Why there’s nothing shabby about a Crummey trust

You probably know about the annual gift tax exclusion. It allows you to give up to $13,000 per year (the limit in 2009) tax free, to an unlimited number of people — and without using up any of your $1 million lifetime gift tax exemption. If you elect to split gifts with your spouse, you can give away up to $26,000 per recipient.

What you may not know is that the annual gift tax exclusion is available only for gifts of a present interest. Contributions to a trust ordinarily don’t count, because a beneficiary’s interest in a trust is considered a future interest. But what if you want to take advantage of the annual gift tax exclusion without simply handing over the cash to your children or grandchildren? One solution is a carefully designed Crummey trust.

What is it?

A Crummey trust (named for the court case that first approved the technique) is an irrevocable trust that’s subject to withdrawal rights. By permitting beneficiaries to withdraw trust contributions during a specified period after they’re made (usually 30 or 60 days), it’s possible to convert a future interest into a present interest that qualifies for the annual gift tax exclusion.

For a Crummey trust to work, you must meet several requirements, including a notice requirement. Trust beneficiaries should receive a written notice (preferably by certified mail) explaining their withdrawal rights, the time limits for exercising those rights and the consequences of forgoing withdrawals.

What are the risks?

A Crummey trust can be a powerful estate planning tool, but it’s not without risks. One potential issue is that your beneficiaries may choose to exercise their withdrawal rights. To achieve your estate planning objectives, you want your contributions to continue growing in the trust indefinitely.

At the same time, you can’t prohibit your beneficiaries from withdrawing the funds: Crummey rights must be real to create a present interest. You can educate your family about the financial benefits of keeping assets in the trust, but you can’t have an agreement that they won’t exercise their withdrawal rights.

Another risk is that the IRS will challenge the trust as a tax-avoidance mechanism, deny the annual gift tax exclusion and present you with a bill for back taxes, penalties and interest. The IRS may claim that you and your family have an understanding — express or implied — that the Crummey rights won’t be exercised.

Families often run into trouble in this regard with irrevocable life insurance trusts (ILITs). A parent makes annual exclusion gifts to an ILIT and the trust immediately uses the funds to make premium payments. The IRS often challenges the arrangement, arguing that in such a situation the Crummey withdrawal rights are illusory because the beneficiary has no opportunity to withdraw the funds.

This problem can be minimized by keeping enough cash in the trust to cover any potential Crummey withdrawals or not making premium payments until the withdrawal period has expired or the trustee has received notification that the beneficiary waives his or her withdrawal right with respect to the funds.

What’s the right withdrawal amount?

Setting the right withdrawal amount is critical to creating an effective Crummey trust. A specific dollar amount may not be appropriate because it doesn’t reflect inflation adjustments to the annual gift tax exclusion amount. A better approach is to establish the withdrawal amount with reference to “the annual gift tax exclusion amount permitted by Internal Revenue Code Section 2503(b).”

It’s also important to include limiting language to avoid running afoul of the “5 & 5 rule,” which provides that a trust beneficiary’s withdrawal rights shouldn’t exceed the greater of $5,000 or 5% of the trust principal. If you violate the rule, it may trigger unexpected and unintended gift and income tax consequences.

What other provisions should you include?

When designing a Crummey trust, consider including language that will allow you some flexibility and help you avoid problems down the road. Here are a few ideas:

Allow trustees to modify withdrawal rights or deny them altogether for a particular beneficiary. Remember that the Crummey benefit is to the person making the gift, but he or she may prefer to forgo the ability to make the gift a present interest gift. There may be times, after all, when preventing withdrawals is more important than preserving the annual gift tax exclusion.

Preserve the parent’s or guardian’s power. You may provide that a minor’s withdrawal rights may be exercised by a parent or legal guardian and that the parent or guardian is authorized to receive notices on the minor’s behalf.

Make sure the withdrawal period is long enough. Typically, 30 days or more is appropriate. If the withdrawal period is too short, the IRS may argue that a beneficiary’s withdrawal rights aren’t genuine.

If your spouse is a trust beneficiary, provide that his or her rights are automatically terminated in the event of a divorce or legal separation. Note that in certain situations this may not be possible, but your estate planning advisor would be able to ensure that the drafting complies with local laws.

If the trust’s beneficiaries include grandchildren or other young people, you may also need to include provisions or take other steps to minimize or eliminate your generation-skipping transfer tax liability.

Don’t try this at home

A Crummey trust can be a very effective estate planning tool. It allows you to leverage the annual gift tax exclusion to transfer substantial amounts of wealth to your family tax free. However, like many estate planning tools, Crummey trusts contain several traps for the unwary. So before taking action, make sure you’re fully informed about your financial situation as well as the advantages and disadvantages of this — or any — estate planning strategy. •