice was mailed to the beneficiary or guardian is strong evidence, in the event of an IRS audit, that the beneficiary was made aware of his or her withdrawal rights. Alternatively, notice can be emailed by a trustee to a beneficiary, and the email can be printed as written evidence that notice was sent to the beneficiary.
As there is no requirement that written notice itself be given, there is naturally no requirement that written acknowledgment of receipt of notice be given by the beneficiary or guardian. However, a copy of the written notice mailed along with a copy of a signed acknowledgment that the beneficiary received the written notice does provide solid evidence, in the event of audit, that notice was actually received by the beneficiary.
It is important to note that, while written notice is recommended, the Internal Revenue Code, the Treasury Regulations, Revenue Rulings and case law, are devoid of any requirement that a beneficiary receive written notice. The provision of written notice, as opposed to verbal notice, is recommended merely as an evidentiary matter so that the donor has proof, in the event of audit, that notice was in fact given to the beneficiary. However, as a legal matter, verbal notice meets the requirement that a beneficiary or guardian be made aware that the withdrawal right exists and the requirements for timely exercise.
In cases where the trustee is himself or herself a beneficiary holding a withdrawal right, or the trustee is the parent and natural guardian of a minor beneficiary holding a withdrawal right, the IRS has noted that the trustee has "actual notice" of the withdrawal rights by virtue of his or her status as trustee. As a result, the trustee need not provide any formal notice to himself or herself with respect to either his or her own withdrawal rights, or the withdrawal rights of his or her minor children, because actual notice suffices.
Turner v. Commissioner
In August 2011, the Tax Court addressed the issue of the notice requirement in its decision in the case Turner v. Commissioner. In Turner, a donor had established a life insurance trust, and premium payments on the policy owned by the trust were made by the donor directly to the insurance company. The trust agreement provided that each "direct or indirect" transfer to the trust gave rise to a withdrawal right for each of the donor's children and grandchildren – however none of the beneficiaries ever received notice of the indirect contributions nor of his or her resulting withdrawal rights.
The Tax Court determined that the present interest requirement was met under these facts, and that the "indirect" gifts to the trust of the premium payments qualified for the annual exclusion solely because each beneficiary had the "legal right" to demand the property. While the decision in Turner suggests that none of the beneficiary notice procedures described above may be necessary to secure annual exclusion treatment for gifts to trusts which provide beneficiaries with a legal right to withdraw property, it remains to be seen whether the IRS will fully acquiesce to the Tax Court's decision, given the Service's reasoning in multiple rulings regarding "illusory" rights and what constitutes a "reasonable opportunity" to exercise them.
If the IRS ultimately does acquiesce to the reasoning in Turner, it will certainly make the administration of these kinds of trust far simpler. However, in the interim, if a donor is audited, he or she can always point to Turner in support of the claim that only a legal right, and not actual notice of the right, is required in order for a trust and its trustee to comply with the Crummey decision. We recently obtained a favorable result for a client who was audited by the IRS in connection with annual exclusion gifts to trusts by citing the rationale in the Turner case. The client never provided any written notice to the beneficiaries who held withdrawal rights. Nevertheless the IRS accepted the argument in Turner, and closed the audit.
Recommended Contents of Notice
When a trustee provides notice of withdrawal rights to a beneficiary, the notice should include the following items: (i) a statement that a gift that was made to the trust, (ii) the amount of the gift that is subject to the particular beneficiary's right of withdrawal, (iii) the amount of time the beneficiary has to exercise the withdrawal right before it lapses, and (iv) a request that the beneficiary notify the trustee if he or she wishes to exercise the withdrawal right. Including these four items will ensure that the beneficiary is fully aware of the nature of his or her withdrawal right and informed of the manner in which it must be exercised. The initial notice could also include a copy of the relevant portions of the trust instrument providing the withdrawal rights.
Adherence to the rules regarding notice of withdrawal rights is a dreaded annual burden to trustees of many irrevocable trusts. For trustees who have not given annual notices, the Turner case provides some cover in case of a gift tax audit.