Couple Gets $1.4 Million in Gift Tax Exclusions for Transfers to Family Trust.

(Parker Tax Publishing April 12, 2015)

The Tax Court held that a husband and wife were each eligible for an annual gift tax exclusion of $720,000 for transfers of property to an irrevocable family trust. The court found the IRS's arguments that the provisions of the trust prevented the gifts from being excludable present interests in property were based on an unrealistic hypothesis and a misinterpretation of the trust's provisions. Mikel v. Comm'r, T.C. Memo. 2015-64.

Background

In 2007, Israel Mikel and his wife Erna established the IEM Family Trust, an irrevocable inter vivos trust, jointly transferring property to the trust with an asserted value of $3,262,000. The trust had 60 beneficiaries at the time, including the couple's children, grandchildren, and respective spouses.

After a contribution of property to the trust, the trustees were required to notify all beneficiaries that they had a demand right to withdraw trust funds, which was to be exercised within 30 days of such notice. The terms of the trust required the trustees to immediately distribute the requested trust funds upon receipt of a timely withdrawal demand. Apart from these mandatory distributions in response to withdrawal demands, the trust empowered the trustees to, within their sole discretion, make distributions for the health, education, maintenance, or general support of any beneficiary or family member.

Any disputes concerning the administration of the trust were to be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith, known in Hebrew as a "beth din." Additionally, the trust contained an "in terrorem" provision designed to discourage beneficiaries from challenging discretionary acts of the trustees, whereby a beneficiary would forfeit rights in the trust if he or she took part in proceedings opposing distributions, including filing actions in court.

On separate gift tax returns for 2007, the Mikels each claimed annual exclusions from the gift tax of $720,000 on the theory that both had made separate gifts of $12,000 to each of the trust's 60 beneficiaries. Following examination of these returns, the IRS sent the Mikels separate notices of deficiency determining that they were ineligible for the claimed annual exclusions.

Analysis

Code Sec. 2503(b)(1) provides an annual exclusion from gift tax for gifts of a present interest in property. In 2007, the annual exclusion amount was $12,000 per donee. Under Reg. Sec. 25.2503-3(b), a "present interest in property" is defined as an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.

The IRS argued that the beneficiaries did not receive a "present interest in property" because their rights of withdrawal were not legally enforceable in practical terms. The IRS hypothesized that the trustees might refuse to honor a timely withdrawal demand, requiring the beneficiary to submit the dispute to a beth din. If the beth din sustained the trustees' refusal to honor the demand, the IRS noted that the beneficiary could seek redress in a New York court, but claimed he or she would be extremely reluctant to go to court because in doing so the beneficiary would forfeit all rights under the trust by virtue of the in terrorem clause.

According to the IRS, a right of withdrawal was enforceable only if the beneficiary could go before a state court to enforce that right, but the in terrorem provision made this right illusory, as beneficiaries would never attempt to enforce their rights in court. The IRS claimed that because the beneficiaries' withdrawal rights were illusory, they did not have present interests in trust property, and therefore the Mikels were not entitled to the gift tax exclusions.

The Tax Court noted two fatal flaws in the IRS's argument. First, it was not obvious to the court why, as the IRS argued, the beneficiary must be able to go before a state court for the withdrawal right to be legally enforceable. The court noted that if the trustees were to breach their fiduciary duties by refusing a timely withdrawal demand, the beneficiary could seek justice from a beth din. A beneficiary would not suffer adverse consequences from submitting a claim to a beth din, and the court found the IRS had not explained why that was not enforcement enough.

Second, the court noted the IRS's argument was not that judicial enforcement was unavailable, but that the remedy was "illusory" because the in terrorem provision would deter beneficiaries from pursuing it. The court concluded the IRS had misunderstood the provision's meaning, stating the provision was designed to discourage legal challenges to discretionary distributions made by trustees, such as for a beneficiary's medical expenses. In contrast, a beneficiary who filed suit to compel the trustees to honor a timely withdrawal demand would not be opposing or challenging a distribution from the trust. The court found that because a beneficiary's challenge to compel mandatory distributions would not be covered by the in terrorem provision, that provision would not, as the IRS argued, dissuade a beneficiary from seeking judicial enforcement of his rights.

Finding the IRS's arguments unconvincing, the Tax Court concluded that the beneficiaries of the Mikel trust possessed a present interest in property because they had an unconditional right to withdraw property which could not be "legally resisted" by the trustees, and because the Mikels had gifted present interests in property to the trust, the court held they were entitled to the claimed gift tax exclusions.

OBSERVATION: The Mikel trust is a "demand trust," often called a "Crummey trust" because of the favorable treatment accorded such a trust in Crummey v. Comm'r, 397 F.2d 82 (9th Cir. 1968). The demand clause in Crummey, substantially similar to that in the Mikel trust, provided that whenever an addition was made to the trust, a beneficiary or guardian acting for a minor beneficiary could demand immediate withdrawal of an amount keyed to the maximum annual exclusion under Code Sec. 2503(b). The Ninth Circuit held this demand right to be a "present interest in property" and the IRS confirmed this conclusion in Rev. Rul. 85-24. The Tax Court adopted the Ninth Circuit's reasoning and result in Estate of Cristofani v. Comm'r, 97 T.C. 74 (1991), explaining that the proper focus of analysis was not the likelihood that the beneficiaries would actually receive present enjoyment of the property, but the legal right of the beneficiaries to demand payment from the trustee.

For a discussion of the gift tax annual exclusion, see Parker ¶221,310. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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