Irrevocable gift trusts can benefit the whole family in times when you might want to make a large gift to your children or grandchildren. In many instances, making the gift by establishing an irrevocable gift trust is a better option than writing large checks and making the gifts in cash. These trusts are also very useful when the gift is marketable securities or an interest in a closely-held business.
What Risks are Associated with Outright Gifts
Outright gifts are irrevocable. When you make an outright gift in cash, you lose all control over how that money is spent. If the gift is $100,000 or less, you may not care how the money is spent. But what if the gift is larger? What if you are considering a gift of several hundred thousand dollars or more. You might be concerned that the gift won’t last very long. Even if your child is responsible, an outright gift means he or she can do anything they want with the money. And what happens if the gifted money is deposited into a joint account with your child’s spouse? In the event of divorce, who gets the money? Your gift may become part of the marital estate subject to equitable distribution.
An outright gift is also exposed to the recipient’s creditors. If your child has a failed business, the money might be lost.
If you are considering a gift of stock, maybe you would like to retain a level of control over how that stock is managed. This is especially true when dealing with closely-held companies where voting rights are particularly important.
What are Some Benefits of Irrevocable Gift Trusts
The benefits of establishing gift trusts are numerous:
When you transfer assets to an irrevocable gift trust, you effectively reduce the size of your taxable estate, potentially decreasing or eliminating estate taxes upon your death. The transfer removes assets from your taxable estate. The transfer also offers asset protection as creditors typically can’t reach them. This means if you face a lawsuit or bankruptcy, the assets in the trust remain protected.
Also, the trust agreement you write sets the terms and conditions for how the assets are managed and when your chosen beneficiaries can receive a distribution. These terms remain in force should you become disabled, and they remain in force after you die.
Other tax benefits include locking in the valuation for estate and gift tax purposes. By placing assets into the trust, especially those anticipated to appreciate significantly, you can lock in their current value for gift tax purposes. This strategy can be advantageous if the assets grow in value. Furthermore, the trust, as a separate entity, might be in a lower tax bracket than you, leading to potential income tax savings. Maybe you can set the trust situs in a state without state income tax potentially saving significantly on state income taxes.
And similar to other trusts, since the trust agreement does not generally become a matter of public record, you retain a level of privacy over how property is managed. Also, assets held within the trust aren’t subjected to probate proceedings, leading to quicker and more efficient asset distributions to beneficiaries.
What are Some Key Features of Irrevocable Gift Trusts
Here are several key features of irrevocable gift trusts:
- It permanently transfers assets. Once you place assets into the trust, you can’t take them back. This commitment ensures the protection and distribution benefits of the trust.
- It has a distinct tax identity. The irrevocable trust often files its own tax return, separate from the grantor’s personal return.
- It offers asset protection. The trust shields the assets from potential creditors and lawsuits, safeguarding them for the beneficiaries.
- It allows for specific distribution terms. You can set detailed conditions for how and when beneficiaries receive trust assets.
- It locks in gift tax exemptions. When you fund the trust, you utilize your gift tax exemptions, which can help in estate tax planning.
- It can name various beneficiaries. You have the flexibility to name multiple beneficiaries, including future generations, charities, or trusts.
- It operates under a named trustee. The trust requires a trustee who manages and distributes the assets as per the trust terms, ensuring professional oversight.
- It provides privacy. Unlike a will, the trust’s terms and assets don’t become public record, preserving the privacy of your financial decisions.
What are the Tax Characteristics of Irrevocable Gift Trusts
For many people, the favorable tax characteristics are a primary reason for setting up irrevocable gift trusts.
First, when you place assets into an irrevocable gift trust, you remove them from your taxable estate, potentially decreasing the estate tax liability upon your death or the death of your spouse.
Second, when you fund the trust, you make a completed gift. Traditionally, gifts are structured so as not to exceed your lifetime gift tax exemption, so you don’t owe federal gift taxes when you fund the trust. And assets transferred that qualify for the annual gift tax exclusion, effectively allow you to give away assets tax-free up to that limit.
Third, these trusts can be treated as separate taxpayers and operate under their own trust identification number (TIN). When this is deemed to be advantageous, these trusts will file their own tax returns distinct from your personal returns. Alternatively, these trusts can be structured as Grantor Trusts. This can be advantageous when you want to pick up the trust income on your personal return but exclude the underlying assets and appreciation from your taxable estate.
Lastly, if the trust benefits multiple generations, proper structuring can allow the trust assets to bypass the Generation Skipping Transfer Tax (GST), avoiding additional taxation when assets pass to grandchildren or further generations.
What is the Annual Gift Tax Exclusion
Under federal law, you can make a gift of a present interest in any given tax year to anyone tax free. The gift must be limited to an amount set by the IRS. For example, the annual exclusion amount for 2023 is $17,000 ($34,000 for a married couple). That means you could give up to $17,000 (or you and your spouse could gift a total of $34,000) to any child, grandchild, or other person completely tax free. And since these gifts can be made each year, they offer the potential of removing significant assets from your estate. Also, these gifts are not even required to be reported to the IRS on a gift tax return (though in many cases it might be a good idea to report them anyway).
How Can Gifts Made in Trust Qualify for the Annual Gift Tax Exclusion
For a gift to qualify for the annual gift tax exclusion, it must be a gift of a present interest. This means the beneficiary has an immediate and unrestricted right to use, possess, or enjoy the gift or its income. Think of it this way: if someone gives you $10 you can go out and buy a beer. That’s a gift of a present interest. You have immediate access to the funds, and you can do whatever you want with the money. Contrast that with a traditional gift made in trust. You might be the beneficiary, but the terms give the trustee the power to make distributions. In other words, you can’t compel the trustee to give you the ten bucks and you can’t buy that beer. The money is for your benefit, but it’s considered a gift of a future interest.
Crummey Trusts – The Problem
So how can you make a gift in trust and have that gift qualify as a present interest?
Enter the “Crummey Trust”. Named after a landmark tax case, Crummey powers give beneficiaries the temporary right to withdraw contributions made to the trust. The effect of this limited withdrawal right is to convert a future interest into a present one without undermining the overall goals of the trust. Beneficiaries typically have a short window, often 30 to 60 days, to exercise their withdrawal rights. If they don’t exercise this right within the timeframe, the right lapses, and the assets remain in the trust, governed by its terms.
When you have the right to withdraw funds from a trust to use for any reason, you are deemed to have a general power of appointment over the assets that you have the power to withdraw. If you do not withdraw the funds, you are deemed to have allowed this general power of appointment to lapse.
The consequences of this lapse are as follows:
- You are deemed to have made a taxable gift to the other beneficiaries of the trust;
- As with the original gift, it is a gift of a future interest since the other beneficiaries do not have immediate access to the assets; and
- You are required to file a gift tax return and use a portion of your own lifetime gift tax exemption.
Crummey Trusts – The Solution
Fortunately, the law provides a solution. The lapse of a withdrawal right is deemed to not be a taxable gift or a release of a general power of appointment if either:
You limit the withdrawal rights to the greater of $5,000 or five (5%) percent of the trust value per beneficiary (a so-called 5/5 power), or
You don’t limit the withdrawal power per se but limit the amount that can be withdrawn in any tax year to no more than $5,000 or five (5%) percent of the trust value in that year (a so-called Hanging Crummey Power).
There are pros and cons of both approaches depending on the purpose of the trust, but in either case the beneficiary has a better tax result.
In short, irrevocable gift trusts containing “Crummey Powers” can take advantage of the grantor’s annual gift tax exclusion. This is a very popular and advantageous planning idea.
How Do I Control When Distributions Are Made
Gift trusts provide incredible flexibility in structuring distributions to beneficiaries. Ultimately, you get to write the terms for how and when distributions are made. For example, you might provide the trustee with discretion to distribute income and principal. This discretion could be limited to an ascertainable standard. Such as for the beneficiary’s health, education, maintenance, and support (a so-called HEMS distribution standard). Or you can allow a trustee to make broad distributions not limited to any standard. If you don’t like giving the trustee that much power, consider a right to receive a fixed percentage.
Before selecting a distribution standard, you should discuss the pros and cons with an experienced trust attorney.
Gift Trusts offer many advantages over gifts made outright. By structuring the trust correctly, both you and your beneficiaries can receive favorable tax treatment, creditor protection, privacy, and many other benefits. To better understand the benefits of including an irrevocable gift trust in your estate plan, contact us today.