THIRD CIRCUIT RULES IN FAVOR OF CRUMMEY POWERS TO CONTINGENT BENEFICIARIES

By Ellen Gordon, CPA, Lopez Edwards Frank & Co., LLP

Property transferred for less than adequate consideration in money or money's worth is, in general, deemed to be a gift for tax purposes. Transfers made during a lifetime (intervivos gifts) may be subject to gift taxes. Most gifts, however, will be exempt from gift taxation by virtue of the annual exclusion and by deductions and credits.

IRC section 2503(b) provides an exclusion for the first $10,000 of gifts made to any person by the donor during the calendar year. The amount permitted to be excluded is not added back to the tax base in computing the estate tax [IRC section 2001(b)]. The donor receives an annual exclusion for only those gifts that constitute a present interest. If a gift is made in trust, the principal is often not a gift of a present interest because the donee does not have the unrestricted right to its immediate use, possession, or enjoyment [IRC Reg. section 25.2503-3(b)].

In Crummey v Commissioner [397 F2d (9th Circuit 1968)], the court ruled that if the trust instrument allows a beneficiary to withdraw each year the lesser of the annual exclusion or the value of the assets transferred to the trust during the year, the annual exclusion will be permitted. The court held that the demand power (Crummey Power) gave each beneficiary a present interest. The holder of the Crummey power must be given notice of a contribution to the trust to which the power relates and must be given a reasonable time within which to exercise the power (usually 30-40 days). The donor receives the annual exclusion regardless of whether the donee exercises the power.

It has been the IRS' longstanding position that a Crummey power given to a person who is not otherwise a beneficiary of the trust is invalid. This position was challenged in the Estate of Maria Cristofani v. Commissioner, a Ninth Circuit case [97 TC 74 (1991)]. In this case, the court held that Crummey powers given to the donor's grandchildren, who were contingent remainder beneficiaries, were effective. The court noted that where trust beneficiaries, including minor and contingent beneficiaries, are given unrestricted rights to demand immediate distributions of trust property, the beneficiaries are generally treated, under IRC section 2503(b), as possessing present interests in the property.

The IRS acquiesced in the Cristofani case, but has continued to litigate Crummey powers to contingent beneficiaries where the facts indicate that transfers are in substance a device to obtain annual exclusions with no donative intent to transfer a present interest. A recent case, the Estate of Lieselotte Kohlsaat [T.C. Memo. 1997-212 CA-3 (May 7, 1997)], was another taxpayer victory.

Lieselotte Kohlsaat (DOD 6/5/90) had been a New Jersey resident. On March 27, 1990, the decedent established an irrevocable family trust and transferred a commercial building valued at $155,000 to the trust. The decedent's two adult children received an interest in one-half of the corpus and income of the trust, and each received a special power to appoint the corpus of his or her one-half share of the trust to his or her children or grandchildren.

Under the trust provisions, 16 contingent remainder beneficiaries were designated, all family members of the decedent. All of the trust beneficiaries were given a Crummey power to demand from the trust an immediate distribution to them of property in an amount not to exceed the $10,000 annual gift tax exclusion following each transfer of property to the trust. Each beneficiary's right to demand a distribution lapsed 30 days after a transfer of property to the trust.

On April 6, 1990, the beneficiaries of the trust were timely notified of their rights to demand distributions of trust property of up to $10,000 each. None of the beneficiaries exercised his or her Crummey power and none of the beneficiaries requested notification of future transfers of property to the trust.

On the estate tax return, the interests of the 16 contingent beneficiaries were treated as qualifying for 16 annual gift tax exclusions under IRC section 2503(b) with regard to the decedent's 1990 transfer of the commercial building to the trust. The IRS had disallowed these 16 annual gift tax exclusions claiming that the contingent beneficiaries did not hold present interests in the trust.

The IRS' argument was that understandings existed between the decedent and the 16 contingent beneficiaries of the decedent's trust to the effect that the beneficiaries would not exercise their rights to demand distributions of trust property, that these understandings negated the decedent's donative intent, and that the substance over form doctrine should apply to deny the annual gift tax exclusions with regard to the interests held by the 16 contingent beneficiaries.

The IRS also contended that the contingent beneficiaries believed that they would be penalized for exercising their rights to demand distributions of trust property or that the trustees purposefully withheld information from the beneficiaries.

According to the court, the evidence did not establish that any understandings existed between the decedent and the beneficiaries that the contingent beneficiaries would not exercise those rights following a transfer of property to the trust. At the trial, several credible reasons were offered by the trust beneficiaries as to why they did not exercise their rights to demand a distribution of trust property. According to the court, the fact that none of the beneficiaries requested notification of future transfers of property to the trust did not imply that the beneficiaries had agreed with the decedent not to do so.

In addition, the court noted that the contingent beneficiaries received actual notice from the trustees with regard to their rights. Moreover, the decedent intended to benefit the contingent beneficiaries by giving them interests in the trust. Lastly, the contingent beneficiaries were relatives of the decedent.

For all these reasons, the court concluded that the contingent beneficiaries' unrestricted rights to demand immediate distribution of trust property constituted present interests in property. The decedent's transfer of the commercial building to the trust qualified for 16 annual gift tax exclusions under IRC section 2503(b) with regard to the present interests of the 16 contingent beneficiaries.

It is uncertain at this time whether the IRS will appeal the decision. *

IRS CRACKDOWN ON ABUSIVE TRUSTS

By Edward A. Slott, CPA, E. Slott & Company, CPAs

Tax schemes whose sole purpose is to beat Uncle Sam out of its fair share, including Family Limited Partnerships (FLPs), trusts, and other similar vehicles, have become the target of a major IRS enforcement initiative. Regardless of the professional credentials of the person who sets up the trusts, the IRS can and may reclassify them as "abusive trusts" and dismiss or reduce the discounts.

The tax concept being sold is that you can transfer property into one of these entities, for example, an FLP or trust, and pay gift tax on the transfer at a reduced or discounted amount. The gift tax return must be filed for gifts in excess of $10,000 per year. However, you must now answer a new question on the gift tax return. "If the value of any gift you report ... reflects a discount... answer "yes" to the question at the top of schedule A." A "Yes" here could invite an IRS audit.

This includes FLPs, business interests transferred to children, the transfer of publicly traded stocks, and a host of trusts, many of which are being promoted as a legal means to avoid paying the gift tax.

One fundamental principle of tax law is that whatever entity controls the assets is the owner and is therefore liable for taxes. If the IRS thinks you control a trust, the trust assets may be included in your estate and subject to estate tax. Many unsuspecting taxpayers are being told otherwise by the people who profit from setting up these trusts.

The IRS, in Notice 97-24, has made it clear that aggressive use of the FLP or abusive trusts will generate a house call. If this includes you, you have two choices: invest in a tax lawyer to defend the trust or pay Uncle Sam directly.

Many of these and other creative estate planning tactics are often not revealed until after the person has died and the estate is settled. If the IRS disregards the trust, the heirs end up with the tax burdens. Unfortunately, if the heirs or the surviving spouse have not planned for these taxes, serious fiscal problems may result.

The IRS has created a hit list of the five types of trusts that will be targeted for a closer look: the business trust, the equipment or service trust, the family residence trust, the charitable trust, and the final trust. Expect them to be joined by the new "Alaska trust."

The "Alaska trust" became official on April 1, 1997, created by an Alaskan statute and designed solely to help high income individuals avoid creditors and tax payments. The problem is the IRS has not yet taken a position on this particular type of trust, so it's anyone's guess as to whether or not it will stand up to
the IRS's current initiative against
abusive trusts.

The IRS is also looking closely at the increasingly popular FLP. FLPs are set up as vehicles to transfer property out of an estate and gain valuation discounts for gift tax purposes, while still retaining control of the transferred assets. But if the purpose of the FLP is purely tax related with no business purpose other than tax avoidance, it will not stand up to the IRS's scrutiny.

One dramatic example of this type of abuse is seen in a recent Technical Advice Memorandum (TAM 9719006) issued by the IRS National Office on March 1, 1997. An FLP was set up two days before the decedent's death and resulted in an egregious 48% discount on the estate tax return. The IRS rejected the discount and the transferred property was included in the estate at full value. The memo stated that the sole purpose of the FLP transfer in this instance was to reduce transfer taxes, which is not a legitimate business purpose.

Trust promoters who promise a guaranteed tax-free trust or partnership that will magically override tax law should be treated with a high degree of caution.

It should be noted that legitimate trusts will be unaffected by this new enforcement endeavor. Trusts set up to transfer property to genuine charities or to facilitate protection or management of assets for minors or incompetents will not be affected.

As a final word of caution, consider the "duck test," an instance where taxes and real life intersect. The IRS calls it "substance over form." If it looks like a duck, walks like a duck, and quacks like a duck, it's a duck. Whether you call it an FLP, an Alaska trust, or by any other name, if it's designed to override well-established tax law, chances are good that the IRS will call it what it is: an abusive trust.

Editors:

Eric M. Kramer, JD, CPA
Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.

Laurence I. Foster, CPA/PFS
KPMG Peat Marwick LLP

Contributing Editors:

Richard H. Sonet, JD, CPA
Marks Shron & Company LLP

Lawrence M. Lipoff, CEBS, CPA
Lipoff and Company, CPA, PC

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

James B. McEvoy, CPA
Chase Manhattan Bank

Nathan H. Szerlip, CPA
Edward Isaacs &
Company CPAs LLP