Taxes are all we think about this time of year as we plan to file our previous year’s returns. Those with significant wealth often look for ways to transfer assets to the next generation with little or no transfer taxes. No one wants to add Uncle Sam to their estate beneficiary list.
As you may already know, a common and effective way of transferring wealth is through an individual’s annual gift tax exclusion. This annual exclusion allows individuals to make gifts up to a set amount each year ($14,000.00 for 2014) to an unlimited number of donees free of gift and generation-skipping transfer tax.
When the donee is a minor, parents and grandparents frequently make their annual gifts to a custodial account under either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). A UGMA or UTMA account is easy to create and maintain. However, each has one major defect: when the beneficiary reaches the age of majority (either 18 or 21 depending on the state in which the beneficiary resides), the beneficiary can do whatever he or she wants with the money in his or her custodial account. If the beneficiary wants to buy a sports car instead of going to college, there is nothing that the donor can legally do to stop such a purchase.
Few people desire their children or grandchildren to receive significant amounts of unrestricted cash at such a young age. Fortunately, there is a special kind of trust that avoids this problem: the "Crummey" trust. Named after a court case that paved the way for this kind of trust, a Crummey trust allows the gifted property to remain in trust for as long as the donor wishes without forfeiting the gift tax annual exclusion. Thus, you can transfer property to remain in a Crummey trust for the beneficiary's entire lifetime or until a chosen age or event (e.g., graduation from college) as you so determine. You decide how the money is used and how much the beneficiary can receive until the specified event occurs.
While the Crummey trust provides the donor with more control, there are three major complexities associated with this kind of trust.
First, the donor must notify the beneficiary that the contributions have been made and each year give him or her a limited period of time (usually 30 days) to withdraw the contributions from the trust. This requirement to give the beneficiary access to the trust property creates a present interest in the property, allowing the donor to qualify for the annual gift tax exclusion. Without providing this window of opportunity for the beneficiary to access the money, the transfer cannot be considered a present gift.
It is usually understood that the beneficiary will not exercise his or her right to withdraw the contributions during this limited window. However, that expectation should always remain unwritten because if there is any documentation of it, the IRS will use that as evidence to claim that the beneficiary did not really have a power of withdrawal. The consequence of failing to qualify as a present gift is the donor may not apply the annual gift tax exclusion to contributions made to the trust during that year. If the beneficiary violates the unwritten understanding by withdrawing property from the trust, the donor can do nothing about it, except to perhaps show displeasure by not making any further contributions to the trust.
Second, the letter alerting the beneficiary he or she can access the trust property during the set window of time must be sent every year under specific rules. Failure to follow these rules may prevent the donor from applying the annual gift tax exclusion for gifts made to the trust that year.
Third, when the beneficiary allows the window of access to the trust property to lapse, it may create gift tax implications for the beneficiary. Upon allowing the window to lapse, it is treated as if the beneficiary gifted a portion of the previously accessible amount back to the other trust beneficiaries. However, if the trust only has one beneficiary, this isn't a problem.
Tax Warrior Perspective
The Tax Warriors® at Drucker & Scaccetti have helped set up and administer many Crummey trusts. These types of trusts are often used with life insurance as a way to keep life insurance proceeds out of an individual’s estate. The tax-free gifts to the trust are used to pay premiums on a policy owned by the trust. When the insured passes, the proceeds from the policy, which can often be much greater than the previous premium payments, are paid to the trust and are not included in the decedent’s taxable estate.
Crummey trusts can be powerful wealth transfer tools when used properly. While the concepts are simple in theory, the administration of the Crummey powers can sometimes fall by the wayside and be neglected in practice. If the Crummey letters are not issued properly and the IRS becomes aware, the prior transfers can be considered taxable gifts or the insurance proceeds can be included in the decedent’s estate which could cause serious unintended gift and estate tax consequences.
If you are interested in transferring assets tax free or would like The Tax Warriors® to review the status and effectiveness of your existing estate plan, call us at (215) 665-3960 or click the “Ask A Tax Warrior” button below. Our highly trained professionals are always prepared to help you with this or any other estate planning matter.