Every taxpayer has two shields from the federal gift tax: a $14,000 annual exclusion and a $5.43 million lifetime exemption. Each of these is indexed for inflation. To the extent the gift tax exemption is used, one’s estate tax exemption is reduced, dollar for dollar.
The purpose of the annual exclusion is to eliminate the necessity of gift tax returns until the total of gifts made to one person exceeds $14,000 in a single year. Note that the annual exclusion is not per taxpayer, it is per donee. A grandfather with six grandchildren may give each of them $14,000 this year without needing to file a gift tax return to report the gifts to the government.
One couple recently leveraged the gift tax exemption and exclusion to avoid all gift taxes on a transfer of property worth $3.2 million to a trust. They each claimed $720,000 in gift tax annual exclusions, and their lifetime gift tax exemption covered the rest.
How is that possible? The trust was a so-called Crummey trust, named for a taxpayer victory many years ago. That case held that the annual gift tax exclusion must be allowed if a beneficiary has a power, even a temporary power, to withdraw trust assets when they are contributed to the trust. In the new case, the couple had named 60 different beneficiaries for their trust, each with a Crummey power of withdrawal.
It’s important to note that the withdrawal power must not be illusory. The beneficiaries must be advised of the power as well as the contributions to the trust, and they must have a reasonable time to exercise the power, typically 30 days. If the power is not exercised, the property remains in the trust for future distribution to the beneficiaries.
The IRS challenged the annual exclusions for the 60-beneficiary trust, but lost in the Tax Court. The Service did not base its arguments on the large number of beneficiaries, or the practical limitations on satisfying a withdrawal demand when the trust held illiquid assets. Rather, the IRS focused on a clause in the trust that had the potential to disinherit any beneficiary who objected to a trustee’s distribution decision. The Tax Court held that the clause in question did not apply to withdrawal demands, which are different from distribution decisions.
The moral of the story is that one can leverage the two gift tax shields considerably. However, excellent legal advice will be a must, because an IRS objection to such arrangements will be likely.