Clauses in Trust Did Not Render Crummey Withdraw Right Illusory, But Court Finds IRS Position Sufficiently Justified Not to Award Legal Fees

The IRS lost in its attempt to claim a taxpayer’s attempt at providing a Crummey power to trust beneficiaries failed to grant a present interest in the case of Mikel v. Commissioner, TC Memo 2015-64.  The IRS’s claim was that there were effectively restrictions imposed on the beneficiary’s withdrawal rights that meant they had no real present interest.

Under IRC §2503(b)(1) an annual exclusion (with an annual cap that is adjusted for inflation) is allowed for gifts to beneficiaries of a present interest in property.  Reg. §25.2503-3(b) provides that a present interest in property is “[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the in- come from property.”

In this case the taxpayer had transferred assets into a trust with 60 beneficiaries, each of whom was required to be given notice of their right, within 30 days of notice, to withdraw the lesser of the amount of the transfer of their behalf or the federal present interest gift tax exclusion, whichever was less.  If a beneficiary did not give notice within 30 days that he/she was exercising this right, the right lapsed and the funds went into the trust.  All notices were given to beneficiaries.

So far this sounds a like a traditional Crummey structure and so you may wonder what the IRS’s issue could have been.  The IRS objected to certain provisions in the trust that dealt the handling of disputes.

First, the trust contained special arbitration requirements to deal with disputes.  As the Tax Court summarized:

If any dispute arises concerning the proper interpretation of the declaration, article XXVI provides that the dispute “shall be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith.” Such a panel in Hebrew is called a beth din. This panel is directed, in the event of any dispute, to “enforce the provisions of this Declaration * * * and give any party the rights he is entitled to under New York law.” Article XXVI states that the declaration as a whole shall be construed “to effectuate the intent of the parties * * * that they have performed all the necessary requirements for this Declaration to be valid under Jewish law.”

If a beneficiary, in spite of the above requirement to submit to arbitration by the panel, decided to bring a challenge in court or before some other venue, the trust contained a penalty clause.

That clause read:

In the event a beneficiary of the Trust shall directly or indirectly institute, conduct or in any manner whatever take part in or aid in any proceeding to oppose the distribution of the Trust Estate, or files any action in a court of law, or challenges any distribution set forth in this Trust in any court, arbitration panel or any other manner, then in such event the provision herein made for such beneficiary shall thereupon be revoked and such beneficiary shall be excluded from any participation in the Trust Estate...

The IRS argued that these provisions effectively removed any real right of a beneficiary of access to a present interest in that gift despite the language granting that right.  The Tax Court notes:

Respondent nevertheless contends that the beneficiaries did not receive a “present interest in property” because their rights of withdrawal were not “legally enforceable” in practical terms. According to respondent, a right of withdrawal is “legally enforceable” only if the beneficiary can “go before a state court to enforce that right.” This is something that respondent believes a beneficiary of the trust would be very reluctant to do.

The IRS argues that if the trustees decided, despite the language in the trust, to refuse to give a beneficiary access to the funds, and the mandatory panel refused to overturn that decision (again despite language in the trust requiring them to apply State law rights in doing so), the beneficiary would not seek relief in state court because of the forfeiture clause that the beneficiary would risking.  The IRS concedes a beneficiary could challenge such an abuse of powers, but argues the downside risk simply eliminates any real risk a beneficiary would actually risk the challenge.

The Tax Court did not accept the IRS view.  First, the Court found that the right to appeal to the arbitration panel gave beneficiaries actual redress against an abuse of power by the trustees noting:

Here, if the trustees were to breach their fiduciary duties by refusing a timely withdrawal demand, the beneficiary could seek justice from a beth din, which is directed to “enforce the provisions of this Declaration * * * and give any party the rights he is entitled to under New York law.” A beneficiary would suffer no adverse consequences from submitting his claim to a beth din, and respondent has not explained why this is not enforcement enough.

A requirement that the remedy must exist in state court was not accepted by the Tax Court.  But the Court found that even if it had decided that a beneficiary must have access to state court that such access existed here.

The Court points out the language of the legal challenge restriction appears to be directed at litigation over a trustee’s use of discretion in making distributions from the trust for the reasons specified in the trust document for the later benefit of beneficiaries and not with regard to non-discretionary distributions that would follow the receipt of a demand from a beneficiary for his/her Crummey distribution.

The IRS argued, though, that the clause also talks about filing in court for any other matter which, in the IRS’s view, would cover this issue.

The Tax Court did not buy this view from the IRS, noting that reading it as the IRS wishes would bar any beneficiary from going to court, period—not just against the trust or for issues in any way related to the trust.  While the Court does see how the clause could be read, standing alone, to deal with any court action it notes “this clause cannot be read literally; otherwise, it would bar beneficiaries from participating in the trust if they filed suit to recover for mischievous behavior by their neighbor’s dog.”

Thus the Tax Court ruled that the taxpayer was entitled to a gift tax exclusion for the gifts to the trust.

However, in subsequent litigation (Mikel v. Commissioner, TC Memo 2015-173) the Tax Court found the IRS’s position was justified enough to rule against the taxpayers’ claim for legal fees.  The Court noted:

We noted in Mikel I, at *18, that the “in terrorem” provisions were “not a paragon of draftsmanship.” A broad, literal reading of one clause arguably supported respondent’s position. Although we concluded that the best reading of the entire document required that this clause “be given a limiting construction,” id. at *19, respondent’s interpretation had a textual basis. We conclude that respondent’s interpretation of these provisions, while not the one we adopted, was “substantially justified” within the meaning of section 7430(c)(4)(B)(i).