Popular Tax Exemption Strategy Upheld

The IRS recently lost a Tax Court case involving an estate and gift tax exemption strategy that the IRS and some in Washington have been trying to eliminate.

The estate planning strategy is known as the Crummey trust, named after the taxpayer in the case that originally approved it. The recent case not only upheld the strategy but showed taxpayers how it can be more effective.

The Crummey trust takes advantage of the annual gift tax exclusion, currently up to $14,000 per person. You can give away up to $14,000 each year to anyone you want. The gift won’t use any part of your lifetime estate planning and gift tax exemption (currently $5.43 million) or incur gift taxes. And you can make these gifts to as many people as you want each year. A married couple can jointly give each person up to $28,000 annually under the exclusion (or $14,000 each separately).

The catch is that to qualify for the annual exclusion the gift must be of a ?current interest.? That means the donee must have access to and rights to the gift now. Normally that means gifts put in a trust don’t qualify.

But a Crummey clause in a trust states that the donee can withdraw the gift from the trust within a certain time after being notified of it. If the donee doesn’t withdraw the gift by the deadline, it stays in the trust subject to the terms of the trust. Subsequent court cases established that the donees should be notified in writing that the gift was made and of their right to withdraw it. A reasonable period, usually of at least 30 days, should be allowed for the donees to exercise the right. Most Crummey clauses provide for 30- or 60-day withdrawal periods.

In practice, few trust beneficiaries withdraw the money. They realize that if they do, their parents or grandparents won’t make any more gifts to the trust on their behalf, might reduce their inheritances in the wills, and could take other actions.

Suppose you have three children and are married. You and your spouse together can put up to $84,000 in a Crummey trust each year. The gifts are out of your estate and don’t use any of your lifetime tax exemption. If each child has three children of his or her own, that makes 12 people you can make tax-free gifts to the trust for, if all are beneficiaries of the trust. Add spouses and the tax-free gifts multiply. (You also can have separate trusts for each beneficiary or for each child and his or her children.)

In the recent case, Mikel v. Commissioner, the taxpayers set up trusts with 60 beneficiaries. They transferred $1.6 million to the trusts tax free and without using their lifetime exemptions. The Tax Court allowed this, because of the Crummey clause.

The trusts also had an in terrorem, or no-contest, clause which we discussed in past visits, providing that any beneficiary who unsuccessfully challenged the terms or operation of the trust would lose his or her benefits under the trust. The court also allowed this clause, because it was limited only to disputes over distributions made in the discretion of the trustees.

The Crummey clause allows you to remove assets from your estate and put them in trust for loved ones without using any of your lifetime estate and gift tax exemption. The strategy is especially valuable if you live in one of the states that still has its own estate or inheritance tax. The strategy should work effectively to reduce those taxes, which often are higher now than the federal taxes.