Did You Make a Taxable Gift in 2019? Don’t Overlook Gift Tax Filing Requirements When Funding Trusts

By Christopher D. Wright  |  February 11, 2020

2020 is here, which means it is time to gather your 2019 tax information and consider any actions you took in 2019 that will impact your tax filing. Did you make any gifts over the course of the year? Many of us give our kids, relatives and friends birthday and holiday gifts. Maybe you gifted your son or daughter with some cash to help with the purchase of a house or new car. If these gifts to an individual total over $15,000 ($30,000 if you are married and gift-splitting), you will need to inform your friendly CPA and file a gift tax return. While cash gifts of this nature are fairly straightforward (as are their impact on tax filings), there is an often-overlooked instance of the gift tax that has the potential to generate quite a headache come April—funding a trust.

HOW IS FUNDING A TRUST CONSIDERED A GIFT?

You may be asking, “I transferred money to a trust, not my children, so how is that a gift?” The answer is that it depends. Was the trust a revocable trust or an irrevocable trust? Transferring assets to your revocable trust is not a gift—because you still have total control over the assets in a revocable trust (and can therefore revoke it at any time), the funding is not considered a completed gift as you did not really give it away. In the case of funding an irrevocable trust, however, the outcome and necessary steps are completely different.

In most cases, transferring assets to an irrevocable trust will be a gift for gift tax purposes¹. One of the key issues to consider when making gifts to a trust is, does that gift qualify for the annual gift tax exclusion? This depends on whether the trust contains what are known as Crummey withdrawal rights. Do some or all of the beneficiaries of the trust have the right to withdraw some or all of the current addition to the trust within a specified time period? If they do, then the transfer to the trust is considered a present interest gift and each withdrawal right holder qualifies for the annual exclusion.

Example: Jerome has created an irrevocable trust for the benefit of his two children. The trust agreement provides that in each year in which an addition is made to the trust, both children have the right to withdraw up to the annual gift tax exclusion amount within 30 days. In 2019, Jerome transferred $30,000 to the trust. Since each of his children has the right to withdraw up to $15,000, the gift to the trust will not be a taxable gift as it falls under the annual exclusion amount. However, a gift tax return should still be filed to report the gift to the trust and that two annual exclusions are applied to the trust.

What if, in addition to the above $30,000 Jerome transferred to the trust, he also gave each child $10,000? The total gift deemed made to each child is now $25,000, and Jerome has made a $10,000 taxable gift to each of his children. This will result in the utilization of $20,000 of Jerome’s lifetime exemption (currently $11.4 million).

Now, let’s consider a scenario where Jerome’s children do not have a withdrawal right. The gift of $30,000to the trust would now be considered a “future interest” gift and does not qualify for the annual exclusion.² The entire $30,000 would be a taxable gift and use $30,000 of Jerome’s lifetime exemption. What if the trust also has the descendants of Jerome’s children as beneficiaries? Well, all of this would be further complicated!  The addition of a second generation to the class of beneficiaries has Generation Skipping Transfer (GST) implications, as the trust now has skip and non-skip beneficiaries and may be a GST trust.³

The significance of a gift to a GST trust is that it is potentially subject to both gift tax and the GST tax. While the gift may qualify for the gift tax annual exclusion, it may not qualify for the GST annual exclusion.⁴ This means that while the gift may not be subject to gift tax, it will be subject to GST tax. Under current law, there is a separate lifetime GST exemption of $11.4 million. It is separate from the gift and estate tax lifetime exemption. Gifts made to GST trusts are considered indirect gifts, and as such are subject to automatic allocation of the GST lifetime exemption unless an election to “opt out” of the allocation is made on a timely filed gift tax return.

Not making this election out of the automatic allocation rules can lead to unnecessarily using a portion of the GST lifetime exemption. This is particularly true of Irrevocable Life Insurance Trusts (an ILIT). In general, most ILITs are drafted so that the primary beneficiaries are the spouse of the donor or the first generation. However, the grandchildren are often also potential beneficiaries of the trust, thus causing the trust to be a GST trust, with any gifts to the trust being subject to the GST automatic allocation rules.

Example: Jerome has created an ILIT for the benefit of his children and grandchildren. Under the terms of the trust, the primary beneficiaries are his children, and they will ultimately receive the proceeds of the life insurance policy outright upon Jerome’s death. The grandchildren of Jerome are contingent beneficiaries should his children predecease him, after the trust is created. The trust creates withdrawal rights in both the children and any grandchildren at the time of the addition. Jerome contributes (or pays directly) an amount sufficient to pay the premium on the life insurance policy owned by the trust. The annual premium is $45,000. Jerome has two children and one grandchild and is not gift splitting with his husband. Jerome has made no other gifts.

At first glance, Jerome might think he has not made any taxable gifts because, as discussed earlier, the trust is assigned three annual exclusions, one for each withdrawal right holder. This is correct for gift tax purposes, but since the ILIT is a GST trust, and the addition to the trust does not qualify for the GST annual exclusion, the transfer to the trust is subject to GST and the automatic allocation rules. If Jerome does not file a gift tax return, $45,000 of his lifetime GST exemption will be automatically allocated to the trust. This is using GST exemption when there would have been no GST implications upon the death of Jerome. Since the intent of the trust is for Jerome’s children to receive the life insurance proceeds outright at his death, that distribution from the trust to his children would not be subject to GST tax as they are not skip persons.

The only way for Jerome to avoid the GST exemption being allocated to the trust is to timely file a 709 and elect out of the GST automatic allocation rules. By doing this, there will be no taxable gift tax, because the gifts qualify for three annual exclusions and no GST exemption will be allocated because he elected out of the automatic allocation rules.

CONCLUSION

When you are determining what gifts you made in 2019, ask yourself the following questions:

1. Did I make gifts totaling more than $15,000 to any individual, charity or trust?

2. Do I have an irrevocable trust in which I made additions?

3. Did I pay the life insurance premiums on a policy held by a trust?

For most taxpayers, the events in #2 and #3 would not immediately cause them to think of filing a gift tax return. However, if the answer to any one of these is yes, there will be a gift tax return filing requirement. Knowing this ahead of time can make things much easier for you and your tax advisor when filing time comes. Understanding the ways in which funding a trust can impact your current year taxable gifts and the utilization of your lifetime exemption for both regular gift and GST tax is very important. Speak to your tax advisor to ensure that any funding of a trust is reported correctly for gift and GST tax purposes.

¹ There are instances when transfers to an irrevocable trust will not be gifts because the grantor has retained incidence of ownership or control that would cause inclusion in the grantor’s estate upon her death. In this case the transfer is not considered a completed gift and no gift has occurred for gift tax purposes.
² In order for a gift to qualify for the annual exclusion, it must be a present interest gift. A present interest gift is one where the donor has no ability to take the gift back and there are no restrictions on the use of the gift by the donor.
³ The classification of a trust as a GST trust is very complex; generally speaking any trust that has more than one generation as potential beneficiaries is a GST trust. There are numerous exceptions to this rule.
⁴ In general, most GST trusts do not qualify for the GST annual exclusion, even if there are withdrawal rights in the second generation beneficiaries.

About Christopher D. Wright