Trusts - Annual Exclusion (Gift) Trusts
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Description/Scope: Making annual gifts to children or grandchildren (or other minors) which will meet the qualifications for the annual exclusion rules, while at the same time providing for both protection of the trust assets and mitigating the potential for the beneficiaries to squander the funds and therefore missing the intention for the care of the beneficiaries. The following is a highlight of the forms presented herein:
What information is needed to form the trust - Trust Information Sheet
Checklist for Forming the Trust Formation of trust checklist
Identification of the gift(s) to be made Identification of gifts form
Cover letter to beneficiary or guardian Letter Explaining Affidavit by beneficiary to refuse the election to withdraw trust funds
Beneficiary's or Guardian's written refusal to take a distribution Non-election of Right to Withdraw
Clause limiting time of withdrawal to be time from notice of gift to the end of the year Dec 31 bar date for drawing
Clause limiting time of withdrawal to be from notice of gift and within 30 days 30 days from gift bar date for drawing
Clause limiting principal distribution to age 35 35th birthday for distribution of corpus
Trust Agreement - Irrevocable trust
Purpose: This information is intended to inform the trustee, the beneficiary, the donor or the professional adviser about forming trusts to receive annual gifts. In most, obviously not all, cases the beneficiary or beneficiaries will be minors. This information is intended to assist with the transfer process, protection of the trust principal and qualification for the annual gift tax exclusion.
Who This Applies to: This will apply to the trustee, the beneficiary, the donor or the professional adviser. For the donor, the methods and techniques herein will be a benefit to those having assets that will create a taxable estate and more. However, those in the larger estates may find it inconvenient to use this technique as there may not be enough beneficiaries or enough time to distribute the assets limited to the annual exclusion. In addition the type of assets to be transferred will impact the use of this method. Whenever, the assets are not liquid or cannot be divided, or control an entity the donor does not want to lose control of the method herein are too restrictive.
When to Perform: At the beginning of the calendar year and an annual checkup at the end of each calendar year.
Special Circumstances
Why This Is Important: Failure to meet the IRS rules will decrease the credit available for estate tax. Failure to meet Trust law will open the trust assets to risks of litigation against a beneficiary and/or allow the beneficiary full access, without restriction, to the trust funds.
General Benefits & Objectives
All the trusts formed to qualify for the annual exclusions must be drafted to allow the beneficiary to draw at a minimum, the income from the trust when the beneficiary becomes 21. The trust will be formed to be a "simple trust" when the beneficiary becomes 21. That means the beneficiary must include the income from the trust on the beneficiary's personal tax return starting at the 21st birthday.Furthermore, the beneficiary must agree in writing to forego the distribution of the gift or receive the gift as a distribution from the trust. Any other drafting may cause the IRS to challenge the validity of the gift.
Taking advantage of the annual gift tax exclusion can be a simple and effective method to help reduce a taxpayer's gross estate during his or her life -- and thus subsequently lower the taxable estate and estate taxes due upon the taxpayer's death. <2> Although the exclusion is legally available to any donor, it is more likely to be used by (and probably most useful for) those fitting the following description: taxpayers who are relatively well-off, very well-off, even wealthy, but not generally, "super-millionaires."
Certain categories of persons will not be interested in taking advantage of the exclusion. First, those individuals whose net assets are less than the amount sheltered by the unified credit will not be interested. <3>
Although married couples will need to do some tax planning to take full advantage of the amount to be sheltered by the unified credit, in general, persons with total assets below the unified credit amounts have no need to lower their estates for tax purposes because their estates will not be subject to tax. Indeed, for most estates of U.S. citizens and resident aliens below these taxable thresholds, there is no estate tax filing requirement. <4>
The second category of persons for whom the exclusion is not particularly useful is the super-rich. Especially wealthy persons are not prohibited from making $10,000 donations to family and friends, however, as a practical matter, unless the super-rich taxpayer has a legion of beneficiaries, he or she simply will not be able to substantially reduce his or her estate by increments measured in the mere ten-thousands.
EXAMPLE: Donald, Malcolm, and Bill are very wealthy individuals. Donald's net worth is approximately $20 million, Malcolm's is $100 million, and Bill's is an even $1 billion. If their investment portfolios are merely earning seven percent annually (not an unreasonable return), Donald is accruing additional wealth (before income taxes) of $1,400,000 each year, Malcolm is adding another $7 million each year to his net worth, and Bill is adding an astounding $70 million annually to his capital. In order to keep even with this income, Donald must give away the exclusion amount of $10,000 to 140 different individuals. Next year -- and every year until his death, he must continue to give away 140 such gifts. Malcolm, to keep pace with his income, must give $10,000 to 700 individuals and Bill must find 7,000 lucky friends every year. Note that in this example no reduction to the value of the estate has taken place. Donald, Malcolm, and Bill have only kept pace with their returns on capital.
It can readily be seen that for those taxpayers in the rarefied atmosphere of extra high wealth, the annual gift tax exclusion is too small and too clumsy a manner in which to dispose of substantial wealth. These persons need far more aggressive and expeditious means to plan their estates. Accordingly, having eliminated the top and the bottom strata, the estate tax planner is left with those taxpayers whose wealth is in the approximate $1 to $10 million net worth category. For these persons, the annual exclusion can be a very useful planning tool. It has been said -- without undue irony -- that the annual gift tax exclusion is the "poor" rich-person's most useful tax planning device.
Special considerations are necessary where the intended beneficiaries are minor children, or if the donor does not wish to make an outright, "no-strings attached" gift. Because the gift tax exclusion does not apply to "gifts of future interests in property," most gifts made in trust are not eligible for the exclusion. <10> In general, to qualify for the gift tax exclusion, a gift must be of a present vested interest. For these purposes, a present interest is an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain). A future interest is defined as including reversions, remainders, and all other interests in property that are limited to commence in use, possession, or enjoyment at some future date or time. <11>
EXAMPLE: Bill has established a trust in the amount of $100,000, for the benefit of Bill Jr., his son. Under the terms of the governing instrument, it is a complex trust. The trustee has discretion to accumulate the principal and interest. The trustee, in his discretion, gives Bill Jr. $10,000 each year. No part of Bill's original donation and no part of each year's distribution qualifies under the gift tax exclusion. Bill Jr. has no present right to anything. <12>
If, on the other hand, Bill Jr. has a mandatory right to the income from the trust, his right will qualify for the gift tax annual exclusion. A transfer to a trust is considered a transfer to the beneficiary of that trust. <13> However, any postponement of the income right will cause contributions to the trust to be ineligible for the gift tax exclusion. And, if the trustee has discretion to distribute principal to anyone other than the beneficiary, the income interest will not qualify for the exclusion because its value will be considered unascertainable at the time of the trust's creation. <14>
There is, however, an exception to the rule that gifts of future interest do not qualify for the gift tax exclusion. A gift of a future interest can qualify for the gift tax exclusion if the recipient is under 21 years of age. In the case of a trust for the benefit of a minor, a gift will not be considered a gift of a future interest if the trust principal and income may be expended by or for the minor's benefit; if the accumulated income and principal will pass to the beneficiary at age 21; and, should the minor die before reaching age 21, any existing principal and income is paid to his estate or to his appointee pursuant to a general testamentary power of appointment. <15>
EXAMPLE: Bill and Melissa establish a trust for the benefit of their little baby girl, Mary. They plan on contributing $20,000 every year from now until she is 21. It is a Section 2503(c) trust and under its terms, Mary will have the right to withdraw the trust funds at age 21. Bill and Melissa's split-gift of $20,000 per year qualifies for the annual gift tax exclusion. In twenty years of annual contributions of $20,000, Mary will have $400,000 plus the earnings thereon. It is easily conceivable that she will have a trust worth over a million dollars at that time -- and that entire sum will have passed to her free of all estate and gift taxes. Similar arrangements (and contributions) can be made to minors under the various states' Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). However, some caution is appropriate here. State law varies; some states terminate the age of minority at 18, others permit UGMA/UTMA gifts to remain in custodianship until the minor's reaching age 21.
Naturally, many donors are hesitant to contribute hundreds of thousands of dollars to a child or grandchild who may be able to withdraw that money when he or she reaches 21. There are several ways to accommodate this concern. The trust fund need not be distributed outright to the beneficiary -- nor need the trust terminate -- at the moment the beneficiary turns 21. Contributions to a minor's trust will qualify for the gift tax exclusion if the beneficiary has either (1) an unencumbered right upon reaching age 21 to withdraw the trust property; or (2) upon reaching age 21, a right to compel distribution of the trust property by giving written notice to the trustee during a limited period of time, which, if not exercised, will permit the trust to continue for the period provided in the trust instrument. <16> If a young beneficiary may be counseled to accept the benefits and security of trust administration, he or she may allow the "window of opportunity" to lapse, and thus permit the trust to continue under its terms. <17>
An alternative to this type of trust is a trust created with "Crummey" powers which allows the gift tax exclusion in situations where the beneficiary has an unrestricted right to withdraw all, or a portion of, the annual additions to the trust corpus. A demand right that lasts for a limited period of time, for example, will qualify. <18> A Crummey withdrawal right only qualifies if it can be realistically exercised. The IRS will not challenge a Crummey power when there is "no impediment under the trust or local law . . . and the minor donee has a right to demand distribution." <19> Where the rights cannot be exercised or that the beneficiaries have no real interests in the trust, the rights are not real vested present interests in the trust and the gift tax exclusion will not apply. <20>
If the Crummey power is limited by the trust instrument's placing discretion in the trustee, no exclusion is allowed. <21> The IRS has disqualified withdrawal rights where there is no proof of actual notice given to the beneficiaries or the beneficiaries are not given enough time to exercise their withdrawal rights. <22>
<<<ENDNOTES>>>
1/ Gift Tax Exclusions and Exemptions, Section 759.5.
2/ For a discussion of the gift tax exclusion rules, see Kleinrock's Analysis and Explanation, Section 759.5.
3/ Under Code Section 2505(a), every individual is granted a cumulative tax credit to be used against the tax assessed on all lifetime gifts made after December 31, 1975, that do not qualify for the marital and charitable deductions, the annual gift tax exclusion, or the medical and educational exclusions. The gift tax credit and the estate tax credit are unified. Under applicable exclusion amounts may be found in Kleinrock's Analysis and Explanation, Section 759.5.
4/ There are a number of special provisions applicable to estates of non-citizen, nonresidents. See generally, Code Section 2101 et. seq. The discussion in this planning note is aimed at estates of U.S. citizens and resident aliens.
5/ Code Section 2503(b)(1) ("the first $10,000 ... shall not ... be included in the total amount of gifts made during such year."
6/ See Code Section 2522(a) and Reg. Section 25.2502- 1(d), Example (3).
7/ Code Section 2523(a).
8/ Reg. Section 25.2511-1(h)(2). United States v. Estate of Grace, 395 U.S. 316 (1969); Schultz v. United States, 493 F.2d 1225 (4th Cir. 1974). An individual cannot increase the number of exclusions to any one individual by using other individuals as agents. Heyen v. United States, 945 F.2d 359 (10th Cir. 1991) (donor transferred shares of stock to 29 persons, all but two then transferred their stock to members of donor's family).
9/ See Kleinrock's Analysis and Explanation, Section 759.6 for a discussion of gift splitting.
10/ Code Section 2503(b)(1).
10/Reg. Section 25.2503-3(a).
11/ Reg. Section 25.2503-3(c), Example (1).
12/ Reg. Section 25.2503-2(a) (final sentence). Helvering v. Hutchings, 312 U.S. 393 (1941).
13/ Reg. Section 25.2503-3(c), Example (4).
14/ Code Section 2503(c).
15/ Rev. Rul. 74-43, 1974-1 C.B. 285,
16/ For income tax purposes, the Section 2503(c) trust is considered a complex trust until the minor reaches age 21. At that time, the trust becomes a grantor trust under Code Section 678 unless the rights retained in the trust upon lapse of the withdrawal power create a new complex trust.
17/ Crummey trusts are discussed in Kleinrock's Analysis and Explanation, Section 759.5.
18/ Rev. Rul. 73-405, 1973-2 C.B. 321.
19/ See TAMs 9141008, 9045002, and 8727003.
20/ PLR 8213074.
21/ See Rev. Rul. 81-7, 1981-1 C.B. 474; PLR 9030005 ; and TAM 9141008.
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Law (commentary and citation)
Regs (commentary and citation)
Cases (commentary and citation)
"'Future interests' is a legal term, and includes reversions, remainder, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession or enjoyment at some future date or time." Treasury Regulations of Gift Tax, section 25.2503-3.Under the provisions of this trust the income is to be accumulated and added to the corpus until each minor reaches the age of 21, unless the trustee feels in his discretion that distributions should be made to a needy beneficiary. From 21 to 35 all income is distributed to the beneficiary. After 35 the trustee again has discretion as to both income and corpus, and may distribute whatever is necessary up to the whole thereof. Aside from the actions of the trustee, the only way any beneficiary may get at the property is through the "demand" provision, quoted above.
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Not Applicable - unless common stock is being transferred
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Annual Exclusion Trust with no distribution before age of majority (usually 21) Relevant to the minor's right to demand a distribution:
At all times all the minor children must live with the parents or guardian and no other legal guardian should be appointed for them. In addition, it was agreed that all the children were supported by the parents and all of them should have the right to make a demand against the trust funds or receive any distribution from them. The beneficiaries must have this right for the reason the tax code will not consider this a gift otherwise. If the IRS were to successfully challenge the gift trust with the argument the gift was not a current gift, instead a future gift, the transfer is not considered to qualify as an annual gift and will be included in the estate of the person making the gift to the trust. IF the minors do not live with the parents, or for some other reason the parents are not the guardians, then the minors MUST have guardians to represent them AND the guardian must have the authority to make a demand for distributions as required in the sample clause. | Forms - Checklists - Etc. | ||||||||||||||
| Checklist for formation
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| Example of a clause if the trust age test in 2503(c) is not used (this is a Crummey trust). Notice the beneficiary is provided for a time to make the election to withdraw the gift after the notice of the date of the gift, but before the end of the year (December 31) |
Additions To The Trust Funds
The Trustee may receive any other real or personal property from the Trustors (or either of them) or from any other person or persons, by lifetime gift, under a Will or Trust or from any other source. Such property will be held by the Trustee subject to the terms of this Agreement. A donor may designate or allocate all of his gift to one or more Trusts, or in stated amounts to different Trusts. If the donor does not specifically designate what amount of his gift is to augment each Trust, the Trustee shall divide such gift equally between the Trusts then existing, established by this Agreement. The Trustee agrees, if he accepts such additions, to hold and manage such additions in trust for the uses and in the manner set forth herein. WITH RESPECT TO SUCH ADDITIONS, EACH MINOR MAY DEMAND AT ANY TIME (UP TO AND INCLUDING DECEMBER 31 OF THE YEAR IN WHICH A TRANSFER TO HIS OR HER TRUST HAS BEEN MADE) THE SUM OF ANNUAL EXCLUSION AS PROVIDED FOR IN THE CODE AS AMENDED FROM TIME TO TIME, OR THE AMOUNT OF THE TRANSFER FROM EACH DONOR, WHICHEVER IS LESS, PAYABLE IN CASH IMMEDIATELY UPON RECEIPT BY THE TRUSTEE OF THE DEMAND IN WRITING AND IN ANY EVENT, NOT LATER THAN DECEMBER 31 IN THE YEAR IN WHICH SUCH TRANSFER WAS MADE. SUCH PAYMENT SHALL BE MADE FROM THE GIFT OF THAT DONOR FOR THAT YEAR. IF A CHILD IS A MINOR AT THE TIME OF SUCH GIFT OF THAT DONOR FOR THAT YEAR, OR FAILS IN LEGAL CAPACITY FOR ANY REASON, THE CHILD'S GUARDIAN MAY MAKE SUCH DEMAND ON BEHALF OF THE CHILD. THE PROPERTY RECEIVED PURSUANT TO THE DEMAND SHALL BE HELD BY THE GUARDIAN FOR THE BENEFIT AND USE OF THE CHILD. The Demand must be in writing and must be delivered to the trustee on or before the expiration of the demand date.
Clause Number ___
Distribution Of The Trust Funds
Under the provisions of this trust the income is to be accumulated and added to the corpus until each minor reaches the age of 21, unless the trustee feels in his discretion that distributions should be made to a needy beneficiary for health care or education. From 21 to 35 all income is distributed to the beneficiary, however no corpus shall be distributed in this time period. After age 35 the trustee again has discretion as to both income and corpus, and may distribute whatever is necessary up to the whole thereof. Aside from the actions of the trustee, the only method for any beneficiary to receive the distribution of corpus is through the "demand" provision, in the Additions To The Trust Funds clause.
Example of Limited Time Period for the beneficiary to demand distribution of the trust funds:
| The following clause is written to provide a time frame for the beneficiary or his or her guardian to withdraw the trust fund addition for the year (the annual gift). The time is limited to be 30 days after the date of the gift (or notice thereof). |
Clause Number ___
Distribution Of The Trust Funds
Notwithstanding any other provision of this Trust Agreement, any Beneficiary shall have the right, by written and signed notice delivered to the Trustee during any calendar year in which any subsequent gift (as defined in Section 2512 of the Internal Revenue Code) is made to this Trust, from the date of the gift until the expiration of thirty (30) days after receipt by that Beneficiary of a Notice to Beneficiaries, as described in Paragraph __________ [5.05], to withdraw from the Trust an amount not exceeding the lesser of his or her proportionate share of the fair market value of the gift on the date of the gift or the amount then specified in Section 2503(b) of the Internal Revenue Code (or twice that amount if the gift is made by both Grantors). In no event may the amount withdrawn by any Beneficiary in any calendar year exceed the amount then specified in Section 2503(b) of the Internal Revenue Code (or twice that amount of the gift is made by both Grantors). This right shall not be cumulative, and any amounts not withdrawn in any year may not be withdrawn in any subsequent year. In the event any Beneficiary is declared incompetent by any court, his or her legal guardian may exercise this right on his or her behalf.
The following are the forms required: (Remember to left click on the water droplets to collapse or expand the list)
| Declaration of
irrevocable gifts
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| Identification of the gift(s)
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| Letter to beneficiary
or beneficiary's guardian explaining gift and the minor's right to withdraw
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| Formal election not to
exercise the right to withdraw
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| Trust Agreement
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| Checklist for annual actions
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Each year determine the amount of the annual exclusion allowed in the tax code.
Decide how much and when you want to make the gifts.
Prepare the Declaration of gift, Schedule of the description of the gifts, the transmittal letter for the notice to the beneficiary, and the affidavit of the beneficiary to forego the election to withdraw the gift.
Overview the trust instrument and make decisions about all the clauses - do you want to make changes.
Overview the trust instrument in context with current Tax and Trust Law.
Obtain the bookkeeping from the Trustee. Determine that the assets are invested properly and in accordance with the Trust instrument. Determine that the expenses are reasonable. Determine the fair market value of the assets are reasonable. Usually Trustees will charge the trustee fees based upon the fair market value of the assets. I have observed many bank trust departments over-charging the trustee fees based upon over-valued assets. Furthermore, most of the bank trust departments will want to prepare trust tax returns and will usually charge more than an independent CPA. I have observed excessive charges anywhere from twice to 10 times the amount an independent CPA (a CPA or Tax Preparer not employee of, nor dependent upon, the bank) charges.
Know who the trustee is. Many times banks will assign trustees far way from the vicinity of the donor or the beneficiary. This is done so the bank can centralize the bookkeeping. I have observed at times local branches transferring the trust account to a regional center of the bank hundreds of miles from the beneficiary and donor.
Obtain a copy of the trust income tax return for your records.
When the beneficiary becomes 21, the trust tax return should include a form K1 for the beneficiary showing the income from the trust as taxable to the beneficiary. IF the trust instrument mandates the distribution of the entire balance to the beneficiary at the age of 21, the trust becomes a "Grantor Trust". IF the trust instrument is drafted to allow for the corpus to stay in the trust, then the K1 will still need to show the income as distributed to the beneficiary. Without this clause the gifts to the trust can be challenged as a future gift.
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