October 17, 2023
Annual Exclusion Gifts – Don’t Make Any Assumptions
Take-Away: As the end of the calendar year nears, many individuals are considering making gifts, relying upon the availability of the federal gift tax annual exclusion opportunity. It is important to keep in mind that in order to qualify as an annual exclusion, the gift must be of a present interest and that gifts to grandchildren in trust have additional requirements to be met in order to qualify for the generation skipping transfer tax annual exclusion opportunity.
Background: Most of us are familiar with the federal gift tax annual exclusion which exempts from federal gift tax (or the use of the donor’s available applicable exemption amount) the gift if: (i) the amount is less than $17,000 in 2023 (probably increasing to $18,000 starting in 2024); and (ii) the gift is a present interest. While the federal gift tax annual exclusion amount is easy to understand, that ease can lead to assumptions that may come back and surprise the donor.
Limited Annual Exclusion Amount: As noted, the annual exclusion maximum amount is $17,000 per donee. [IRC 2503(b).] This amount is adjusted periodically for inflation. The current projection is that the gift tax annual exclusion amount for 2024 will be adjusted for inflation to $18,000 per donee. That’s the good news.
Unlimited Number of Annual Exclusion Gifts (Currently): Currently there is no limit on the number of annual exclusion gifts that a donor may make in a calendar year. However, Treasury’s 2024 Greenbook identifies a recommended tax revenue generator by limiting the number of annual exclusion gifts that a donor can make to a trust of up to $50,000. While that is not the law currently, there have been many proposals in the last couple of years that would also limit either the number of annual exclusion gifts that a donor can make in a single year (one Bill provides up to 10) or the aggregate amount of gifts that can be made by the donor in reliance on the annual exclusion gifting opportunity, e.g., no more than $100,000 in another Bill. None of the changes are part of the law, but as Congress begins to search (perhaps in earnest) for new tax revenues, the annual exclusion gift opportunity seems to be a target that could attract some bipartisan support. That’s the bad news.
Present Interest Requirement: In order to qualify for the federal gift tax annual exclusion opportunity, the subject of the gift must be a present interest. A present interest is defined as an unrestricted right to the immediate use, possession or enjoyment of property or the income from the property. [Regulation 25.2503-3(b).]
Trusts: Often a transfer to a trust, in order to meet this present interest requirement, will provide that the beneficiary of the trust possesses a limited right to withdraw the transferred amount, a so-called a Crummey Withdrawal Right. [Crummey v. Commissioner, 397 F.2d 82 (9th Circuit, 1968.)] The beneficiary’s right to withdraw the transferred amount thus satisfies the present interest requirement that the beneficiary must have the immediate access to possess the transferred asset or amount. Note, however, that some older trust instruments tie the beneficiary’s withdrawal right to a time when the annual exclusion amount was much lower; for many years the annual exclusion amount was pegged at $10,000. Consequently, a gift to a trust with a Crummey Withdrawal Right should not be presumed to be the current maximum amount of $17,000; if the amount withdrawable under the trust’s terms is fixed at $10,000, the donor’s $17,000 gift to the trust, subject to the beneficiary’s withdrawal right, will only shelter $10,000 of the $17,000 amount transferred from federal gift taxation. Check the terms of the trust to confirm that the withdrawal right is tied to the current federal gift tax annual exclusion amount, and do not assume that the currently higher amount will automatically apply.
Business Interests: The transfer of a business interest to a donee also might not meet the present interest requirement, even though if falls below the federal gift tax annual exclusion amount. The gift of an interest in an entity might not qualify for the annual exclusion depending on the terms of the business’ existing operating agreements. Recall that the donee with a withdrawal right must possess an unrestricted right to the immediate use, possession, or enjoyment of the property or the income from the property for it to satisfy the present interest requirement. The same applies when the gift is not in trust, but in a closely held business interest. Often those entity agreements do not permit the donee the immediate access to the enjoyment of the underlying property owned by the entity. Rather, often in family business situations, the entity contains many restrictions on access to, and the transfer of, interests in the entity in order to claim valuation discounts for the transferred interest. And some entities leave the distribution of income to a controlling manager with no ‘right’ to the immediate enjoyment of the donee’s pro rata share of entity income.
Example: A classic case where this problem arose was Hackl v Commissioner, 118 Tax Court 279 (2002), affirmed 335 F.3d 664 (7th Circuit, 2003). In that case vacant farm/agricultural land was transferred by Mr. Hackl to an LLC. Mr. Hackl then gifted LLC units to his children. Mr. Hackl claimed that these gifts of LLC units to his children were annual exclusion gifts. The IRS successfully challenged the claimed annual exclusion gifts because: (i) there was no assurance that any distribution of income would be made to the child-member, because the land was at that time unproductive; and (ii) the LLC’s operating agreement failed to give the child-member the right to immediately withdraw from, or liquidate, his/her interest in the LLC by forcing the redemption of the gifted LLC units. From these facts and the LLC’s Operating Agreement’s restrictions, both of these courts found that the transferred LLC units to the donor’s children were not present interests, i.e., the donee-child had no control over the units, could not immediately convert them to cash by selling them, and had no right to compel the distribution of income from the transferred LLC units. In short, like many family situations, while dad made the gifts, dad stayed in complete control of the entity and those who held interests in the entity. Accordingly, before any gift is made of an interest in a closely held entity, the existing operating or buy-sell agreements need to be carefully reviewed to confirm if the donee of an interest in the entity can immediately possess/control/ enjoy the transferred interest in order to satisfy the present interest requirement.
Suggestion: If the subject of an annual exclusion gift is an interest in a closely held entity like a partnership or LLC, consider giving the donee a ‘put’ right that forces the donor to ‘buy-back’ the transferred interest for a short period of time after the gift is made, e.g., 30-45 days, in order to be able to show the IRS that the donee could claim an immediate right to the enjoyment of the gifted asset simply by exercising their limited ‘put’ right to convert their interest in the closely held entity to cash, or cash equivalent assets.
GST Implications: Yet another area where some assumptions can lead a donor astray is with regard to the generation skipping transfer (GST) tax exemption, which is also currently $17,000, and which is also subject to the present interest requirement. Just because a gift qualifies for the federal gift tax annual exclusion amount does not mean that the same gift will automatically qualify for the generation skipping transfer tax annual exclusion amount. Additional rules apply in order to qualify for the GST annual exclusion. Assume a gift is made in trust in the annual exclusion amount ($17,000) over which the trust beneficiary, a grandchild of the donor, possesses a withdrawal right (a Crummey Withdrawal Right.) That transfer to the trust will meet the federal gift tax annual exclusion rule. However, with regard to the GST annual exclusion amount, additional requirements must be met in order to qualify for the federal GST tax annual exclusion amount. For example, the trust to which the gift is made must: (i) benefit only one skip person, i.e., one grandchild; and (ii) the trust’s assets must be includible in the skip person/ grandchild’s estate if the trust does not terminate prior to the skip person/grandchild’s death. [IRC 2642(c)(2).] The Crummey Withdrawal power does not meet these requirements and consequently, the transfer to the trust does not qualify for the GST annual exclusion opportunity, but it would qualify for the federal gift tax annual exclusion opportunity.
Conclusion: When it comes to making annual exclusion gifts, remember the present interest requirement can be fact-specific. In addition, do not assume that satisfying the federal gift tax annual exclusion opportunity automatically satisfies the GST annual exclusion opportunity if the transfer is made by the donor to a trust with withdrawal rights held by more than one beneficiary.