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George F. Bearup, J.D. Senior Legal Trust Advisor

6-Apr-21

Incomplete Gifts

Take Away: Even when a trust is irrevocable, for federal gift tax purposes it is possible that the transfers by the settlor to that irrevocable trust will be treated as incomplete, thus causing the value of the trust’s assets to be taxed in the settlor’s estate at death. Incomplete gifts have gained a lot of attention in recent years as an intentional means to avoid state income taxation of an irrevocable trust’s accumulated income, e.g. a Delaware Incomplete Non-grantor Trust, or DING.

Background: An incomplete gift can be confusing. Keep in mind that most incomplete gifts are still, in a general sense, completed transfers of property to irrevocable trusts, i.e. the transfer of property to the trust actually occurred in entirety. However, for tax reporting purposes, the completed transfer to a trust can be deemed an incomplete gift due to the settlor’s retention of certain powers (direct or indirect) over the trust. The gift tax Regulations specify when a gift is complete or incomplete. [Treasury Regulation 25.2511-2.] The result of an incomplete gift is that the settlor’s transfer of property to the trust is not subject to immediate gift taxation, or the use of the settlor’s available lifetime transfer tax exemption [i.e. $11.7 million in 2021] but the value of the trust property is included in the settlor’s taxable estate at death at its then fair market value.

A couple of examples of incomplete gifts follow.

Private Letter Ruling 201507008 (February 13, 2015):

  • Trust Instrument: The settlor created an irrevocable trust for her benefit and the benefit of her issue. The trustee was an independent trust company. The trust protector and the distribution advisor under the trust were neither related nor subordinate to the settlor. [IRC 672(c).] Under the trust instrument the settlor designated a distribution advisor who had sole discretion to direct an independent trustee to distribute trust income or trust principal to the settlor. The distribution advisor also had the sole discretion to direct trustee to distribute income or principal to any living issue of the settlor, but only with the settlor’s written consent. If there were no living issue during the settlor’s lifetime, then the issue of the settlor’s father could be substituted to receive discretionary distributions from the trust. Net income that was not distributed by the trustee would be added to trust principal at the end of each tax  year. Also under the trust instrument the settlor retained a consent power: with the written consent of the trust protector she could appoint during her lifetime, i.e. a limited power of appointment, or under her Will, i.e. a testamentary power of appointment, any part of the accumulated net income and principal to an identified foundation and to any issue of her father. However, the settlor could not appoint any of the trust’s income or principal to herself, her creditors, her estate or the creditors of her estate. On the settlor’s death the accumulated and unappointed trust income and principal would be divided into separate shares for each of her then living children. The settlor also retained the right to borrow part of the trust’s income and principal a with fair market interest rate charged on the loan i.e. causing the trust to be classified as a grantor
  • Legal Questions: The first question posed in this PLR was who owned the trust property? The settlor or the trust? The second question posed was whether the transfer of assets to the trust were completed gifts?
  • Settlor was Legal Owner: The settlor is treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the principal or income is subject to a power of disposition, exercisable by the settlor or a non-adverse party, without the consent of any adverse party. [IRC  674(a).] The IRS concluded that the settlor will be treated as the owner of any portion of a trust in respect of which a power is exercisable by the settlor or a non-adverse party enables the settlor to borrow the trust corpus or trust income, directly or indirectly, without adequate interest or without adequate security. [IRC 675(2).] Accordingly, due to her ability to receive distributions from the trust without an adverse party’s consent, and her ability to borrow from the trust without adequate security for the loan, the settlor is treated as the owner of the trust.
  • Incomplete Gift:  For several reason, the settlor’s transfer of assets to the trust was deemed to be

Consent Power with a Non-Adverse Party: A completed gift arises when the donor parts with dominion and control so as to leave the donor powerless to change its disposition.[Treasury Regulation 25.2511-2.] An incomplete gift is one where the donor reserves the power to re-vest beneficial title in herself. Here, the settlor retained the consent power over the trust income and principal. Specifically, the donor is still considered to possess a power if it is exercisable by her in conjunction with any person who does not have a substantial adverse interest in the disposition of the trust property. [Treasury Regulation 25.2511-2(e).] Here, the distribution adviser under the trust had no substantial adverse interest in the disposition of trust property, as he was only a co-holder of the settlor’s consent power with regard to distributions from the trust. Therefore, the settlor’s retained right to consent to distributions to others under the trust caused her transfer of property to the trust to be wholly incomplete for gift tax purposes.

Lifetime Limited Power of Appointment: Additionally, the settlor also retained a lifetime power of appointment to appoint income and principal to her father’s issue or to a foundation. While the settlor could only exercise the lifetime limited power of appointment in conjunction with the trust protector, the trust protector was merely a co-holder of the power of appointment, and as such he had no substantial adverse interest in disposing the assets transferred by the settlor to the trust. The settlor’s reserved power of appointment to change the interests of the trust beneficiaries  with her lifetime limited power of appointment caused her gift to the trust to be incomplete. [Treasury Regulation 25.2511-2(c).]

Testamentary Limited Power of Appointment: The settlor’s retained testamentary limited power of appointment  to appoint trust assets to her father’s issue, or to a foundation,  on her death is also retained dominion and control over the remainder of the trust, causing her  transfer to the trust be incomplete. [Treasury Regulation 25.2511-2(b).]

Later Completed Gifts: The settlor retained dominion and control over the trust’s income and principal until the trust adviser or the trustee exercised its distribution power. The settlor’s power over the trust’s income and principal was presently exercisable and not treated as a condition precedent. Even if the trust adviser or the trustee could defeat the settlor’s ability to change beneficial interests under the trust, her transfer of assets to the trust was incomplete for gift tax purposes. As such, any distribution of income or principal by the distribution adviser from the trust to any beneficiary, other than the settlor, was a completed gift by the settlor at the time of the distribution. Similarly, the settlor’s actual exercise of her retained limited power of appointment in favor of any individual other than herself would be a completed gift of the appointed property at the time of the exercise.

Settlor’s Death: Because her transfer of property to the trust was treated as an incomplete gift, on the settlor’s death, the fair market value of the property held in the trust will be includible in the settlor’s gross estate for federal estate tax calculation purposes.

George Farkiris v. Commissioner, Tax Court Memo 2020-157 No. 18292-12 (November 19, 2020). This recent decision was a denial of a request for a reconsideration of an earlier decision by the U.S. Tax Court in Farkiriss v. Commissioner, Tax Court Memo 2017-126.

  • Facts: Farkiris gave the St. George Theatre to Grou Development LLC. Mr. Farkiris was the managing member of Grou Development, LLC.  The LLC purchased St. George Theatre in 2001 for $700,000. It was a one-time vaudeville house. Due to the needed rennovations, the initial thought was to tear the structure down, but that met with substantial community opposition. A new non-profit [Richmond Dance, for ease referred to as the charity] agreed to purchase the theatre in a bargain sale. The LLC was concerned that the charity had not yet received its tax exempt status letter from the IRS, which was necessary to obtain a charitable income tax deduction from the negotiated bargain sale. A strawman tax exempt charity was found to act as the middle-man in the transaction to take title until the charity obtained its tax exempt status. The LLC sold the theatre for $470,000.  As part of the Sales Agreement, the LLC reserved the right to take back title to the theatre from the strawman charity and transfer the title to Richmond Dance.
  • Issue in Dispute: The IRS argued that the LLC retained dominion and control over the theatre after the transfer to the strawman charity. Consequently, there was no completed gift and the charitable contribution deduction should be denied in full. Mr. Farkiris responded that the restrictions that were focus of the IRS’s position were in the Sales Agreement and not the deed, and therefore the deed (without any restrictions or reservations) should control.
  • Tax Court: The Tax Court found that even though title to the theatre was transferred to the charity, the LLC retained some control over the use of the theatre. The Tax Court found that the LLC had not relinquished dominion and control over the theatre as required for a completed gift. The Tax Court focused on two key provisions of the Sales Agreement between the LLC and the strawman charity:
  • The strawman charity was prohibited from selling the theatre during the 5-year period after the deed had been the delivered to it; and (ii) the LLC had retained the right during that 5-year period to transfer the theatre to Richmond Dance once the IRS recognized its tax exempt status.

The Agreement also said “these provisions shall survive the closing.” The Sales Agreement also stated that the deed conveying the theatre to the strawman charity was to include a 5-year restriction barring the strawman charity from transferring the theatre to any party other than Richmond Dance. From these provisions, the Tax Court concluded that the LLC could direct the transfer of title to the theatre for 5 years, which afforded the LLC a substantial “ – indeed paramount- element of dominion and control over the subject of the purported gift, exercisable against the purported donee after the transfer of legal title to it.”

As a result, because there was no completed gift, the donor was not entitled to a charitable income tax deduction for the transfer of title of the theatre to the charity. Because there was no completed gift with the transfer of title to the charity, the value of the ‘gift’ to the charity was $0.00. This meant that Mr. Farkiris’ reported charitable income tax deduction was zero. This, in turn,  led to a gross valuation misstatement on Mr. Farkiris’ income tax return. As a result, Mr. Farkiris was liable for a 40% accuracy related penalty on his income tax returns. [IRC 6662(h). .

Mr. Farkiris’ income tax deductions of $1,138,886, $594,111, and $143,516 were all disallowed because the LLC’s gift to the strawman charity was not a completed gift, due to the retained dominion and control which was sustained in the Tax Court’s November decision, including the 40% penalty for misstating his income tax liability.

Conclusion: Just because a transfer has been made does not mean that a completed gift occurred. It is important to review the terms of a trust, or the terms of a Sales Agreement, to determine if the donor has in fact relinquished complete dominion and control over the transferred property. If there is some control, direct or indirect, then there is no completed gift, and the result may be estate inclusion or the loss of a charitable income tax deduction.