Retention of Testamentary Special Power of Appointment Did Not Make Gift to Trust Incomplete With Respect to Term Interest

The BNA Tax and Accounting Center is the only planning resource to offer expert analysis and practice tools from the world's leading tax and accounting authorities along with the rest of the tax...

By Deborah M. Beers, Esq.

Buchanan Ingersoll & Rooney, PC, Washington, DC

In CCA 201208026, the IRS Chief Counsel's office determined that the donors made completed gifts of the term interests in a trust upon transfer of property to the trust, despite the donors' retention of a testamentary special power of appointment. This ruling, which surprised planners who have relied on the use of such powers to create incomplete gifts, is, under the facts presented, perhaps not so surprising. The IRS also determined that no annual exclusions were allowable for the beneficiaries' withdrawal rights under the trust because any disputes concerning those rights must be submitted to binding arbitration.

Facts:

Under the facts of the CCM, Donor A and Donor B ("Donors") gratuitously transferred property to an irrevocable trust ("Trust") on Date and designated their adult child, Child A, as the sole trustee. The Trust beneficiaries are Donors' children, other lineal descendants, and their spouses. Neither Donors were either mandatory or discretionary beneficiaries of the Trust.  Trust will terminate when both Donors have died.

Although Donors renounced any power to determine or control the beneficial enjoyment of Trust income or principal, Trust provides Donors with testamentary limited powers of appointment.  If Donors do not exercise their testamentary powers, the property remaining in Trust at termination will be distributed to Child A and Child B.

Child A, as trustee, has absolute and unreviewable discretion in administering Trust for the benefit of Donors' children, other lineal descendants, and their spouses (beneficial term interests).  Income and principal may be distributed at any time for a beneficiary's health, education, maintenance, support, wedding costs, purchase of a primary residence or business, or for any other purpose. Income and principal may also be distributed to a charitable organization.

Each beneficiary may withdraw an amount of property (based on the §2503(b) annual exclusion amount) in any year in which a transfer is made to Trust. However, this may be voided by the trustee for additions made to Trust.

Trust provides that the construction, validity, and administration of Trust are to be determined by state law, but provision is made for "Other Forum" - apparently binding arbitration - Rules. Specifically, all questions and disputes concerning Trust must be submitted to the Other Forum that is charged with enforcing Trust. A beneficiary filing or participating in a civil proceeding to enforce Trust will be excluded from any further participation in Trust.

The purpose of this trust may have been, like the purpose of the trusts described in PLR 200612002 and PLR 200637025, to make this apparently nongrantor trust subject to income tax in another state with a tax rate lower than the grantors' - possibly Delaware - without making a completed taxable gift. Such trusts are sometimes referred to as Delaware Incomplete Nongrantor (DING) Trusts, and the IRS, in the foregoing rulings and others, has ruled that the retention of a testamentary power of appointment was sufficient on the facts of those rulings to make the gifts incomplete. In CCA 201208026, however, the IRS ruled differently.

Rulings:

1. Complete vs. Incomplete Gift: Donors' representative had contended that, because Donors retained testamentary limited powers of appointment over Trust, they retained dominion and control over the transferred property. Therefore, they did not make any completed gifts.

The IRS began by observing that, under applicable Treasury regulations, a transfer is a completed gift where the donor has so parted with dominion and control over the transferred property so as to leave him with no power to change its disposition.

In addition, if, upon a transfer of property, the donor reserves any power over its disposition, the gift may be wholly incomplete, or may be partially complete and partially incomplete, depending upon all the facts in the particular case.1 "Accordingly, in every case of a transfer of property subject to a reserved power, the terms of the power must be examined and its scope determined."

Regs. §25.2511-2(c) provides, in part, that a gift is incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves (unless the power is a fiduciary power limited by a fixed or ascertainable standard).  The relinquishment or termination of a power to change the beneficiaries of transferred property, occurring otherwise than by the death of the donor (the statute being confined to transfers by living donors), is regarded as the event that completes the gift and causes the tax to apply. The regulations further provide:For example, if a donor transfers property to another in trust to pay the income to the donor or accumulate it in the discretion of the trustee, and the donor retains a testamentary power to appoint the remainder among his descendants, no portion of the transfer is a completed gift. On the other hand, if the donor had not retained the testamentary power of appointment, but instead provided that the remainder should go to X or his heirs, the entire transfer would be a completed gift. 

In the CCA, when each Donor transferred property to the Trust on Date, he or she retained a testamentary limited power to appoint so much of it as would still be in Trust at his or her death. Donors did not retain any income rights either outright or in the discretion of the trustee. Trust also emphasized that Donors did not retain any powers or rights to affect the beneficial term interests of their children, other issue, and their spouses (and charities) during the Trust term. With respect to those interests, Donors fully divested themselves of dominion and control of the property when they transferred the property to Trust.

Accordingly, for gift tax purposes, Donors' transfers to Trust constituted a completed gift of the beneficial term interests. Donors' testamentary limited powers of appointment related only to Trust remainder.

Comment:

It is important to take away from CCA 201208026 the lesson that the mere retention of a testamentary special power of appointment, without more, is not sufficient to make a gift to a trust incomplete as to both the life (term) interest and the remainder interest. To make the gift incomplete as to the entire trust, the donors in the CCA would have needed to retain an interest or power in addition to their special testamentary power of appointment. Further, since the point of the DING trust is to shift the income taxation of the trust to another state, the retained interest or power would have to be one that did not cause the trust to be taxed as a grantor trust - perhaps a discretionary power to distribute corpus among a class of beneficiaries, subject to an ascertainable (i.e., "HEMS") standard.2

NOTE: In the CCA, the Chief Counsel's Office opined that "§2702 applies in valuing the gifts in this case." Under §2702(a)(2), the value of any retained interest in trust which is not a "qualified interest" is treated as being zero. An interest in trust includes a power with respect to a trust if the existence of the power would cause any portion of a transfer to be treated as an incomplete gift. Accordingly, "Donors' retained testamentary powers are interests, and the value of their retained interests is zero. Therefore, the value of the Donors' gift is the full value of the transferred property." This exceedingly harsh conclusion is, in the words of the Chief Counsel, not without its "litigation hazards," however.

2. "Illusory" Crummey Withdrawal Powers. As a fallback position, Donors in CCA 201208026 contended that, if they made completed gifts, the gifts were of minority interests to the beneficiaries equal in value to their respective withdrawal rights (Crummey Powers). Therefore, the allowable gift tax exclusions effectively reduced the amount of taxable gifts to zero. (The allowable gift tax exclusion currently is $13,000 per donor, per donee.)

However, the Chief Counsel's Office determined that, because the withdrawal rights were not legally enforceable, they were not present interests.3

In the CCA, the demand rights were only enforceable in "Other Forum," described as a "private forum" - presumably binding arbitration. Neither state nor federal courts are bound by the determination of private forums. In addition, under the terms of Trust's "in terrorem" clause, if the beneficiary proceeded to a tate court, his existing right to income and/or principal for his health, education, maintenance and support would immediately terminate. He would not receive any income or principal for his marriage, to buy a home or business, to enter a trade, or for any other purpose. He would not have withdrawal rights in the future, and his contingent inheritance rights would be extinguished.  Thus, as a practical matter, a beneficiary would be foreclosed from enforcing his withdrawal right in a state court of law or equity.

Withdrawal rights such as these are - in the view of the IRS - "illusory," and, consequently, no annual exclusion is allowable for any of them. Advisors should take heed, therefore, not to encumber the exercise of Crummey withdrawal rights with unduly burdensome legal restrictions.

 For more information, in the Tax Management Portfolios, see Lischer, 845 T.M., Gifts,  and in Tax Practice Series, see ¶6320, Gift Taxation.

 


 1 Regs. §25.2511-2(b). 

 2 See, e.g., §674(b)(5)(A). 

 3 See Cristofani v. Comr., 97 T.C. 74 (1991).