Gifts to an irrevocable trust have long qualified for a gift tax annual exclusion because of Crummey withdrawal powers. But what happens when a trust has 60 beneficiaries and the donors put in place a no-contest clause and mandatory arbitration clauses? In the case of Mikel v. Commissioner, the IRS disallowed the gift tax annual exclusion. However, the Tax Court last month ruled in favor of the annual exclusion for the 60 beneficiaries. Its decision underscores the importance of clearly stated intentions, and the value of having life insurance in an irrevocable trust fund, including a lifetime reduction of income tax and the avoidance of income tax on assets passed on to heirs.
Important case facts
As reported in the April 15 edition of WRNewswire, an AALU Washington Report, Israel and Erna Mikel created and funded an irrevocable trust for the benefit of their family members, 60 beneficiaries in total. The trust gave each beneficiary Crummey withdrawal power, and the trustees gave the beneficiaries written notice of the gifts and their withdrawal rights, which included that the trustee must immediately distribute any demanded assets outright and free of trust.
The trust also included an arbitration clause requiring that any disputes regarding the interpretation of the disposition provisions be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith, known as a Beth Din. Further, the trust included a no-contest clause that revoked the share of any beneficiary who takes any legal action to “oppose the distribution of the Trust Estate or [to contest] any distribution set forth in the Trust…”
The donors claimed $720,000 of annual exclusions for the gifts made in the first year. The IRS disallowed the gift tax exclusion.
As stated in WRNewsire, the Tax Court held in favor of the taxpayers, finding that neither the no-contest clause nor the mandatory arbitration clause deprived the beneficiaries of their present interest under the Crummey power. With 60 beneficiaries, the interest of each was relatively uncertain. However, the court based its decision on the key rule from the original Crummey case: “all that is necessary is to find that the demand could not be [legally] resisted.”
The court didn’t question that the Crummey power created a present interest that qualified for the gift tax annual exclusion.
Important case takeaways for policyholders and life insurance professionals
• No-contest clauses are popular in drafting irrevocable life insurance trusts; they relieve the trustee of time-consuming and potentially expensive litigation. It’s interesting to note that in this case, the court found that this particular clause did not apply to the beneficiaries’ ability to enforce their Crummey powers.
• The court held that the provision in the trust requiring that disputes be adjudicated by a religious court also did not change the donor’s gift tax eligibility for the gift tax annual exclusion because the religious court was required by the trust to interpret the trust in accordance with state law. However, a drafter who wants to require binding arbitration should note that most state courts have held such clauses unenforceable when used in trusts; trust language must explicitly state that the arbitrator must apply the same state law that would be used by a state court.
• When no-contest clauses are included in a trust, it’s important that intentions are clearly expressed in a manner which does not compromise the trust interests of the beneficiaries.
Crummey withdrawal powers make life insurance in irrevocable trusts one of the most powerful ways to accumulate and pass on wealth to heirs without triggering tax consequences. When was the last time you examined the language in your irrevocable life insurance trusts? Marsh & McLennan Agency formerly Benefits Resource Group Wealth provides professional consulting services including estate planning, life insurance implementation, and implementation of trusts with the guidance of an attorney.
Marsh & McLennan Agency formerly Benefits Resource Group Wealth Management offers a free audit of your life insurance policy. We encourage you to contact Charles J. Farro to ensure your policy is updated the way it should be and that intentions are clearly stated regarding your wishes. Chuck is the president and co-founder of Marsh & McLennan Agency formerly Benefits Resource Group. You can contact him by phone at 216-393-1818 or email firstname.lastname@example.org.