- Chief Counsel Advice Memorandum 201208026 (9/28/2011)
- April 5, 2012
- Law Firm: Proskauer Rose LLP - New York Office
In a recently released Memorandum, the IRS Office of Chief Counsel concludes that contributions made by Settlors to a discretionary trust for their descendants were taxable gifts, since (1) the Settlors had not retained any rights that would make the gifts incomplete and (2) the withdrawal powers granted to the beneficiaries were unenforceable in state court and thus illusory.
Under the trust agreement, the Settlors retained testamentary limited powers of appointment, presumably with the intent that these retained powers would render contributions to the trust incomplete under Treas. Reg. § 25.2511-2(b), and thus not subject to immediate gift taxation. The Settlors then commenced funding the trust each year with interests in a family entity (the nature of which is not specified in the Memorandum) in amounts equal to the couple's annual gift tax exemption amounts with respect to the trust beneficiaries.
The Memorandum, however, concludes that, under established case law, a testamentary power of appointment relates only to the remainder of the trust and not to the interest held for the benefit of the current beneficiaries. As a result, each gift to the trust has to be thought of as consisting of two parts, a current interest (which is complete for gift tax purposes) and a remainder interest (which is incomplete for gift tax purposes).
In this case, the value of the gift of the current interest is equal to the entire fair market value of the transferred property, for two reasons: (1) since the Trustee of the trust has the power to terminate the trust at any time by distributing all of the principal to one or more of the current beneficiaries, the present value of any remainder interest is negligible and (2) because the incomplete gifts of the remainder interests are not "qualified interests" under the special valuation rules of § 2702, the value of the retained interest is treated as zero.
As a result of this analysis, practitioners wishing to ensure that a gift is incomplete should not rely on a retained testamentary power and should make certain that the grantor is also given an applicable lifetime power, such as a lifetime limited power of appointment or a power to veto trust distributions.
The Memorandum goes on to discuss the withdrawal rights granted to the beneficiaries, which were designed to ensure that gifts to the trust were free of gift taxation to the extent of the Settlors' annual gift tax exemption amounts with respect to the beneficiaries. The trust agreement designates relevant state law as the law of the trust, but requires that all disputes relating to the trust to be resolved in an "Other Forum" (likely a reference to mandatory binding arbitration). In addition, the trust agreement provides that any beneficiary who participates in any civil proceeding to enforce the trust will have his or her beneficial interest terminated.
The Memorandum concludes that the beneficiaries have no means of enforcing their withdrawal rights under state law, since the Other Forum is not bound by state law and no beneficiary would be willing to petition the state court for relief at the risk of terminating his or her beneficial interest in the trust. Because these withdrawal rights are therefore deemed unenforceable, the Settlors were not allowed to use their annual gift tax exemption amounts to shield any portion of their contributions to the trust.