Don’t let your Crummey trust crumble The annual gift tax exclusion is a deceptively powerful estate planning tool. It allows you to give up to $13,000 per year (adjusted regularly for inflation) to an unlimited number of recipients. If you elect to split gifts with your spouse, the limit doubles to $26,000. Best of all, the annual exclusion lets you remove a substantial amount of wealth from your taxable estate without tapping any of your $1 million lifetime gift tax or $3.5 million estate tax exemptions. There’s just one catch: The annual exclusion applies only to gifts of a present interest — that is, the recipient must have all immediate rights to the use, possession and enjoyment of the gifted property or of the income from such property. But gifts to a trust are, by definition, gifts of future interests. So how do you make annual exclusion gifts to a trust? One way is to provide trust beneficiaries with Crummey withdrawal rights. A Crummey solution Named after the taxpayer who first used the strategy successfully more than 40 years ago, Crummey rights allow beneficiaries to withdraw trust contributions for a limited period of time (30 days, for example) after they’re made. By providing these rights, you can convert a future interest into a present interest even if the withdrawal rights are never exercised. For this strategy to be effective, however, the trust must be drafted carefully, and its provisions must be followed to the letter. Among other things, you must provide beneficiaries with a timely, detailed written notice of their withdrawal rights. The IRS has never liked Crummey trusts, and it may challenge annual exclusion gifts if it believes the arrangement is a sham or that there’s an express or implied understanding between you and your beneficiaries that Crummey rights won’t be exercised. It’s OK to talk to your beneficiaries about the financial benefits of keeping assets in the trust, so long as you don’t imply that withdrawals are prohibited. Fact vs. fiction To withstand an IRS challenge, Crummey rights must provide beneficiaries with a real opportunity to withdraw funds from the trust. For example, Crummey rights typically are incorporated into irrevocable life insurance trusts (ILITs) so that insurance premiums can be funded with annual exclusion gifts. But a common mistake is to make contributions to an ILIT that are equal to the annual insurance premium and then to use those funds immediately to make the premium payment. The problem with this approach is that, practically speaking, the beneficiaries couldn’t exercise their Crummey withdrawal rights even if they wanted to. The IRS would likely view the arrangement as a sham and deem the contributions ineligible for the annual exclusion. To avoid this result, maintain sufficient liquid assets in the trust to fund any potential Crummey withdrawals. Alternatively, the trustee should wait to make premium payments until the withdrawal period has expired. Beware of the “5&5 rule” Under the “5&5 rule,” unless a beneficiary’s withdrawal rights are limited to the greater of $5,000 or 5% of the trust principal, a beneficiary who allows Crummey rights to lapse will be considered to have made a gift to the remainder beneficiaries of the trust. The result can lead to a variety of gift and estate tax problems, because the beneficiary’s gift will likely be treated as a future interest gift and thus won’t be eligible for the annual exclusion. A common mistake is to provide beneficiaries with withdrawal rights equal to the annual gift tax exclusion. If the trust principal is $260,000 or less, the Crummey rights will be greater than 5%, violating the 5&5 rule. To avoid this risk, the trust should include language providing that Crummey withdrawals cannot exceed the greater of $5,000 or 5% of the trust principal. Avoid the pitfalls A Crummey trust can be an effective estate planning tool, but to pass muster with the IRS it needs to be designed and operated carefully. Review “Crummey trust dos and don’ts” below, and be sure to have your trust documents drafted by your estate planning advisor. • |
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