For a long time, a popular tax-planning strategy has involved the use of an “incomplete gift.” Treas. Reg. Section 25.2511-2(b) provides that a gift may be incomplete if the donor retains any power over its disposition. In order to take advantage of this regulation, a donor would transfer property to an irrevocable trust but retain a limited power of appointment exercisable in his will to name other beneficiaries of the trust. Properly structured, these trusts avoided treatment as grantor trusts and were instead treated as separate taxpayers.

One popular use of this approach was to create a trust in a state that did not impose income tax on trusts, such as Delaware. If appreciated assets were transferred to that trust, the taxpayer may have been able to avoid paying any state income tax upon the eventual sale of those assets – although the assets of the trust would still be included in the donor’s gross estate for estate tax purposes because the donor retained the ability to control the disposition of these assets. In addition, the distribution of any assets to the beneficiaries of the trust during the lifetime of the donor would result in a completed gift. This kind of trust provided only a state income tax advantage.

In ILM 201208026 (February 24, 2012), the IRS challenged this approach in connection with a trust in which the donor retained no right other than a testamentary limited power of appointment (i.e., the donor was not within the class of discretionary beneficiaries of trust distributions). The IRS asserted that because the disposition of the assets could only be altered at the death of the donor, only the value of the remainder interest in the assets constitutes an incomplete gift. The value of the life or term interest is fixed and the donor cannot change it, so it is a completed gift in the year of the transfer to the trust. The respective values of the life and remainder interests are normally determined actuarially and depend upon the donor’s age at the time of the gift. In this case, however, the valuation provisions of IRC Section 2702 applied, and since the interest was not a qualified interest, it’s value was zero. The entire transfer was a completed gift.

Since a large number of these trusts have been created, this issue will certainly reach the courts. Many advisors believe that the IRS’s position is wrong and courts will eventually reject it.