LIFETIME GIVING AND INTER VIVOS GIFTS ANNE C. BEDERKA, ESQ.

LIFETIME GIVING AND INTER VIVOS GIFTS by ANNE C. BEDERKA, ESQ. Greenfield Stein & Senior LLP New York, NY Updated and Co-Authored by JOANNE BUTLER, ESQ. Shipman & Goodwin Greenwich, CT 129

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INTER VIVOS GIFTS I. GIFTS NOT SUBJECT TO TAXATION A. TAXATION OF GIFTS: BASIC PRINCIPLES 1. Tax Exclusive Nature of Inter Vivos Gifts. It has been a long-standing tenet of trusts and estates practice that lifetime gifts offer a greater tax benefit than transfers at death. There are two primary reasons for this. First, lifetime gifts are taxed on a tax exclusive basis, meaning the transferor pays gift tax only upon the amount of the actual gift, and not upon the amount of the gift tax paid. (In contrast, transfers at death are taxed on a tax inclusive basis -- estate tax is paid both upon the property transferred to the beneficiaries and upon the amount paid to the taxing authorities.) Second, a lifetime gift removes from the transferor s taxable estate not only the property gifted and any gift tax paid 1 but also all appreciation and income generated between the date of the gift and the transferor s death. 2. ATRA Provides Permanence of Exemption Amounts. The enactment of Economic Growth and Tax Relief Reconciliation Act of 2001 ( EGTRRA ), enacted in June 2001 (P.L. 107-16), altered the above analysis somewhat and created uncertainty for estate planners. Prior to the enactment of EGTRRA, the amount that one could give away tax-free (the exemption amount ) was the same rerardless of whether such gifts were made during life or upon death. However, under EGTRRA a transferor could give away tax-free during his lifetime only $1 million (not counting the annual exclusion and other exempted transfers, discussed below) while at death a transferor could give away as much as $3.5M (in 2009). The 2010 Taxpayer Relief Act ( 2010 TRA )(P.L. No. 111-312) once again unified the estate and gift tax exemptions but the provisions of the 2010 TRA were set to expire in 2012. The 2010 TRA increased the estate and generation-skipping transfer ( GST ) tax exemption amounts to $5 million for decedents dying during and generation-skipping transfers made in 2010-2012, and the gift tax exemption amount to $5 million for gifts made in 2011-2012. Among other provisions, the 2010 TRA also adjusted the $5 million exemption amounts for inflation, provided portability of spouses exclusion amounts for estates of decedents dying and gifts made in 2011-2012 and reduced the maximum estate and gift tax rate to 35% for decedents dying and gifts made in 2010-2012 and for generation-skipping transfers made during 2011-2012. The American Taxpayer Relief Act of 2012 ( ATRA ) (P.L. No. 112-240) made permanent the provisions of the 2010 TRA the $5 million estate, gift and GST tax exemption amounts and portability of a deceased spouse s exemption but also increased the top tax rate from 35% to 40%. In 2016, the estate, gift and GST tax exemption amounts were increased for inflation to $5,450,000. 2 1 But see, IRC 2035(b) and section 4 below. 2 From $5,250,000 in 2013, $5,340,000 in 2014 and $5,430,000 in 2015. 131

3. State Gift Tax. Only Connecticut imposes a separate gift tax taxing lifetime gifts totaling more than $2M with a top rate of 12%. Although New York does not have a gift tax, 3 gifts made within three years of death will be included in the decedent s New York taxable estate if made between April 1, 2014 and January 1, 2019 while the decedent was a New York resident. 4. Gift Tax Exemption and Annual Exclusion Should be Used. Due to the taxexclusive nature of the gift tax, full use should be made of each donor s $5 million (increased for inflation) gift tax exemption to the extent that the donor s financial and other circumstances permit. The question of what property to give and the form the gift should take depends on a host of factors, including whether the donor wishes the donee to have income-producing or appreciating assets, whether the donor has a larger plan to cede control over time of an asset such as a family business, and the donor s basis in the property. 4 To the extent possible, the gift tax exemption should be used sooner rather than later. If the transferor dies within three years of making the gift, the federal gift tax paid is included in the transferor s gross estate and is itself subject to estate tax, effectively eliminating the tax exclusive advantage of making a lifetime transfer. See, IRC 2035(b). Lifetime transfers that do not require application of the gift tax exemption and techniques that minimize gift tax on lifetime transfers should also be used. Discussed below are the use of annual exclusion gifts, payments of tuition and medical expenses, gifts of partial interests in trust, and the use of a durable power of attorney to make gifts. B. USE OF THE ANNUAL EXCLUSION 1. $14,000 Gifts to Donees a. $14,000 Per Donee. Under IRC 2503(b), U.S. citizens or residents are permitted to transfer, tax-free, up to $10,000 in each calendar year to an unlimited number of donees. Starting in 1999, the $10,000 amount began being adjusted for inflation in increments of $1,000. 1997 Taxpayer Relief Act (P.L. 105-34), 501(c). For 2016, the annual exclusion amount is $14,000. Rev. Proc. 2015-53. b. To Whom Transfers May Be Made. Annual exclusion gifts may be made to any person, regardless of his or her relationship to the donor. A gift to two or more persons holding title to property jointly (such as tenants in common or joint tenants) is a gift to each person in proportion to his or her interest in the property. Helvering v. Hutchings, 312 U.S. 393 (1941). A transfer to a trust is considered a gift to the beneficiaries of the trust, as opposed to the trust or the trustee. Reg. 25.2503-2(a). A transfer to a corporation is considered a gift to the individual shareholders to the extent of their proportionate interest in the corporation. Reg. 25.2511-1(h). 3 The New York State gift tax was repealed for gifts made on or after January 1, 2000. 4 The donee of an inter vivos gift takes the donor s adjusted basis in the property. IRC 1015(a). This is referred to as carryover basis. Basis is increased by the amount of Federal gift tax paid by the donor. IRC 1015(d). For the purposes of determining loss, the donee s basis is equal to the lesser of the donor s basis or the fair market value of the property on the date of the gift. IRC 1015(a). 2 132

c. Reciprocal Gifting is Prohibited. Where two or more donors give away identical sums to one another s families, and seek to apply the annual exclusion to the transfers in order to increase the non-taxable gifts to their own families, the cross-gifts will not be eligible for the annual exclusion. Sather v. Commr., T.C. Memo 1999-309, rev d in part on other grounds, 251 F.3d 1168 (2001). Similarly, when two donors establish identical trusts, each giving the other donor s family members beneficial interests in the trust, the transfers will be treated as reciprocal and the annual exclusion will be denied. Rev. Rul. 85-24. d. Gifts of Fractional Interests and Discounts. Gifts may be made of partial interests in property. For example, a donor may make annual gifts of interests in a partnership or a corporation or of interests in real property so that, over time, the donee s aggregate interest in the property increases incrementally. Discounts on valuation may be given for minority interests, lack of marketability, blockage or built-in capital gains tax. i. Minority Discount. The minority discount recognizes that shares of stock representing a minority interest in a closely held company are worth less than a proportionate share of the value of the assets of the corporation. This is because the holder of a minority interest has no control over corporate policy or decision making with respect to that interest. See Moore v. Commr., 62 T.C.M 1128 (1991), Ward v. Commr., 87 T.C. 78 (1986). ii. Lack of Marketability. A lack of marketability discount may be applied if there is no ready market for shares of stock in a closely held business. Such a discount reflects the reality that, in the absence of a ready market, such shares would be more difficult to sell. See Estate of Branson v. Commr., T.C. Memo 1999-231. iii. Discount for Blockage. The blockage discount recognizes that where one person holds a large number of publicly traded shares in a business, those shares cannot be liquidated quickly without depressing the market and therefore must be liquidated over time. Reg. 25.2512-2(e). iv. Built in Capital Gains. The discount for built in capital gains taxes reduces the fair market value of stock to take into account potential capital gains tax liabilities that would be incurred if a corporation liquidated, distributed or sold its assets, because no willing buyer of the corporation s stock will pay an amount that did not take into account a reduction in the stock s value for the amount of the potential tax. See, Eisenberg v. Commr., 155 F.3d 50 (1998), Dunn v. Commr., 301 F.3d 339 (2002). e. No Carryforward. If a donor transfers less than the annual exclusion amount to a donee during the calendar year, the balance of the annual exclusion is lost; there is no carryforward of the unused portion of the exclusion. 2. Gift-Splitting a. $28,000 Limit. If the donor is married and both spouses are U.S. citizens or residents, the donor and his or her spouse are entitled to transfer up to $28,000 in each calendar year to an unlimited number of third-party donees and the gifts will be considered to 3 133

have been made one-half by each spouse for gift tax purposes if the proper election is made. IRC 2513. As noted above, because the annual exclusion amount for 2016 is $14,000, the amount a donor and his or her spouse may transfer is $28,000 per donee per year. b. Transfer of Partial Interests to Spouse. If a donor transfers property in part to his spouse and in part to a third-party donee, the value of the gift to the donor s spouse may not be split. However, the gift to the third-party donee may be subject to gift splitting, provided the gift is capable of being valued. Reg. 25.2513-1(b)(4). For example, if a donor creates a trust for his wife for life and upon her death directs the principal be paid over to his children, the value of the trust remainder passing to the donor's children may be subject to gift-splitting. If, however, the donor gives his wife a general power of appointment over the principal of the trust, gift-splitting is not permitted or needed, arguably, because the retention of a general power of appointment would make the gift incomplete until the power was actually exercised. IRC 2513(a) and Reg. 25.2513-1(b). c. Election to Gift-Split. The election to gift-split must be made with respect to all gifts made during a given calendar year to which the election applies, and cannot be applied to a portion of the gifts. Reg. 25.2513-1(b). d. Consent to Gift-Splitting. The consent of both spouses is required. IRC 2513(a)(2). Consent must be given on an annual basis no later than the April 15 th following the year in which the gifts were made, unless a request for an extension of time to file a gift tax return has been made. IRC 2513(b) and Reg. 25.6081-1. Consent is signified on the gift tax return(s) filed for that year. Reg. 25.2513-2. Consent, once given, may be revoked, but no such revocation can be made after the date the gift tax return is actually due (i.e., April 15th). Reg. 25.2513-3. e. Liability for Tax on Split Gifts. Tax liability for the entire amount of tax on split gifts made during a calendar year is joint and several. Reg. 25.2513-4. 3. Annual Exclusion Applies Only to Gifts of Present Interests a. No Gifts of Future Interests. The annual exclusion is not available for gifts of future interests in property. Rather, the annual exclusion may only be applied to gifts of present interests. The regulations to IRC 2503(b) define a present interest as [a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain.) Reg. 25.2503-3(b). In contrast, where an interest in property will not commence in use, possession, or enjoyment until some future date or time, such interest is a future interest the gift of which will not qualify for the annual exclusion. Reg. 25-2503-3(a). See also, Fondren v. Commr., 324 U.S. 18, 20 (1945) (in determining whether an interest is a present or future one, the critical question is not when title to the property vests in the donee, but rather when the donee attains the right presently to use, possess or enjoy the property. ) b. Outright Gifts May Be Gifts of Future Interests. Even outright gifts may be considered gifts of future interests if enjoyment of the gift is postponed. For example, the 4 134

transfer of limited liability company ( LLC ) membership units by a husband and wife to their children and grandchildren did not qualify for the gift tax annual exclusion because the donees did not have the unrestricted right to the immediate use, possession or enjoyment of the LLC units or the income therefrom -- LLC members had no right to withdraw their capital, the LLC would likely make no distributions in the near future and any potential income distributions were at the discretion of the LLC s manager. Hackl v. Commr., 335 F.3d 664 (7 th Cir. 2003), aff g 118 T.C. 279 (2002). A different result was reached in Estate of Wimmer v. Commr., T.C. Memo 2012-157 (2012). The Wimmers formed a family limited partnership and were the initial general and limited partners. The assets of the partnership consisted of publicly traded and dividend paying stock. From 1996 through 2000, George Wimmer made gifts of limited partnership interests to related parties. The partnership made distributions to the limited partners in 1996, 1997, and 1998 to pay federal income tax and beginning in 1999, the partnership distributed all dividends, net of partnership expenses, to the partners in proportion to their partnership interests. Limited partners also had access to capital account withdrawal. The court held that the limited partners received a substantial present economic benefit sufficient to render the gifts of limited partnership interests present interest gifts on the date of each gift which qualified for the annual gift tax exclusion under IRC 2503(b). c. Gifts in Trust under IRC 2503(b). Gifts in trust create two separate interests: an interest in trust income ( income interest ), and an interest in the principal of the trust upon its termination ( remainder interest ). A remainder interest is a future interest to which the annual exclusion may not be applied. The annual exclusion may be applied to a gift of an income interest if -- and only if -- the trust instrument gives the beneficiary the unrestricted current right to a determinable amount of trust income. Reg. 25.2503-3(b). Even gifts of present interests will not qualify for the annual exclusion if the value of the interest cannot be measured. i. Example: If a donor creates a trust for his brother for life, with the principal of the trust payable upon his brother s death to his brother s only child, the gift to his brother of the income of the trust is a present one, to which the annual exclusion applies. The gift to the donor s brother s child of the remainder of the trust is a future one, for which no annual exclusion is permitted. (The respective values of the income and remainder interests are determined under the rules set forth under IRC 7520 for valuing partial interests.) ii. Example: If, under the above example, the trustee was authorized to accumulate income and add the same back to principal, the gift to the donor s brother would not be a present one and the annual exclusion would not apply. Reg. 25.2503-3(c). iii. Example: If instead, under the above example, the trustee was authorized in his discretion to pay income of the trust not only to the donor s brother, but also to the donor s other siblings, the annual exclusion would not apply, because the amount each sibling would receive would depend upon the exercise of the trustee s discretion, and could not be presently ascertained. Reg. 25.2503-3(c). iv. Example: If, under the above example, the trustee was directed to accumulate trust income until the donor s brother reached age thirty, and thereafter to pay over all income of the trust to the brother, the annual exclusion would not apply, because the brother s 5 135

right to use of the income has been postponed until a future time. See, U.S. v. Pelzer, 312 U.S. 399 (1941). v. Example: Finally, if, under the above example, the trustee was given discretion during the trust term to pay over principal of the trust to and among the donor s brother and his children, the annual exclusion would not apply to the brother s income interest, because the value of the income interest would depend upon the extent to which the trustee exercised his power to invade principal, and thus would not be capable of valuation as of the date of the gift. See, Schayek v. Commr., 33 T.C. 629 (1960), but see Jones v. Commr., 29 T.C. 200 (1975) acq. 1958-2 C.B. 6 (present interest not rendered indeterminate by trustee s power to invade principal because the power was limited by an ascertainable standard and the possibility of the invasion was remote). See also, PLR 8213074. 4. Exceptions to the Present Interest Rule a. IRC 2503(c) Trusts for Minors. IRC 2503(c) provides an exception to the rule that gifts of future interests do not qualify for the annual exclusion. It allows the annual exclusion to be applied to gifts made to minors in trust as long as certain conditions are met. i. Statutory Requirements. IRC 2503(c) provides as follows: No part of a gift to an individual who has not attained the age of 21 years on the date of such transfer shall be considered a gift of a future interest in property for purposes of subsection (b) if the property and the income therefrom- (1) may be expended by, or for the benefit of, the donee before his attaining the age of 21 years, and (2) will to the extent not so expended- (A) pass to the donee on his attaining the age of 21 years, and (B) in the event the donee dies before attaining the age of 21 years, be payable to the estate of the donee or as he may appoint under a general power of appointment as defined in section 2514(c). If the above requirements are met, the entire value of the trust qualifies for the annual exclusion. ii. No Substantial Restrictions on Trustee s Discretion. To meet the requirements of IRC 2503(c)(1), the trust instrument need not direct that all income be paid over currently to or for the benefit of the donee. The trust instrument must, however, give the trustee discretion to pay over income to or for the benefit of the donee, and may not contain substantial restrictions on the trustee s exercise of that discretion. Reg. 25.2503-4(b)(1). The Tax Court has held that a direction in a trust instrument to pay the income beneficiary or apply on his behalf so much of the trust income and principal as may be necessary for the education, comfort and support of the beneficiary and to accumulate all income not so needed 6 136

did not impose a substantial restriction that violated the requirements of IRC 2503(c)(1). Heidrich v. Commr., 55 T.C. 746 (1971), acq. 1974-2 C.B. 3. See also, Rev. Rul. 67-270 (direction in trust instrument to pay income beneficiary so much of trust income and principal as is necessary for donee s support, care, education, comfort and welfare did not impose substantial restriction disqualifying trust from annual exclusion.) If, however, the trust instrument limits the application of income to specific needs and circumstances, and does not allow the trustee to expend income for the general support of the income beneficiary, the trust will not qualify for the annual exclusion. For example, where the trust instrument permitted the trustee to expend income only for medical and other emergencies, the trust did not qualify for the annual exclusion under IRC 2503(c). Faber v. U.S., 309 F. Supp. 818 (S.D. Ohio 1969), aff d, 439 F.2d 1189 (6 th Cir. 1971). iii. Trust Term May Be Extended At Option of Donee. While IRC 2503(c)(2) requires that the trust fund pass to the donee upon reaching age 21, this requirement does not prohibit the donee from extending the term of the trust upon reaching majority. Reg. 25.2503-4(b)(2). A trust instrument may provide that the trust may continue beyond the beneficiary s reaching age 21, provided that the beneficiary is given the right, upon attaining age 21, to either (i) demand distribution of the trust fund at any time; or (ii) compel distribution during a limited period of time by giving notice to the trustee. Rev. Rul. 74-43. If the beneficiary does not exercise his right to terminate the trust, the trust will continue for the term provided in the trust instrument. iv. Reasonable Time to Exercise Right of Withdrawal. The IRS has determined that giving the beneficiary a period of sixty days after reaching his 21 st birthday to exercise his right of withdrawal is sufficient to qualify the trust for the annual exclusion. PLRs 8521089, 8512048 and 8507017. The IRS has also found thirty days to be sufficient. PLRs 8539022 and 8039023. v. Principal Must Be Controlled by Donee At Death. To meet the requirements of IRC 2503(c)(2)(B), the trust instrument must either direct that the principal of the trust be paid over to the income beneficiary upon his death before attaining age 21, or must give the income beneficiary a so-called general power of appointment over trust principal, allowing the beneficiary to direct the disposition of the trust fund upon his death. vi. Default Provisions Permitted in Absence of Exercise of Power of Appointment. If the trust instrument gives the donee a power of appointment, the trust instrument may direct that the trust fund be paid over to third parties in the event the donee fails to exercise his power. Reg. 25.2503-4(b)(3). Thus, a trust instrument may give the donee the right to appoint the principal of the trust as he directs, and in default of the exercise of the power by the donee, may direct that the trust fund be paid over to persons selected by the donor. vii. Donor Should Not Serve as Trustee. The donor should not serve as a trustee of a 2503(c) trust. Because the trustee possesses significant discretion to distribute trust income and principal, the donor who acts as trustee will be considered to have retained a power to control the beneficial enjoyment of the trust fund. As a result, the trust fund will be includible in the donor s estate under IRC 2036 and 2038. Regs. 20.2036-1(b)(3) and 20.2038-1(a)(3). 7 137

b. Crummey Trusts. A trust may also qualify for annual exclusion treatment if the trust instrument gives the beneficiaries a demand or withdrawal right with respect to funds transferred into the trust, referred to as a Crummey power. A so-called Crummey trust has advantages over both IRC 2503(b) trusts and 2503(c) trusts. Unlike 2503(b) trusts, a Crummey trust need not pay out all of its income in order to qualify for the annual exclusion. Moreover, unlike 2503(c) trusts, a Crummey trust need not be subject to termination when the income beneficiary attains age 21. Even more significantly, a Crummey trust allows a donor to apply multiple annual exclusion amounts to reduce or eliminate taxable gifts. However, as discussed below, Crummey trusts have annual notice requirements and may have negative gift and income tax implications for the donee. i. Right of Withdrawal Creates Present Interest. Typically, a Crummey trust gives beneficiaries the right to demand, on an annual basis, trust principal up to the amount of the annual exclusion. Beneficiaries are given a limited amount of time to exercise their withdrawal right. This right of withdrawal -- regardless of whether it is exercised -- converts what would otherwise be a gift of a future interest in trust into a gift of a present interest that qualifies for the annual exclusion. As will be seen below, the IRS has attempted to limit the number of annual exclusions that may be used to offset gifts to a trust so that annual exclusions are not applied in respect of persons with contingent interests or no interests (other than their right of withdrawal) in the trust. ii. Crummey v. Commissioner. In this seminal case the donors created a trust for their four children. The trustee had discretion to accumulate trust income until each beneficiary attained age 21, was required to pay over trust income between ages 21 and 35, and thereafter was permitted to withhold income or distribute it to the beneficiary and his or her issue. The trust was not set to terminate until the death of each child, whereupon trust principal was payable to the child s issue, subject to certain restrictions. The trust instrument also gave the income beneficiaries the right to withdraw annually an amount equal to the lesser of $4,000 or their pro rata share of the funds transferred into the trust that year. Crummey v. Comm r, 397 F.2d 82 (9 th Cir. 1968.) Under the trust instrument, the beneficiaries right to withdraw the funds transferred into the trust expired at the end of the calendar year in which the transfer was made. The Ninth Circuit ruled that the beneficiaries right to demand immediate payment gave them a present interest in the annual additions to the trust. The annual exclusion was therefore found to apply to the full value of the property that was subject to the beneficiaries right of withdrawal, even though the income of the trust was not to be distributed currently and the trust was not scheduled to terminate when the beneficiaries reached age 21. iii. Cristofani Expands Circle of Crummey Holders. In a subsequent case, the IRS sought to disallow the annual exclusion for gifts to a trust where Crummey powers were given to beneficiaries with only contingent remainder interests in the trust. Cristofani Estate v. Comm r, 97 T.C. 74 (1991). Under the trust created by the donor, trust income was payable to the donor s two children, and the trustees also were given discretion to apply principal for the benefit of the children. Upon the donor s death, trust principal was payable to the donor s living children and to the issue of any deceased child. The donor s five grandchildren therefore had only contingent remainder interests in the trust. The trust agreement gave each of the children 8 138

and grandchildren a power of withdrawal equal to the $10,000 annual exclusion, which power expired 15 days after funds were transferred to the trust. The donor claimed seven $10,000 annual exclusions for the transfers to the trust, and the IRS sought to disallow five of such exclusions on the ground that the donor s grandchildren did not have present interests in the trust. The Tax Court ruled that the grandchildren s right to withdraw principal within 15 days of a contribution gave them a present interest in the trust and therefore that the donor was entitled to claim annual exclusions corresponding to the funds subject to a power of withdrawal by his grandchildren. In so holding, the Court observed that in determining whether a present interest exists, the critical inquiry is not whether the beneficiary actually will receive present enjoyment of the property, but rather is whether the beneficiaries have a legal right to withdraw funds from the trust. The IRS acquiesced in 1992 and again in 1996 to the result only in the Cristofani decision. 97 T.C. 74 (1991), acq. in result only, 1992-2 C.B. 1, acq. in result only, 1996-2 C.B. 1. iv. IRS Has Sought to Limit Application of Cristofani. The IRS stated that it will not seek to deny annual exclusions where Crummey powers are held by income beneficiaries and vested remaindermen, but would seek to challenge where facts and circumstances indicate that the donor did not intend to make a bona fide gift of a present interest. The IRS also indicated that it would mount a challenge in those circumstances where it can be shown that there was a prearranged understanding that the withdrawal right would not be exercised or that doing so would result in adverse consequences to the holder.... AOD 1996-010. See, TAM 9628004, in which the IRS denied annual exclusions based on evidence of a pre-arranged understanding that the beneficiaries would not exercise their withdrawal rights where: (i) the trust agreement did not require notice to Crummey holders of their withdrawal rights or of additions to the trusts in question; (ii) in the year the trusts were created, the Crummey holders withdrawal rights expired before the transfers were actually made to the trusts, leaving no time for the exercise of those rights; (iii) many of the Crummey holders had no interest in the trusts other than their right of withdrawal; and (iv) none of the Crummey holders -- even those who had no other interests in the trust funds -- exercised their right of withdrawal. See also, TAM 9731004, in which the IRS denied annual exclusions for the primary beneficiaries children and siblings who had only contingent income and remainder interests and for spouses of the beneficiaries children and siblings who had withdrawal powers but no other interests. But see, Kohlsaat Estate v. Commr., T.C. Memo 1997-212 (rejecting IRS position that contingent or no interests combined with a lack of exercise of Crummey powers signaled improper pre-arranged plan, and allowing annual exclusions for contingent beneficiaries who had never exercised their withdrawal rights). v. Notice of Demand Right. In order for additions to a Crummey trust to qualify for the annual exclusion, reasonable notice must be provided to the donees of their right of withdrawal. The IRS has taken the position that the annual exclusion is not available unless the beneficiaries receive current notice of their right to withdraw funds. Rev. Rul. 81-7. But see, Turner Estate v. Commr., T.C. Memo 2011-209 (indirect gifts to beneficiaries when grantor paid life insurance premiums on policies held in a trust qualified for the annual exclusion notwithstanding that beneficiaries did not receive notice of the transfers). An addition to a trust qualifies as a present interest even if contributed in one year where the beneficiary may exercise the demand right in the following year. Rev. Rul. 83-108. Beneficiaries may not waive their 9 139

right to notice of future additions to the trust. TAM 9532001. Prudent planning therefore requires that the trust instrument include a notice requirement, that actual written notice be given to the beneficiaries each time an addition is made to the trust, and that an acknowledgement of the right of withdrawal be executed by all beneficiaries each time an addition is made. vi. Notice to Minors. Where Crummey holders have not yet attained majority, notice must be given to a parent or guardian of the minor. PLR 8133070. vii. Reasonable Time to Exercise Right of Withdrawal. The IRS has not stated what constitutes a reasonable time within which to exercise withdrawal rights but several Private Letter Rulings have held that where a beneficiary has at least 30 days to exercise his withdrawal rights was a reasonable opportunity. See, PLRs 200130030, 200123034 and 200011054. Note that in Cristofani the Crummey holders were given 15 days to exercise their rights of withdrawal, and the IRS did not challenge that period as unreasonable. But see, TAM 9141008 (20 days found to support conclusion that donor did not intend Crummey holders to exercise right of withdrawal). viii. Requirement of Transferable Assets. No annual exclusion is available unless the trust owns assets that may be used to satisfy a withdrawal demand. TAM 8445004. ix. Gift Tax Consequences of Crummey Powers. The annual power to withdraw funds from the trust is considered to be a general power of appointment held by the Crummey holder under IRC 2514(c). To the extent that the Crummey holder does not exercise his or her right of withdrawal in a given year, there is a release or lapse of this power of appointment, which may constitute a taxable gift from the Crummey holder to the person or persons who will benefit from the lapse under the terms of the trust. IRC 2514(b) and (e). x. $5,000 or 5% Exception. There is a safe harbor provision, however, which provides that no taxable gift occurs unless the property that is subject to the lapsed power of withdrawal exceeds the greater of $5,000 or 5% of the total value of the property from which the withdrawal power could have been satisfied (the so-called five and five exception ). IRC 2514(e). Therefore, a lapse of a right to withdraw less than $5,000 (or 5%) annually will not have any gift tax consequences to the Crummey holder. A gift tax problem may arise, however, where the donor wishes to take full advantage of the annual exclusion, and therefore gives the Crummey holder the right annually to withdraw the full amount of the addition to the trust. In such an instance, if the withdrawal power is not exercised, the Crummey holder may be treated as having made a gift of the difference to the persons who would take the trust funds in default of the exercise of the withdrawal power. xi. Avoiding Completed Gifts to Third Persons. The provisions of IRC 2514 apply only in those circumstances where the lapse of the Crummey holder s withdrawal power would constitute a completed gift to a third person or persons. Therefore, where a Crummey holder and/or his estate is entitled to all of the income of a trust and is also entitled to all of the principal, no gift tax consequences arise from the lapse of the annual power of withdrawal. This is because the lapse of the power of withdrawal does not provide a benefit to any third person. See, Reg. 25.2511-2(b) and PLR 8142061. Moreover, where a Crummey 10 140

holder is given the right to direct the disposition of the trust principal upon his death through a power of appointment, no gift tax consequences arise from the lapse of his annual power of withdrawal, because the Crummey holder s retained power to appoint the trust fund results in no completed gift being made at the time the withdrawal power lapses. PLRs 8825111, 8545076, 8517052 and 8229097. See also, Reg. 25.2511-2(b). Therefore, trust instruments often give Crummey holders a general or limited power of appointment over the trust fund. xii. Hanging Powers. To avoid the gift tax consequences of a completed gift upon the lapse of a right of withdrawal, practitioners have also given Crummey holders so-called hanging powers over trust principal. Under this approach, the right to withdraw the amount of the annual addition to the trust does not lapse automatically upon the expiration of the notice period. Rather, in each year of the trust, the right of withdrawal lapses only to the extent of the greater of $5,000 or 5% of the property from which the withdrawal could have been satisfied (as provided in IRC 2514(e)). The balance of the funds over which the Crummey holder was given a right of withdrawal continues to be subject to that right of withdrawal. Example: In year 1 of the trust, the donor contributes $10,000. The donor s son has the right to withdraw the entire $10,000 but does not elect to exercise his right. At the end of the year, the son s right to withdraw trust principal lapses, but only to the extent of the greater of $5,000 or 5% of the trust assets. The balance of $5,000 continues to be subject to the son s right of withdrawal. In year 2, the donor again contributes $10,000 to the trust, over which the son has a Crummey power. The son now has a right to withdraw $15,000 -- $5,000 hanging over from year 1 and $10,000 for year 2. If the son again elects not to exercise his right of withdrawal, his withdrawal right will lapse with respect to $5,000 of such funds, and his right to withdraw the remaining balance of $10,000 will continue, and so on. xiii. Only 1 Five and Five Exemption Per Donee. Under IRC 2514(e), a Crummey holder is entitled to only one five and five exemption each year. Thus, a donor may not avoid potential gift tax problems by creating multiple trusts for the same donee. Rev. Rul. 85-88. xiv. Avoiding Tax Savings Language. In drafting a hanging power provision in a Crummey trust, the practitioner must be careful to avoid any language that suggests that the purpose of the provision is solely one of tax savings. No reference should be made to avoiding a taxable gift, and the amount of the withdrawal power that will lapse annually should not be tied to the amount that may lapse without creating a taxable gift. The provision should state simply that each Crummey holder s right of withdrawal shall lapse only to the extent of $5,000 or 5% of the trust assets. See, TAM 8901004. xv. Income Tax and Estate Tax Implications for Donees. A Crummey holder may be considered to be the owner, for income tax purposes, of those trust funds over which he or she has a right of withdrawal and may be required to report as income a percentage of trust income, deductions, and credits corresponding to his or her ownership interest. IRC 678. To the extent that a Crummey holder continues to have a right of withdrawal over trust property at the time of his or her death (prior to the termination of the trust), the property that is subject to 11 141

the right of withdrawal is includible in the Crummey holder s estate under IRC 2041. Moreover, to the extent that a Crummey holder failed to exercise a power of withdrawal in the years before his or her death, trust property that was the subject of taxable lapses may also be includible in the Crummey holder s estate under IRC 2041. See, Reg. 20.2041-3(d). If the Crummey holder survives to the termination of the trust, the Crummey holder will own the trust property outright, and the entire value of the property will be includible in her estate under IRC 2033. C. TUITION AND MEDICAL EXPENSES 1. Tuition Exclusion a. Tuition Paid to Qualified Educational Organization is Not a Taxable Gift. IRC 2503(e) provides that any amount paid on behalf of an individual as tuition to a qualified educational organization for education or training is not a taxable gift. To qualify for the tuition exclusion, the educational organization must be one that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. Reg. 25.2503-6(b)(2). The educational organization must also have as its primary purpose the presentation of formal instruction. If an organization is engaged in both educational and non-educational activities, the tuition exemption is not available unless the non-educational activities are merely incidental to the formal educational instruction. Reg. 1.170A-9(b). The term educational organization includes primary, secondary, preparatory and high schools, and colleges and universities. Reg. 1.170A-9(b). It would likely not include summer camp, nursery, pre-school or day care programs that were merely custodial as opposed to educational. See, Rev. Rul. 78-446. b. Tuition Must Be Paid Directly to School. The tuition exclusion is available without regard to the relationship between the donor and the donee. Reg. 25.2503-6. However, the tuition must be paid directly to the education institution; it may not be reimbursed to the student. Reg. 25.2503-6(b)(2). c. Tuition May Be Prepaid. The amount of the tuition exclusion is unlimited and in addition to the 2503(b) annual exclusion. Tuition for future years may be pre-paid by a donor provided that tuition must be forfeited and cannot be subject to refund in the event the donee ceases to attend school. TAM 199941013. See also PLR 200602002. d. Exclusion Does Not Apply to Education Trusts. The exclusion is not available to funds placed in trust for a student s education. Reg. 25.2503-6(c). Moreover, the tuition exclusion may not be applied to payments made to pre-paid tuition programs under IRC 529. IRC 529(c)(2)(A)(ii). e. Exclusion Does Not Cover Living or Other Expenses. The exclusion applies to tuition only for full-time or part-time studies. It does not cover amounts paid for books, supplies, room and board, or any other incidental expenses that do not constitute tuition. Reg. 25.2503-6(b)(2). 12 142

2. Medical Expense Exclusion a. Medical Expenses Paid Directly to the Provider Are Not Taxable Gifts. Any amount paid on behalf of an individual to a medical provider in respect of medical care is not a taxable gift. IRC 2503(e). This exclusion also applies without regard to the relationship between the donor and the donee. Reg. 25.2503-6. The exclusion applies to expenses incurred for the diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure or function of the body or for transportation primarily for and essential to medical care. Reg. 25.2503-6(b)(3). The exclusion also applies to amounts paid for medical insurance on behalf of any person. Id. b. Medical Expenses Must Be Paid Directly to Service Provider. To qualify for the unlimited exclusion for amounts paid to a medical provider for medical care, payment must be made directly to the service provider, and cannot be reimbursed to the donee. Regs. 25.2503-6(b)(1)(ii) and (c). c. Exclusion Does Not Apply to Amounts Reimbursed by Insurer. The exclusion does not apply to amounts paid for medical care that are reimbursed by the donee s insurance. Reg. 25.2503-6(b)(3). d. Exclusion is Not Available for Contributions to 529A State-Run Qualified ABLE Programs. These programs are established and maintained by a state (or its agency or instrumentality) for tax years beginning after December 31, 2014. A person may make contributions to an account established for the sole purpose of supporting individuals with disabilities to maintain their health, independence and quality of life. IRC 529A(c)(2)(A)(ii). The medical expense exclusion does not apply to contribution to ABLE Programs any contribution is treated as a gift of a present interest qualifying for the annual exclusion. Prop. Reg. 1.529A-4(a)(1). II. DURABLE POWERS OF ATTORNEY A power of attorney is a document by which an individual (the principal ) grants to one or more persons (the agent or attorney-in-fact ) the authority to perform certain financial transactions on his or her behalf. A durable power of attorney allows the agent to act even if the principal becomes incapacitated and unable to make decisions on his or her own behalf. Durable powers of attorney are a popular estate planning tool because they allow individuals to delegate management of their financial affairs in the event of incapacity through the use of a relatively simple document. The powers given to an attorney-in-fact may be very broad or, conversely, may be quite limited. A. CURRENT LAW IN NEW YORK 1. New York Statutory Short Form Power of Attorney. The New York State legislature enacted sweeping changes to New York s power of attorney statute which became effective on September 1, 2009. Amendments to the statute became effective as of September 12, 2010, retroactive to September 1, 2009. N.Y. Gen. Oblig. Law 5-1501 through 5-1514. The changes to the statute were intended to provide safeguards against abuse and misuse of the 13 143

power of attorney. The new law requires that all powers of attorney 5 executed in New York contain a cautionary statement to the principal and important information to the agent regarding the agent s fiduciary duties using the exact wording provided in the statute. GOL 5-1513. The new power of attorney must be signed by both the principal and agent and acknowledged by them before a notary public. GOL 5-5-1501B(1)(b) and (c). The effective date of the agent s authority is the date the agent signs in front of a notary public. Any writing that complies with the new statutory requirements may be used as a power of attorney. GOL 5-1504. However, there are benefits of using the statutory short form. First, if the statutory short form is used, third parties (i.e., financial institutions) are legally required to honor it. GOL 5-1501(2)(q) and 5-1504(1). There is nothing that requires the acceptance of a form that is not a statutory short form. GOL 5-1504(a)(6). Second, if the statutory short form is used, the powers enumerated in the form will be construed in accordance with the detailed construction provisions of the statute, thereby reducing the possibility of disagreement over the scope and meaning of the enumerated powers. 2. New York Statutory Gifts Rider. The most significant change in the new power of attorney statute is the Statutory Gifts Rider ( SGR ), a separate document that supplements the statutory short form and when read together comprises one document. GOL 5-1514(9)(c)- (d). If the SGR is not completed, the agent may only make gifts of $500 per year in the aggregate, if the principal grants that authority under the power of attorney. GOL 5-1502I(14). The purpose of the SGR is to give gift giving authority to the agent. The SGR is divided into three categories: (a) limited authority -- i.e., for annual gift tax exclusion amount gifts to the principal s spouse, children and more remote descendants and parents, (b) modified authority -- i.e., for gifts less than or in excess of the annual gift tax exclusion amount to other beneficiaries or other gift transactions 6, and (c) specific authority for gifts of any amount to the agent or agents. The principal must sign the SGR in front of two witnesses and the principal s signature must be acknowledged before a notary public. 3. Modifications. Both the statutory short form power of attorney and SGR may be modified to make additional provisions, including language to limit or supplement the authority granted to the agent. GOL 5-1503. For example, the statutory short form can be changed from a durable to a non-durable power of attorney. 4. Revocation. The execution of the statutory short form power of attorney does not automatically revoke any other powers of attorney previously executed by the principal unless the principal so indicates. 5 Defined in GOL 5-1501C to exclude powers of attorney granted in connection with certain commercial and business transactions. 6 Such as gifts in trust for the benefit of persons designated by the principal or for purposes that are in the principal s best interests such as for estate planning purpose, if the principal so designates. 14 144

B. ESTATE TAX IMPLICATIONS OF INVALID GIFTS 1. Invalid Gifts Result in Inclusion in Donor s Estate. When the principal dies, the IRS looks to state law to determine whether gifts made by his agent under a power of attorney were authorized under the instrument. See, Commr. v. Estate of Bosch, 387 U.S. 456, 465 (1967); Estate of Goldman v. Commr, T.C. Memo 1996-29; TAM 9342003. Where a gift made under a durable power of attorney is found to be invalid under state law and the terms of the instrument, the property subject to the gift becomes includible in the principal s gross estate as a revocable transfer under IRC 2038. TAM 9342003, TAM 9403004. See also, Estate of Goldman v. Commr, T.C. Memo 1996-29 (NY power of attorney did not explicitly authorize gifts and absence of intent by principal to make gifts); Gaynor Estate v. Commr., T.C. Memo 2001-206 (CT power of attorney did not authorize gifts and no showing that decedent had any established gift giving pattern or that she intended to include such a power in the power of attorney). 2. Valid Gifts Avoid Inclusion in Donor s Estate. Conversely, where the IRS determines that the gift would be upheld under state law even in the absence of a express authorization in the instrument to make a gift, the gift will not be included in the principal s gross estate under IRC 2038. See, e.g., TAM 199944005 (applying Texas law, Service upheld validity of gifts for estate tax purposes where instrument granted attorney-in-fact broad powers, gifts were relatively small compared to size of principal s estate, gifts did not disadvantage principal, and gifts were consistent with principal s prior pattern of gifting and her testamentary plan); Estate of Ridenour, T.C. Memo 1993-41 (applying Virginia law, court ruled gifts were valid for estate tax purposes where gifts were consistent with principal s past pattern of gifting); Estate of Bronston v. Commr, T.C. Memo 1988-510 (applying New Jersey law, court ruled gifts were valid where instrument authorized agent to grant and convey any property owned by the principal and gifts were consistent with principal s past pattern of gifting). C. PRACTITIONERS MUST USE NEW NY STATUTORY SHORT FORM To avoid having to defend the validity of gifts made under a power of attorney, practitioners should be certain to use the new New York statutory short form. Moreover, clients that executed powers of attorney before 2009 should be counseled to execute new forms containing the SGR. Failure to do so may cause a battle on two fronts between beneficiaries fighting over the propriety of the gifts made, and between the principal s estate and the IRS. III. GRANTOR RETAINED INTEREST TRUSTS (GRITs, GRATs, GRUTs and QPRTs) A. GRANTOR RETAINED INCOME TRUST ( GRIT ) 1. Generally. A GRIT is an irrevocable trust created by an individual (the grantor ) during his or her lifetime. The grantor transfers property to a trust while retaining the right to receive income from the trust for a specified term of years (or until the grantor s earlier death). At the end of the trust term, the trust remainder is distributable to the beneficiaries named in the trust instrument. Often the trust instrument provides that if the grantor dies prior to the 15 145