Irrevocable Life Insurance Trust/Crummey Trust

An irrevocable life insurance trust, commonly known as an "ILIT," is a type of trust used to avoid the inclusion of life insurance proceeds in a decedent's estate.

Many people erroneously assume that life insurance proceeds are always non-taxable. This is not entirely accurate. Life insurance proceeds are not considered taxable income.  However, life insurance proceeds are considered part of the decedent's estate if there is incidents of ownership. For example, if John Doe purchased a life insurance policy in his own name for the benefit of his wife, the proceeds would be included in his estate at death. The inclusion of life insurance proceeds in a decedent's estate is a material concern because life insurance proceeds can easily be millions of dollars.

When a person passes away, the federal government imposes a tax on estates that exceed a certain amount. Your estate is everything you own at death essentially. Of note, California does not currently have an estate tax. This exclusion amount is $5.34M in 2014. This is pegged to inflation so it will increase in 2015. If you pass away in 2014 and your estate eclipses $5.34M, the estate tax will generally be imposed. Since life insurance proceeds can be in the millions of dollars, this can be the difference between an estate being below or above the estate tax threshold. Thus, some people opt to create an ILIT so as to avoid the inclusion of life insurance proceeds in their estate given the concern of the estate tax. Although there are additional benefits for an ILIT. 

A typical way to create an ILIT is as follows. 

Maude, a wealthy widow, has only one child, a son named Sam. Maude's estate is above the estate tax threshold. Maude wishes to reduce her estate tax liability and simultaneously benefit Sam.

Maude meets with an estate planning attorney who tells Maude about the advantages of an ILIT. Convinced of an ILIT's benefits, Maude decides to create one. The attorney tells Maude that it is best to create an ILIT by gifting the maximum annual gift tax exclusion amount, $14,000 in 2014, to her son each year through a Crummey Trust. The trustee of the Crummey Trust then uses Maude's $14,000 gift to Sam to purchase a life insurance policy for her life.

Many years pass by and each year Maude gifts $14,000 to Sam's Crummey Trust. In turn, the Crummey Trust's trustee pays the premium on Maude's life insurance policy. When Maude ultimately passes away, multiple benefits are realized. First, by gifting thousands of dollars to Sam's Crummey Trust, Maude's estate has reduced her estate tax exposure because of the decreased value of it. Second, the life insurance proceeds for Maude's policy are not included in her estate for estate tax purposes because there is no incidents of ownership. Third, Sam receives the life insurance proceeds tax free.

Annual Gift Tax Exclusion Amount for 2013

"Gift" is the painting's title

For the past couple of years the annual gift tax exclusion amount was $13,000. This meant that a person could gift up to $13,000 to another person without (a) having to file a gift tax return and utilizing a portion of their lifetime gift tax exemption amount or (b) filing a gift tax return and paying the gift tax in order to avoid a loss of a portion of their lifetime gift tax exemption amount. Of note, the gift tax applies to any type of property transfer, personal, real, intangible, etc. IRC §2511(a) Thus, the transfer of stock, a home or a musical copyright would count as a gift if certain conditions were met.

In October, the IRS announced that the annual gift tax exclusion amount for 2013 would be $14,000. The reason for the increase is to reflect inflation. In prior years, inflation did not merit an increase in the exclusion amount.

There is no California gift tax. Hence, the increase only affects the federal gift tax.

It should be noted that certain items are not subject to gift tax regardless of the size of the gift. For example, gifts made to charity, payment of medical expenses, payment of school tuition and intra-spousal gifts are all considered exempt from the gift tax. This means that a person could pay the entire tuition costs for a student attending McGeorge School of Law for Spring 2013, $21,486, and not have to worry about any gift tax liability or ramifications. I use McGeorge as a reference because I went to school there.

As of this writing, there has been no legislation affecting the estate and gift tax regime for 2013. For both of these items, the exclusion amount for 2012 is $5.12M. If no legislation is passed, the estate and gift tax will revert back to $1M exclusion limits for each. Still, the last time the estate and gift tax was addressed occurred in December 2010 in a lame duck session of Congress. Hence, just because it is the 11th hour, it does not mean that nothing will be enacted. 

So while the annual gift tax exclusion amount for 2013 has been addressed, the more important lifetime exclusion amounts for both gifts and estates remain a mystery. Ultimately, something will occur in the next month or so. Either the estate and gift tax will be amended to increase the lifetime exemption amount or nothing will happen and each will revert back to $1M. An optimist would say that at least some resolution will be reached shortly.

Estate and Gift Tax: Clawback

The future of the estate and gift tax is muddled to put it mildly. If no legislation is enacted before the close of the year, the estate and gift tax exemption limits for 2013 will revert back to the $1M threshold. For this year, 2012, the current estate and gift tax limit is $5.12M. In case you are curious as to the $120,000 part of the figure, when the estate tax was modified in 2010, it set the limit at $5M for 2011 and pegged it to inflation for 2012.

The estate and gift tax system are linked together so as to prevent somebody from giving away their entire estate before they die. This is known as the unified credit. If a person uses up a portion of their gift tax exemption, assuming they decline to pay the gift tax, this lowers the amount of their estate tax exemption. If a person never uses any of their lifetime gift tax exemption their full estate tax exemption remains intact.

Due to the rather large estate and gift tax exemption for 2012, $5.12M, this intrigues many an affluent parent, uncle, grandparent, etc. who wish to take advantage of the current scheme and gift a substantial amount of property to a lucky soul or souls tax-free. However, due to potential fluctuations in the estate and gift tax system, this attractive option is not as clear-cut as it appears. The following example illustrates this point.

Assume Mary Magnanimous is a wealthy widow worth $4.12M living in San Francisco, CA. She decides to gift $3.12M in cash to her neighbor James Joyce in 2012. Fast forward to January 2013 and Mary passes away with an estate worth $1M. According to the estate and gift tax regime, lifetime gifts are added to the value of a decedent's estate. This is where the term "clawback" comes from. In other words, gifts made during the decedent's life are brought back into equation when valuing the decedent's estate. The problem for 2013 is what happens to a person like Mary Magnanimous who decides to gift an amount in excess of $1M, will the gift be subject to clawback or is the gift not subject to clawback? In other words, when Mary passes away in 2013, will her estate be valued at $1M or will it be valued at $4.12M. The former figure represents Mary's estate value excluding her $3.12M gift in 2012 whereas the latter represents Mary's estate value including her $3.12M gift in 2012.

The application or non-application of clawback is enormous. If clawback is applied, her estate would be subject to a 35% estate tax on the amount above $1M, namely $3.12M, which results in a tax of $1.092M owed to everybody's friend, the IRS. Conversely, if clawback is not applied,  Mary's estate tax would be $0 because her estate of $1M would not exceed the exemption amount, $1M.    

Unfortunately, there is no definitive answer as to whether clawback will occur or not. I have read online that clawback will occur automatically. This is simply not true. Don't believe everything you read on the Internet! More importantly though, the current law does not directly address the clawback issue. 

We just have to wait and see what happens to the estate and gift tax system for 2013. The very likely scenario is that a lame-duck session of Congress will take up the issue in December. That is what happened in 2010 when the estate and gift tax was set to revert back to $1M in 2011 as well.

Child's Bank Account

Many people, armed with good intentions, often add their child to their bank account. As said by a relative of mine, "mom just wanted to make sure that if something happened to her, we would have access to her account to pay her bills." 

This type of do-it-yourself estate planning is ill-advised for at least 3 reasons:

1. Creditor attachment

If the child were to have a judgment rendered against them, the bank account may be subject to levy, i.e. they take your money away. While the probate code says that the ownership interests in a joint tenancy bank are initially allocated in proportion to contribution, whereby the parent can argue that the child supplied no funds. Prob C § 5301. The parent will nonetheless have to prove that the child supplied nothing to account. Thus, the parent might have to hire legal counsel to show that all funds can be traced to them instead of the child to avoid attachment.

2. No duty to account

In a curious court ruling, Lee v. Yang (2003) 111 CA4th 481, the court held that an account owner who withdraws more than that owner's share of account contributions has no duty to account to the other owner. Thus the child could virtually drain the account of everything and not have to account to the parent. Of note, a current bill in the California legislature would reverse this court ruling. Still, for the time being, the child could freely withdraw the entire balance of the account and not have to reimburse the parent for the withdrawn funds.

3. Gift taxes

Each person is allowed to gift to another, subject to limited exceptions, $13,000 per year. If you have a bank account worth $50,000 for instance and you add your child's name to the account, you arguably have gifted more than the allotted $13,000 to the child because the child may withdrawal the entire balance. In turn, you have to file a gift tax return, IRS Form 709, or pay the gift tax. Either way, a gift tax return will have to be filed. 

What can a parent do then?

For starters, a parent should not add their child's name to the account. 

The ideal solution is to transfer the account into a trust.  If the parent ever becomes incapacitated, the child can become the trustee and manage the account on behalf of the parent subject to various fiduciary duties. These duties are not imposed on the child when they are simply a co-owner of the account.

An alternative is to name the child the pay-on-death beneficiary. When the parent passes away, the child will merely have to show the bank (1) a death certificate and (2) some form of identification, e.g. a driver's license, to inherit it. The one drawback with a P.O.D. is that the child could not access the funds while the parent is alive. A P.O.D. is only effective at death. Hence, if the parent ever becomes incapacitated, the child could not gain access to the funds at that point unlike a trust.

Types of Irrevocable Trusts

The majority of trusts that are drafted are known as revocable or living trusts. However, some people write irrevocable trusts as well if the situation dictates the necessity for such. The following are some of the more common irrevocable trusts:

Life Insurance Trust (commonly known as a ILIT)

In this type of trust, parents gift money to their children to pay the life insurance policy premiums, which are taken out for the parent's lives, and the parents then designate the children as the policy's beneficiary. An ILIT provides the benefit of reducing the parent's taxable estate for Estate Tax purposes and provides the children with liquidity to satisfy Estate Tax obligations. For example, the parents might gift $26,000 to their children annually to purchase the largest life insurance policy they can obtain. When the parents pass away, the proceeds from the policy will not be included in his or her gross estate for Estate Tax purposes. In turn, the children will reap sufficient liquidity to pay any Estate Tax liability. Generally speaking, the IRS requires prompt payment of the Estate Tax, hence access to large quantities of cash is needed to pay it. Unfortunately, you cannot barter services with the IRS as a form of payment so money is needed to pay them off not your impressive karaoke skills.  

Crummey Trust 

This type of trust allows a parent to gift the maximum annual exclusion amount, $13,000 in 2012, to their child's trust. The name is derived from the court case which recognized its validity, Crummey v Commissioner (9th Cir 1968) 397 F2d 82. Basically, a parent tells their child that they are gifting their Crummey Trust $13,000 and the child has the right to withdraw said funds within a specified time period if they so desire. Invariably the child will not withdraw the funds whereby the funds become part of the child's trust. If this seems like a big charade to you, then you can think prudently. 

Charitable Trust

Since the Estate Tax allows a charitable deduction, a wealthy individual might write a trust which benefits a recognized charity to offset the Estate Tax. There are two types of these, a charitable remainder trust ("CRT") and a charitable lead annuity trust ("CLAT"). In a CRT, individuals are designated as beneficiaries for a specified period of time, with the remainder interest passing to charity. In a CLAT, the formula is reversed, the charity is the initial beneficiary for a specified period of time, with the remainder interest passing to named individuals. 

Special Needs Trust (commonly known as SNTs)

A SNT is a trust designed for individuals who are disabled with the goal of retaining the individual's public benefits such as Medi-Cal and Supplemental Security Income while simultaneously allowing them to receive property. There are two types of SNTs, a First-Party Specials Needs Trust and a Third-Party Special Needs Trust. In a First-Party SNT, the disabled individual themselves creates the trust. For example, the individual is awarded a substantial judgment for a personal injury claim and creates the First-Party SNT to maintain eligibility for public benefits. Conversely, with a Third-Party SNT, some person other than the disabled individual, almost always the parents, creates the trust for the individual. 

Qualified Domestic Trust (commonly known as a QDOT)

In the case of a couple, the Estate Tax is not an immediate concern should one spouse away. The reason for this is because one spouse is allowed to transfer to the surviving spouse an unlimited amount of property upon their passing. IRC §2523. For example, if Jack and Jill were collectively worth $250M and Jack suddenly passed away in a tragic hot air balloon accident, Jill would have no immediate concern of paying the Estate Tax since Jack could leave his entire to her absent Estate Tax liability. Although Jill's estate would have to pay the Estate Tax once she passes away. Regardless, the major qualification for the unlimited marital deduction is that the surviving spouse be a U.S. citizen. IRC §2056(d).

If the surviving spouse is not a U.S. citizen, the couple can write a QDOT to take advantage of, albeit partially, the marital deduction for Estate Tax purposes. The nuances of a QDOT are beyond the scope of this brief post because the requirements are rather technical and more importantly for you the reader, quite boring. However, a prior post is dedicated to this topic.   

There are many other types of irrevocable trusts. I focused on the above trusts because I see them in use most frequently.

Estate Tax Legislation

The Estate Tax is definitely one estate planning topic that captures the attention of many. The following are two competing bills that seek to amend the Estate Tax. I contrasted three main topics of the Estate Tax, and the Gift Tax because of its close association to the Estate Tax, that each bill addressed.

I am by no means endorsing or opposing either bill in any way.

Rep. Jim McDermott (D-Wa), The Sensible Estate Tax Act Of 2011.

1.    Applicable Exclusion Amount

The applicable exclusion amount for 2012 is slated to be $5M plus inflation. Rep. McDermott's bill would decrease the applicable exclusion amount to $1M in 2012.

2.    Estate Tax Rate

The Estate Tax rate is currently set to be 35% for 2012. Rep. McDermott's bill would increase the Estate Tax rate to 55% for 2012.

3.    Gift Tax Exemption

Rep. McDermott's bill would peg the Gift Tax exemption to the Estate Tax exemption. Hence, if the Estate Tax was $1M, since Rep. McDermott's bill passed, then the Gift Tax exemption would also be $1M.

Rep. Kevin Brady (R-Tex), The Death Tax Repeal Permanency Act Of 2011.

1.     Applicable Exclusion Amount

Rep. Brady's would repeal the Estate Tax. Therefore, no tax would be imposed on a decedent's estate, regardless of the size, for the estates of decedents dying on or after the date of the enactment of the Death Tax Repeal Permanency Act of 2011.

2.      Estate Tax Rate

Since Rep. Brady's bill would abolish the Estate Tax, then clearly there would be no Estate Tax rate. For clarity's sake, Rep. Brady's bill would effectively make the multiplier "0."

3.    Gift Tax Exemption 

Rep. Brady's bill would make permanent the $5M Gift Tax exemption. 

Death Taxes

When a person passes away, there are numerous taxes associated with the transfer of the decedent's assets. The following are examples of these transfer taxes.

Estate Tax

The Estate Tax is a tax levied on a decedent's estate when the estate's amount exceeds the applicable exclusion amount. For example, the current exclusion amount in 2011 is $5M. Thus, if a single person were to pass away next week and their estate was worth $10M, their estate would be, generally speaking, subject to the Estate Tax. The Estate Tax's top rate for 2011 is 35%.

The future of the Estate Tax is under considerable debate at the moment. The applicable exclusion amount is set to revert back to 2003 levels, $1M, if no action is taken for the year 2013, the $5M exclusion expires after 2012. It is likely that the Estate Tax will be revisited sometime in late 2012 because Congress has a habit of waiting until the last moment to resolve anything.

Gift Tax

The Gift Tax is a tax levied on the transfer of property between parties absent consideration. For example, if Donald gave the keys to his Ferrari to his friend Doug out of the blue and said "the car is yours to keep" and Doug then hastily sped off in the Ferrari, such would constitute a gift. The reason being is that there was an (1) intent to make a gift, Donald was not asking for anything in return, (2) delivery of the gift, Donald gave his keys to Doug and (3) receipt of the gift, Doug drove off with the car.

The Gift and Estate Tax are linked together to prevent a person from giving away their estate before they die in order to avoid the Estate Tax. Thereby, giving away large gifts over one's lifetime can reduce the amount of the Estate Tax available to that person on their death. So before you decide to give away all of your possessions on your death bed to avoid the taxman, remember the preceding sentences.

The current amount a person can give away before they incur Gift Tax is $5M. Again, this figure is under considerable debate as well because the figure has been tinkered with many times over the past couple of years.

Generation Skipping Transfer Tax

The GST Tax is designed to address the situation where a person transfers property to a "skip person" that avoids the application of the Gift and Estate Tax. This "skip person" is almost always a grandchild. Hence, the law typically arises when a grandparent transfers property to a grandchild. For example, a grandparent might create a trust that distributes income derived from the trust to the child and the grandchild, and upon the child's death, the principal will be distributed to the grandchild.

The GST Tax uses the same applicable exclusion amount as the Estate Tax, $5M in 2011. 

The GST Tax is largely irrelevant for the vast majorities of individuals because not many people have millions of dollars earmarked for a grandchild's inheritance through a trust.

Property Taxes (Prop 13)

If the decedent's estate owned real property, then property taxes will need to be addressed. Prop 13, the California constitutional amendment that governs property taxes, says that each piece of real property can be assessed a 1% levy and each year the property's assessed value can be at most raised 2% from the previous year. However, before you tell me that I am uninformed because your property tax bill is clearly greater than 1% of the assessed value, please remember that cities and counties are allowed to tack on various fees for infrastructure projects and pension obligations. 

California Uniform Transfers to Minors Act (CUTMA)

One alternative to the creation of a trust for a child is to create a custodianship under the California Uniform Transfers to Minors Act (CUTMA) (Prob C §§3900-3925). The following are some questions that focus on this topic.

1. What is a CUTMA?

A CUTMA is a legal arrangement in which property is given by a donor to an adult, the custodian, who is entrusted with managing and expending the property for the beneficiary, who must be a minor, until the minor reaches age. When the minor reaches age 18, the custodian transfers all remaining property to the minor. Prob C §§3914(a), 3920.

For example, assume Donald gave $10,000 to Clarence to manage and expend for the benefit of Donald’s son, Bobby. At the time, Bobby was age 14. Clarence then used the money for various reasons to benefit Bobby. When Bobby turns 18, Clarence is obligated to transfer ownership of the remaining property, if any, to Bobby.

For reference, the generic term for this type of account is “UTMA.” “CUTMA” is used in California because a “C” is added to the beginning to denote its California origin. So whenever you see or hear the term “UTMA” this is basically the same arrangement as a “CUTMA” account. Many bankers are familiar with the term “UTMA.”

2. How do I set up a CUTMA account?

Large commercial banks are readily familiar with establishing a CUTMA account. If you look on the website of large commercial banks such as HSBC, Bank of America, CitiBank or Chase, each will have a description on how to set one up.

It is quite easy. If you can set up a checking account, you can set up a CUTMA account.

3. Am I limited by the type of property I can fund a CUTMA account with?

No, there are no longer any limits on the types of property that may be devised to a minor under CUTMA. See Prob C §§3901(f), 3909(a)(7).  

4. When can a CUTMA account be established?

A CUTMA account can be established during the lifetime of the donor or at the donor’s passing by specifying for the creation of such in the donor’s will.

5. Is a CUTMA account considered a taxable gift?

No, CUTMA gifts qualify for the annual gift tax exclusion under IRC §2503(b), which is $13,000 for 2011 and is adjusted annually for inflation. Rev Proc 2009-50, 2009-45 Int Rev Bull 617.

6. What are some advantages in creating a CUTMA account as opposed to a trust?

A CUTMA account is very ease to create. Banks are very familiar with the process, court-supervision is not required, bond is not required of the custodian and the custodian need not provide an accounting to the beneficiary.

7. What are some disadvantages in creating a CUTMA account as opposed to a trust?

Each CUTMA account may have only one beneficiary and one custodian. Prob C §3910. Hence, if a couple has multiple children, then a separate CUTMA account will need to be established for each child which can cause administrative headaches.

The custodian of the account cannot be instructed as to what investments he or she should make as in the case of a trust. Prob C §3914(a). In particular, the custodian is free to expend the money as they advisable and without the need to obtain court approval.

The beneficiary may incur adverse tax liability through the “kiddie tax” if their unearned income is too high. This results in the child being taxed at the parent’s income tax level rather than the child’s level.

Finally, CUTMA accounts are treated as the student's assets for financial aid purposes. 20 USC §1087vv(f).

8. What are some alternatives to a CUTMA account?

A donor could deliver proceeds to the child’s parents if the amount does not exceed $5,000 and the parent promises to use the proceeds for the child’s benefit. Prob C §§3400-3402.

If the donated property exceeds $5,000 and the child has no guardian of the estate, a court may authorize that the money be deposited in a blocked account or may authorize the purchase of a single-premium deferred annuity. Prob C §3413(a).

A donor could create a trust for the child’s benefit. This would be the most flexible option available since the trust could specify the trustee’s duties.

A court-supervised guardianship of the child’s estate could be established to handle the child’s property. Prob C § 1510.

Estate Planning Fees

A common question from a homeowner who is interested in writing a revocable trust, is what are the costs and obligations, other than attorney fees, involved with the process? The following are
some topics raised by that question.
 
Property taxes
 
Whenever there is a “change in ownership”, the property taxes for that particular parcel of land will be re-assessed to its current the fair market value. Rev & T C §60. For example, if Bobby purchased from Sam a home for $500,000 in San Jose in 2007, Bobby’s property taxes would be based off of that $500,000 figure. Now assume that Bobby had purchased the property for $40,000 from Sam in 1979. In 2011, Bobby decides he wants to write a trust to avoid probate. However, Bobby is hesitant to write a trust and fund it with his home. He is worried that the Santa Clara County Assessor will try to re-assess his property taxes to its 2011 fair market value and in turn raise his property taxes. Fortunately for Bobby, California law is very specific in saying that a home transfer to a revocable trust is not considered a “change in ownership.” Rev & T C § 62(d)(2). Thus, the fear of re-assessment for property taxes when funding a revocable trust with a home is unwarranted.

Documentary transfer tax

In the case of a real property transaction, the transfer of a home from seller to buyer for example, there is the inclusion of a fee known as the documentary transfer tax. Rev & T C § 11911. The deed, the document which denotes the identity of the seller and buyer, must show the amount of the documentary transfer tax due. Rev & T C §11932. For reference, the tax rate is $0.55 per $500 of value (0.11 percent) sold. Rev & T C §11911.

Since a trust needs to be properly funded, whereby a trust transfer deed will need to be drafted, the documentary transfer tax becomes an issue, albeit only superficially. The reason for the superficiality is that California law states that a transfer of a home to a revocable trust is exempt from the fee imposed by the documentary transfer tax because there is no consideration tendered. Rev & T C §11930. Therefore, the documentary transfer tax is not an issue when a homeowner funds his or her trust when their home.
 
Income tax returns
 
Most revocable trusts are known as “Grantor Trusts” in IRS language. IRC §§671, 676. This means during the time that the trust is revocable, the settlor, the person who wrote the revocable
trust, is not required to file an additional tax return for the revocable trust. Hence, the creation of a revocable trust will not result in the settlor having to file more paperwork with the IRS and
California Franchise Tax Board.
 
Gift taxes
 
The inapplicability of gift tax in regards to creating a revocable trust bears mentioning to erase any confusion. There is no gift tax if you transfer property from yourself to a revocable trust that you created. A revocable trust is not a separate legal entity. Goldberg v. Frye (1990) 217 CA3d 1258. Hence, if you transfer property to your revocable trust it would be as if you handed an item from
your left-hand to your right-hand. Thus, there is no gift tax in the revocable trust creation equation because there is no third-party involved.
 
Recording Fees
 
Once a person has executed a trust transfer deed, it needs to be recorded in order to give proper notice to third-parties that the buyer is now the owner of the property. However, whereas there are exemptions with the previously mentioned fees and taxes, there is no such exemption for recording a deed. Each county has their own schedule of fees to record a document. For example, to record a deed in Santa Clara County, it is $15 for the first page and $3 for each additional page. The deed may be presented personally to the clerk-recorder or you can mail it in.
 
Notary Fees
 
It should be mentioned that a notarized signature is not required to execute a revocable trust. In that, there is no California law that says that a signature has to be notarized when executing a revocable trust. However, out of custom, a signature is notarized when executing a revocable trust.

A California notary may charge up $10 per signature when executing a revocable trust. Govt C § 8211. Often times, the attorney drafting the trust doubles as a notary and the fee is waived.

Gift Tax Law

In a previous post, I discussed the Estate Tax and the nuances behind it. Another one of the transfer taxes is Gift Tax. Here are some questions commonly posed in regards to Gift Tax. 

1. What is Gift Tax 

The Gift Tax is a transfer tax imposed by law where a person, the donor, gives the recipient, the donee, an item of property free of consideration. In IRS speak, Gift Tax is imposed on lifetime transfers of property for less than adequate and full consideration in money or money's worth. IRC §§2501(a), 2512(b). For example, if I gave my 325i BMW to my cousin Bob for free, this would constitute a gift and Gift Tax would follow. 

2. What gifts are always excluded from Gift Tax? 

Contributions made for the following items, regardless of the contribution amount, are exempt from Gift Tax: medical expenses, educational expenses, charitable donations and gifts between spouses who are U.S. citizens. IRC §§2503(e); 2522(a); 2523(a). 

3. Who pays Gift Tax? 

Surprisingly the donor pays Gift Tax rather than the donee. IRC §2502(c); Treas Reg §25.2511-2(a). For instance, if Donald gave Hugo a $20,000 Rolex watch as a gift, then Donald would be liable for paying Gift Tax. 

4. What is the annual exclusion amount? 

The annual exclusion amount represents the figure at which a donor may avoid Gift Tax liability if they gift property for less than or equal to the annual exclusion amount.

In case you are wondering, the annual exclusion amount for 2011 is $13,000. IRC §2503(b). Spouses can gift up to $26,000 to one individual because California is a community property state.

The annual exclusion amount is also not cumulative. Thus, if a donor uses less than their annual exclusion amount for one year, they cannot transfer the surplus to the next.  For example, if Donald gave Hugo $10,000 in 2011, he could not give Hugo $16,000 (assuming the annual exclusion amount stays the same) in 2012. 

5. How does Gift Tax harmonize with estate planning? 

In light of the annual exclusion amount, some clients utilize Crummey Trusts for their children while other clients create irrevocable life insurance trusts (“ILITs”). 

6. What prompted Gift Tax? 

The Gift Tax was enacted by the federal government to prevent a person from giving away all of their property to avoid the Estate Tax. Since the Estate Tax is imposed only at death, a person could presumably drain their estate through gifting over time to prevent its application. Not surprisingly, the federal government closed this loophole in 1932 when it instituted Gift Tax. 

7. What is the Gift Tax rate? 

The Gift Tax rate starts at 18% and caps out at 35%. IRC §2502(a)(2). 

8. What is the legal definition of a gift? 

The following link explains this well. 

9. Is there a federal Gift Tax? 

Yes, there is a federal Gift Tax. All that is mentioned in this post relates to the federal Gift Tax. 

10. Is there a California Gift Tax? 

No, the State of California does not impose Gift Tax. The California Gift Tax was repealed by the California electorate via ballot proposition on June 8, 1982. Rev & T C §§13301-14302. 

11. Is inheritance considered a gift? 

Inheritance is not considered a gift in the strict legal sense. While in substance inheritance is very much like a gift in that you did nothing to earn the property, inheritance is subject to the Estate Tax not the Gift Tax. 

12. Who can I give gifts to? 

Anybody is eligible to receive a gift on your behalf. Furthermore, there is no limit on the number of donees that a donor may benefit. For example, if a donor had $130,000, he or she could gift $13,000 to ten different individuals absent Gift Tax liability. 

13. Is extending a loan to a relative a gift? 

Yes, provided you extend to the borrower-relative a below market interest rate. Federal law stipulates the minimum interest rates that must be used between a lender (you) and a borrower (relative) and lays out the income and Gift Tax consequences if the loan incorporates an interest rate below the required minimum rate of interest. IRC §7872. 

14. Can I gift services? 

No, Gift Tax applies to the transfer of property, not to services. 

15. How do you value gifts? 

A gift is valued at its “fair market value” as of the date of the gift. IRC §2512(a). Fair market value is defined as "the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts." Treas Reg §25.2512-1. 

Estate Tax in 2011

The estate tax might be the most discussed issue in estate planning but most certainly not the most relevant given the circumstances of most individuals. For example, almost invariably the first question I am asked by clients at our initial meeting is whether the government will inherit their entire estate or impose substantial taxes on it. Almost always, my response is “no.”

Regardless, the following are some common questions that deal with the nuances of the estate tax. 

1. What is the federal estate tax? 

The federal estate tax is a tax levied against a decedent's taxable estate by the IRS when the estate is in excess of a fixed amount. This fixed amount is known as the applicable exclusion or exemption amount. 

2. How is taxable estate calculated? 

The taxable estate is determined by subtracting certain deductions from the decedent's gross estate. IRC §2051.

The gross estate includes all of the decedent's property, real or personal, tangible or intangible, wherever located IRC §2031(a). For example, this figure includes homes in the U.S. and abroad, bank accounts, stocks, retirement accounts, mutual funds, bonds, promissory notes, copyrights, patents, yachts, jewelry, castles, planes, trains and automobiles, etc.

The deductions include items such as expenses, indebtedness and taxes. IRC §2053. The most common deduction is for the mortgage amount remaining on the decedent's home. Treas Reg §20.2053-7.

For illustrative purposes, if the decedent owned a $10,000,000 home with a mortgage balance of $3,000,000 along with a bank account worth $500,000, stocks worth $500,000, bonds worth $2,000,000 and mutual funds worth $1,000,000, then their taxable estate would equal $11,000,000. 

3. Who is affected by the estate tax? 

The estate tax is imposed on every decedent who is a citizen or resident of the United States. IRC §2001(a).

Nonresident aliens are taxed on U.S.-based property. IRC §§2101, 2103. 

4. What is the exemption amount in 2011? 

The exemption amount in 2011 is $5,000,000. 

5. What does $5,000,000 signify? 

The $5,000,000 figure signifies the maximum amount at which taxes will not be owed. For example, if a person passes away and leaves a $3,000,000 estate, then no estate tax will be due.
Conversely, if a person passes away and leaves a $6,000,000 estate, then the estate tax will be levied on $1,000,000. 

6. Does California have a state estate tax? 

For decedents who passed away after December 31, 2004, there is no California estate tax. However, for decedents who passed away earlier, there may be an estate tax due. 

7. What is the maximum estate tax rate in 2011? 

The maximum estate tax rate in 2011 will be 35%. This means that no matter how large the estate, for example $10 billion, the maximum taxation rate for such an estate will not exceed 35%. 

8. How do people plan for the estate tax? 

There are numerous planning strategies that address the challenges posed by the estate tax. The most common method to cope with the estate tax is to write an AB trust. In short, an AB trust will allow a husband and wife, who are both U.S. citizens, the opportunity to leave to their beneficiaries, tax-free, double the estate tax exclusion amount. The link will provide more detail about this. 

9. Is the estate tax relevant given the high exemption amount? 

The answer depends on who is answering the question. For the wealthy individual, the estate tax is a huge estate planning issue since taxation can consume a significant portion of their estate. However, since very few people have over $5,000,000 in assets, there is no need to be concerned with a largely irrelevant issue. Out of the millions of people who will pass away next year, maybe a few thousand or less will be affected by the estate tax. 

10. Will the estate tax ever be an issue for me? 

Since the estate tax is a controversial and fluid issue, the estate tax will continue to be relevant. For example, the chart below shows the estate tax exemption amount and rates for each year since 2001. The chart shows that the estate tax has been subject to fluctuations over the past decade.

Year                    Amount Excluded                   Maximum Tax Rate


2001                   $675,000                                  55%


2002                   $1 million                                 50%


2003                   $1 million                                 49%


2004                   $1.5 million                              48%


2005                   $1.5 million                              47%


2006                   $2 million                                 46%


2007                   $2 million                                 45%


2008                   $2 million                                 45%


2009                   $3.5 million                              45%


2010                   Repealed 0%                           (restrictions apply)


2011                   $5 million                                 35% 

11. Does a high estate tax exclusion amount render estate planning irrelevant? 

Regardless of the consequences of a high estate tax exclusion amount, there are many issues in estate planning that affect a large portion of the population. For example if a person's estate is, generally speaking, in excess of $100,000, then upon that person's passing, a probate will be needed to distribute the estate to the beneficiaries. Since probate is quite expensive and lengthy, the avoidance of it is recommended by estate planning attorneys. Thus, people write trusts to avoid probate. 

12. Are there tax laws related to the estate tax? 

Yes, there are many tax laws related to the estate tax. One important related law is the gift tax. The gift tax was enacted to prevent people from giving away, or gifting, all of their estate in order to avoid paying the estate tax. Thus, the gift tax caps the amount a person may gift to another person. The recently amended estate tax law, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, increased the amount of the lifetime gift tax exemption from $1,000,000 to $5,000,000. 

13. Why is the estate tax such a controversial issue? 

The estate tax is a controversial issue because political ideologies clash markedly. There are plenty of other arguments for and against the estate tax but here is one from each side. Progressives see the estate tax as preventing dynastic transfers of wealth that create trust fund babies who lack the necessary ambition in life to succeed. Conversely, conservatives see the estate tax, or Death Tax as they like to call it, as an unfair form of taxation because the estate has already been levied an income tax. 

14. Who benefits from the estate tax? 

Clearly the federal government benefits because the estate tax generates billions of dollars of revenue for it. Also, estate planning attorneys, financial advisors, certified public accountants and associated professionals benefit from the estate tax because the very wealthy enlist their help to cope with the estate tax. 

15. When was estate tax instituted? 

The estate tax was first enacted in 1916. Since then, it has been amended numerous times. 

16. Can the estate tax be repealed? 

Yes, like any law, the estate tax can be repealed. 

17. What happened in 2010? 

Due to partisan squabbling, Democrats and Republicans were unable to amend the estate tax for 2010, which caused a temporary repeal. I do not know of any estate planning attorney who thought this would happen. This meant that regardless of the size of the decedent’s estate, no estate tax would be due in 2010.

However, other portions of the estate tax law changed in 2010 as well, most notably the “stepped-up basis” rules. In understandable language, “stepped up basis” means that a beneficiary inherits the basis of the property at the date of death value from the decedent. IRC §1014. For example, if the decedent purchased a home for $100,000 and when they died was worth $1,000,000, the beneficiary would inherit the property for $1,000,000. Then when the beneficiary later sells that asset for $1,000,000, no taxes would be due because no capital gain would have taken place.

Consequently, the vast fortunes of people such as George Steinbrenner, the former owner of the New York Yankees, and Dan Duncan, a Texas multi-billionaire, were seemingly going to be transferred tax-free to their heirs. However, due to the estate tax law, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the heirs of these fortunes are now confronted with the option of using the estate tax rules of 2010, with its unlimited estate tax cop but limited the stepped up basis rules, or the estate tax law of 2011 with its estate tax cap of $5,000,000 but with an unlimited amount of stepped basis. 

Crummey Trust

The following are questions commonly associated with Crummey Trusts:

1. What is a Crummey Trust?

A Crummey Trust is a trust in which the beneficiary, a child for example, has the power to withdraw monetary contributions made to a trust for a short period of time, 45 days for example, such that the transfer qualifies for the annual gift exclusion. IRC §2503(b). Once the withdrawal period has expired, the contribution becomes subject to the terms of the trust.

2. What purpose does a Crummey Trust serve?

A Crummey Trust is used to obtain the annual gift tax exclusion through the medium of an irrevocable trust.

For illustrative purposes, the following hypothetical should be helpful:

Samuel is a wealthy industrialist who would like to gift money to his teen aged children Bobby and Beth. Rather than give the money to his children outright, which would be most likely considered imprudent given teenager immaturity. Samuel decides to create a Crummey Trust so that he can take advantage of the annual gift tax exclusion while simultaneously keeping the trust in control of the money. 

Samuel appoints Theo to become the trustee of his childrens' Crummey Trusts by giving him $13,000 to hold in trust for Bobby and $13,000 to hold in trust for Beth. Each year thereafter, Samuel gives Theo $13,000 for Bobby's trust and $13,000 for Beth's trust. By gifting the money through a Crummey Trust, Samuel avoids having to pay gift tax for these contributions. Also, Samuel does not have to worry about his children quickly frittering away the money because the trust will restrict when distributions are made.

3. Who is the intended beneficiary of a Crummey Trust?

A child is the intended beneficiary when making a Crummey Trust.

4. Are there ongoing requirements?

Yes, each time a person gifts money (or property) to the trust, notice needs to be given to the beneficiary informing them of their ability to withdraw all or some of the contribution from the trust within a certain number of days. There is no definitive rule on the duration of the power to withdraw, although the IRS has allowed the annual exclusion for periods as short as 15 days. See, e.g., Estate of Maria Cristofani (1991) 97 TC 74, acq 1992-1 Cum Bull 1, acq 1996-2 Cum Bull 1.

For illustrative purposes, presume that on March 1, 2010 Samuel donates $13,000 to each child's Crummey Trust. Thereafter, Theo the trustee gives notice to Bobby and Beth that they may withdraw all or some of this $13,000 from the trust within 30 days . While each child has the ability to withdraw the $13,000, it is highly unlikely that either child would do so because this will strongly discourage Samuel from ever donating money to the child's Crummey Trust. Regardless, once those 30 days have elapsed, namely come April 1, 2010, the $13,000 for each child becomes the property of each's Crummey Trust.

5. Is a Crummey Trust irrevocable?

Yes, a Crummey Trust is irrevocable. Thus, once a person creates a Crummey Trust, they cannot later on revoke it. This is particularly important, since most trusts written in California, colloquially referred to as "living trusts", can be revoked.

6. Where does the name "Crummey Trust" come from?

The term "Crummey Trust" is derived from the court case which validated its usage. Crummey v Commissioner (9th Cir 1968) 397 F2d 82.

7. How much does it cost to write a Crummey Trust?

There is no mandatory minimum or maximum attorney fee to draft a Crummey Trust.

8. In light of the attorney fee, can I write my own Crummey Trust?

Yes, California law explicitly says that you may act as your own lawyer. However, given the technicalities associated with a Crummey Trust, it is not a document that can be easily drafted by a non-attorney. Frankly, few legal documents should ever be drafted without the assistance of an attorney.

Furthermore, since a Crummey Trust involves large sums of money, it is logical to presume that a person wanting a Crummey Trust can afford the attorney fee to create a Crummey Trust.