Imagine paying your attorney a small fortune to draft your trust documents, only to have the Internal Revenue Service attack your gifting plan to the trust years later. Some taxpayers find themselves in this unfortunate situation when it comes to the common, yet often mishandled, area of Crummey withdrawal powers.
What Are Crummey Powers?
Many estate plans call for annual gifts to heirs, often through trusts. To be eligible for the annual gift tax exclusion — currently $13,000 per year — these gifts must be of a “present interest,” which means that the recipient must be able to access the assets immediately without restriction. In many cases, gifts to trusts are of a “future interest” because the beneficiary’s access is restricted until some future date or event. The Crummey power, named after a taxpayer from the landmark tax case in 1968, is an often-used trust provision that allows a gift that would otherwise be a future interest gift to be treated as a present interest gift, and thus be eligible for the annual gift tax exclusion.
Crummey powers give the beneficiary a limited time (often 30 or 60 days) to withdraw contributions to a trust, converting the future interest gift to a present interest gift. This withdrawal right is generally limited to an amount equal to the current annual gift tax exclusion. If the beneficiary does not exercise this right within the specified time, the Crummey power is deemed to have lapsed and the assets remain in trust.
Avoiding IRS Attacks On Crummey Powers
The IRS has long viewed Crummey powers as a fancy tool that estate-planning attorneys use to treat a future interest gift as a present interest gift when no one intends for the beneficiary to actually exercise withdrawal power. Despite unsuccessful challenges to Crummey powers in the courts, the IRS continues to attack them. Accordingly, trustees, advisors and beneficiaries must follow Crummey rules closely to avoid such disputes.
The most basic step, sometimes forgotten by careless trustees and advisors, is providing notice to beneficiaries of the withdrawal power when a gift is made to the trust. This procedure is often spelled out in the trust document, generally requiring that beneficiaries receive detailed and timely written instructions on how they might exercise their withdrawal rights. The IRS has confirmed in multiple private letter rulings that in certain situations actual knowledge of the gift is sufficient notice of the withdrawal power, such as when the Crummey power holder is a trustee. The tax courts, despite many rulings, have never specifically stated that a beneficiary must be given notice upon a contribution to a trust, leaving some practitioners to speculate that notice isn’t required as long as the beneficiary is aware of the withdrawal right. However, written notification is always prudent, since it provides concrete proof that notice was given.
To follow the IRS’ accepted practices relating to Crummey withdrawal powers, trustees, trust advisors and grantors should take these additional steps:
- Ensure that there is no express or implied agreement between the trustee or the grantor and the beneficiaries that the withdrawal power won’t be exercised. The benefits of keeping assets in the trust can be explained to beneficiaries, but the trustee or grantor should never imply that withdrawals are prohibited.
- Specify a withdrawal period of at least 30 days in the trust document. While a shorter time may be accepted, if it is too short, the IRS may argue that the Crummey power holder was not given sufficient time to consider or exercise the withdrawal right.
- Encourage beneficiaries to simply allow the withdrawal period to lapse without acting, rather than proactively notifying the trustee that they do not wish to exercise their withdrawal rights. This is because when a beneficiary expressly decides not to exercise his or her withdrawal right, the money that could have been withdrawn is considered a gift to the other beneficiaries for gift tax purposes. However, when the beneficiary allows the withdrawal right to lapse there is no deemed gift so long as the Crummey power does not exceed the greater of $5,000 or 5 percent of the value of the trust property (commonly referred to as the 5 and 5 exception). Note that the exception applies only to the lapse, not to the waiver or release, of a Crummey power.
- Do not allow a beneficiary to waive his or her withdrawal right for current or future contributions to the trust. The IRS prohibits such waivers.
- For trusts that own life insurance policies, make sure there is cash in the trust to fulfill any potential beneficiary distributions during the entire withdrawal period. For example, using most or all of the cash contributed to the trust to pay premiums before the beneficiary’s withdrawal period expires undermines the legitimacy of the Crummey withdrawal power, as it leaves insufficient cash available to fulfill the withdrawal right. Many advisors recommend that insurance trusts be funded with some cash up front to alleviate this problem.
- For insurance trusts, do not allow the grantor to pay annual insurance premiums directly. The trust should make all premium payments.
- Send Crummey notices using a method that can provide proof of mailing date, such as certified mail or a courier service. In addition, the trustee or trust advisor can have the beneficiary sign the notice of withdrawal acknowledging that it has been received; however, as noted above, the signature should not specify a release or waiver of the withdrawal power.
- Do not provide Crummey withdrawal powers to an individual who doesn’t have a substantial economic interest in the trust, often referred to as “naked Crummeys.” Absent some potential future benefit from the trust, it is likely that an individual would exercise his or her withdrawal right. A naked Crummey holder’s failure to take the money casts doubt on the legitimacy of the Crummey power.
- Try to avoid making contributions to the trust so late in the year that the withdrawal period extends into the next year. This prevents potential complications in determining the year in which the gift is made or when the Crummey withdrawal rights lapse.
Hanging Crummey Powers
As discussed above, it can sometimes create problems when beneficiaries allow their withdrawal rights to lapse, as this is considered a taxable gift to other beneficiaries if the amount exceeds the greater of $5,000 or 5 percent of the trust assets. One potential solution is the “hanging Crummey” provision. This allows for the lapse of the withdrawal power only for the portion covered under the 5 and 5 limitation. The withdrawal power attributable to the remaining portion is carried over to future years and continues to “hang” until it is exhausted or the withdrawal power is exercised.
For example, Tom and Jerry are equal beneficiaries of a trust with $50,000 of assets to which a $26,000 contribution is made, resulting in a withdrawal power of $13,000 each. Absent a hanging Crummey provision, Tom and Jerry have each made taxable gifts of $8,000 to the other when they allow their withdrawal powers to lapse because only $5,000 is covered by the 5 and 5 rule. With a hanging Crummey provision, the $8,000 is not a taxable gift, but instead carries over to the next year. If no contribution is made to the trust in that year, $5,000 of that amount will lapse, leaving $3,000 to be carried over to the following year.
One must consider additional factors when dealing with hanging Crummeys. First, the IRS has indicated that it will ignore hanging Crummey powers that contain a provision (typically known as a savings clause) nullifying a previous gift to the trust if it is determined that the transfer is subject to gift tax. One may avoid this issue simply by stating that the power will not lapse to the extent it exceeds the 5 and 5 limitation, omitting any language tied to the ultimate taxability of the gifts.
Second, careful thought must be given to the timing of contributions to the trust and the lapse of associated withdrawal powers, as taxpayers are only allowed one 5 and 5 exception per tax year. When applying the exception, the lapse date of the withdrawal power is the relevant date, rather than that of the contribution. For example, if a gift is made on Dec. 15, 2010, and the beneficiary has a 30-day withdrawal period, the lapse will not occur until 2011. If a subsequent gift is made in June 2011, only $5,000 of the beneficiary’s withdrawal right is allowed to lapse in 2011, even though the gifts were made in different tax years. Had the original gift been made in November 2010, $5,000 would have been allowed to lapse in 2010 and $5,000 in 2011.
Many IRS challenges result when estate planners do not follow the generally straightforward yet strict requirements for Crummey trust provisions. The key to avoiding such attacks is dotting your i’s and crossing your t’s. Follow the guidelines above, and you have won the battle before it’s begun.
