Wealthier Americans face a challenge: how to transfer money to future generations while paying as little as possible in taxes to Uncle Sam. The reason that's difficult is that the estate tax imposes a 40% tax on transfers at death above the lifetime exemption amount, while the gift tax imposes a similar tax on transfer made during one's lifetime. Moreover, many people are reluctant to give outright gifts to children and grandchildren for fear that the recipients will squander the gift. However, by using what's known as Crummey trust provisions, you can make gifts that qualify for the annual gift tax exclusion while retaining control over how the trust money is invested and eventually distributed to your loved ones.
What are Crummey trust provisions?
The Crummey trust provisions are specially designed terms of a trust that allow the donor to claim the annual gift tax exclusion for money placed in the trust. The annual gift tax exclusion lets you transfer up to $14,000 this year without any gift tax consequences, but the provision typically doesn't apply to gifts made in trust. The reason is that the exclusion requires the gift of a present interest in property, and most trusts are set up so that the beneficiary only gets a future interest.
In a landmark 1968 Tax Court case, the Crummey family tried to create a present interest in a gift made in trust. The provisions of the Crummey trust included a right for the beneficiaries of the trust to make an immediate withdrawal of money deposited in the trust. After a short period of time, that withdrawal right went away. The IRS argued that the deposits to the trust shouldn't qualify for the annual gift tax exclusion because they weren't present interests, and there was no reasonable likelihood that the recipient would exercise the power of withdrawal. However, the Tax Court found that the withdrawal right was a present interest, and so it allowed the taxpayer to claim the exclusion and pay no gift tax.
The benefits of the Crummey trust decision are potentially enormous. Each year, a person can make transfers of $14,000 to the trust without any gift tax consequences. Moreover, the annual gift tax exclusion applies to each recipient, so multiple gifts in that amount can be made to as many children, grandchildren, or other individuals as the donor wishes. The only restriction is that the Crummey withdrawal powers must be available to each beneficiary in order for the donor to claim the exclusion.
The downside of Crummey trusts
From the gift tax perspective, Crummey trusts work well. However, the question that every potential user of the Crummey strategy asks is what stops a beneficiary from exercising the withdrawal power and just taking the $14,000.
The answer is more practical than legal. Legally, nothing stops a beneficiary from exercising the Crummey power. However, families that use this strategy make it perfectly clear that if beneficiaries do withdraw the money, then they can fully expect not to receive any further money from the gift giver. In wealthy families, that usually provides enough of an incentive to prevent the strategy from going awry.
Moreover, during the period when trust beneficiaries are minors, it's their parents rather than the children themselves who have the fiduciary duty to consider the child's long-term best financial interest. That often provides the certainty that donors need in order to feel comfortable with the strategy.
Consider the greater good in your legacy
It's always hard for people to give away their wealth during their lifetime. No matter how much money you have, there's always the fear that you'll run out and regret that you made gifts earlier than you had to. However, given the potential cost of the estate and gift tax, taking advantage of provisions like Crummey trusts in order to reduce the amount of your family assets that will go to the IRS is the best way to protect and provide for your loved ones' financial needs -- both now and for generations to come.