Whether annual exclusion gifts may be made from revocable living trusts has been the subject of some concern since Private Letter Ruling 8609005.(1) If they may, the issue becomes how such a transfer can be effectuated safely. With one exception,(2) the issue has been addressed solely by private letter rulings within the Service.

The problem, as you may recall, is whether, if a grantor of a revocable trust directs annual exclusion gifting of trust property, that gift constitutes a "relinquishment of a right to revoke" under Section 2038 of the Code, which if made within three years of death is brought back into the grantor's estate under Code Section 2035.

In P.L.R. 8609005, supra, the Internal Revenue Service held that where a revocable living trust in terms permitted annual exclusion gifts to certain named beneficiaries, and such gifts were made within three years prior to death, they were included in the grantor's estate under 2035 and 2038.

Section 2038(a)(1) reads in pertinent part:

"The value of the gross estate shall include the value of all property . . . [t]o the extent of any interest therein of which the decedent has at any time made a transfer . . . where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power . . . to alter, amend, revoke, or terminate, or where any such power is relinquished during the 3-year period ending on the date of the decedent's death." (Emphasis added)

Section 2035, which provides in Subsection (a) that transfers within 3 years of death are includable in the gross estate; in Subsection (b)(2), that gifts for which a gift tax return was not required are excepted; and in Subsection (d)(1) that estates of decedents dying beginning in 1982 are also excepted; also provides in Subsection (d)(2) that

"[the exceptions] shall not apply to a transfer of an interest in property which is included in the value of the gross estate under section 2036, 2037, 2038, or 2042 or which would have been included under any of such sections if such interest had been retained by the decedent." (Emphasis added)

Before analyzing P.L.R. 8609005, it may be helpful to look at some of the more clear (but probably rare) examples of what is included (and what is not included) by Section 2038. If D deeds a $10,000 parcel of real estate to A and reserves a power to terminate, the retained power is included under Section 2038. If he subsequently conveys that power to A, and dies within three years, the relinquished power is includable under Section 2038.

Suppose, further, that D deeds to A, reserving the same power of termination. Then suppose that D exercises his power, and deeds the property to X, dying immediately thereafter. What is included in his gross estate? Clearly nothing. He has not retained a Section 2038 power, nor has he relinquished it.

Now let us suppose that D deeds $10,000 of assets to T, in trust for D, A, B, and C, during life, with discretionary power in the Trustee to distribute income and principal for the benefit of any or all of them, and that D retains a right of revocation. When D dies, Section 2038 causes inclusion of the entire trust corpus, because of the retained right to revoke. And if D shortly prior to death relinquishes the power to the donees by making the trust irrevocable, Sections 2038 and 2035 cause inclusion.(3)

What if D by direction to the trustee causes a gift of the trust property to be made to X, and then dies within three years? Quite clearly, nothing is includable in X's gross estate. The exercise, as distinguished from the relinquishment, of a right to revoke, does not trigger Sections 2038 and 2035.

And then let us consider what the result would be if D causes the trustee to make a gift of the trust property to A. Logically, the transaction seems to be an exercise of D's right to revoke, or at least the relinquishment in gross of the power to revoke, rather than what was clearly intended to be covered by the section, the conveyance of the right to revoke to the donee of the power. That is, it is one thing to terminate a right to revoke as to an otherwise completed gift, and something else to give up a right to revoke as to prospective discretionary transfers. The Service, however, would view it otherwise, as a relinquishment of D's power of revocation, and does not make the distinctions I suggest.

The problem in the real world of things is acute. Many clients have revocable living trusts, have given durable powers of attorney, and are nonetheless competent to direct their affairs. When such a client wishes to make annual exclusion gifts to his or her families, he or she probably has three options: making the gift directly to the family member; requesting the agent under the durable power to do so, or asking the trustee of his or her living trust to make the transfer. The selection of the course of action typically involves considerations of economy of effort, location of the asset, and ease of generating appropriate records. Typically, these considerations would indicate that the gift should be given from the revocable living trust. The client does not have to attend to finding the stock certificates, locating the transfer agent, preparing transfer instructions, arranging insured mailing to the transfer agent, or generating an appropriate record. The client need only to write a letter to the trustee and request that the transfers be made. And so this course often has been taken, probably without much thought to estate tax considerations. The property in the living trust was just like the Grantor's own, wasn't it?

If the client has four children, each of whom has three children, and makes maximum annual exclusion gifts for 3 years, the date-of-gift value of the transfers will equal $120,000. If these gifts involve property appreciating at 30% per year, the figure can exceed $250,000 (remember, 2035 picks up property at date of death values). If husband and wife gifts are involved, the figures double to perhaps $500,000. At a 50% tax bracket, the situation rapidly becomes disastrous if something goes wrong. In an area where arrangements may be viewed retrospectively and taxed retroactively, caution should prevail.

The positions of the Treasury appear only, at the moment, in Private Letter Rulings which, in themselves, disclaim precedential value. However, a word to the wise would seem to be sufficient. We will discuss these in chronological order.

The problem was first stated in Private Letter Ruling 8609005, supra. There, D executed a funded revocable living trust with independent trustees, which gave the trustees the discretion to pay income and principal to D, and to make annual gifts to A, B, C, and E in amounts up to $10,000 for each of years 1983, 1984, and 1985. Such gifts were made for 1983, and D died. Held, the distributions by the trustees were relinquishments of D's power over the assets, and 2038 applied to make the gifts includable; and 2035 applies as well because, had the power to revoke thus released been retained, the assets would have been includable.

Though the facts upon which this ruling was based present, of those of all the rulings, perhaps the best case for inclusion, I submit the ruling is in error. If D had made the whole trust irrevocable instead of the trustee making the gift, that act would have been a Section 2038 event (relinquishment of a power to revoke). But as the transaction was cast, it is much more reasonable to distinguish between the release of a right to revoke to an existing donee, and the release of a right to revoke in gross, where the donees are all future, unascertained and discretionary, viewing the former as a relinquishment within the meaning of the rule, and not the latter. To me, the Section implicitly requires that there be a relinquishment to the donee of an otherwise completed gift of a right to revoke.

Then came Private Letter Ruling 9040003, June 30, 1989. Again, A executed and funded revocable living trust agreement distributable, on A's death, to A's estate. A directed the trustee to make annual exclusion gifts to certain descendants, which were made. Held, since A was the only interested party in the trust, and no distributions could be made to others even on death, A was the owner and the entire trust was treated as an agency, and includable under 2033, not 2038. Further, since 2038 did not apply, 2035(d)(2) did not either. The annual exclusion gifts stand.

P.L.R. 9010004, November 17, 1989, also involved a revocable, funded living trust, but this one was self-trusteed. During A's lifetime, A had the power of direction of distribution of income and principal. In the event of A's disability, the trustee could make discretionary distributions of both for the benefit of A and her dependents. On death, distributions to A's descendants were provided for. A made annual exclusion gifts by signing stock powers and delivering them and the shares to the transfer agent. The Treasury interpreted the facts as a revocation of the trust as to those assets rather than an amendment and a relinquishment to benefit third persons, and accordingly allowed the annual exclusion gifts. It distinguished the case where third parties could benefit from the trust.

P.L.R. 9010005, issued on the same day, November 17, involved a revocable funded living trust with permissible lifetime distributions only to A, the grantor. On death, distribution was to be made to A's relatives. A directed her trustee to make annual exclusion gifts, and in doing so specifically relying upon and referring to her right to withdraw principal. Held, the annual exclusion gifts were allowed. The Treasury relied upon the fact that "the gifts could only have been transferred out of the trust pursuant to the exercise of A's power to withdraw trust corpus for A's benefit." Accordingly, Sections 2038 and 2035 did not apply.

Ruling 9015001, December 29, 1989, involved a revocable funded living trust. During life, income and principal were to be paid to the grantor or as grantor directed. During grantor's disability, the trustees were given the power to make similar distributions, and were specifically given power to distribute to Grantor's children. On death, distribution was to be made to trusts for the benefit of Grantor's family. Grantor instructed the trustees to make annual exclusion gifts. Held, the transfers are includable in the grantor's gross estate as "lapses" or "relinquishments" of a right to revoke under 2038 brought in under 2035, over the estate's contention that the trust was simply a probate-avoiding device just like a will, which would not result in such inclusion:

"Although . . . there is little substantive difference between the use of a revocable trust and a probate estate/will arrangement . . . , the form employed is significant in the context presented here. That is, the form of the transaction (utilization of a revocable trust) necessarily dictates the application of section 2038 which, under the language of the statute, triggers the application of section 2035(d)(2). Indeed, if section 2035(d)(2) does not apply in a situation involving transfers from a revocable trust such as that presented here, then the reference in that section to a 'transfer . . . which . . . would have been included under [section 2038] if such interest had been retained,' would be rendered meaningless."(Emphasis added)(4)

Further, the Treasury rejected the claim that the transfers should be characterized as transferred out of the trust, by the trustee acting as agent, pursuant to power to withdraw, in view of the grantor's power to direct distribution to others. Treasury also rejected the estate's contention that the transaction should be viewed as the exercise of a 2041 general power, upon which 2035 does not operate, rather than a 2038 power of revocation relinquishment: even if 2041 applies, 2038 does too, and 2035 applies anyway, the Service held.

In P.L.R. 9016002, the revocable funded living trust provided for payment of income and principal as the grantor "shall from time to time direct". Annual exclusion gifts at the direction of the grantor were made from the trust. Held, the distributions were relinquishments of grantor's right to revoke, includable in her gross estate. Again, the Treasury relied upon form, and also rejected the estate's eminently reasonable suggestion that the transfers should be viewed as transferred out of trust by the trustee as agent.

In P.L.R. 9017002, a funded revocable trust provided for income distributions to grantor or as she directed during life, for principal distributions "to me" as directed, and after death to trusts for her children. Grantor directed the trustee to make annual exclusion gifts. Held, the gifts "could only have been transferred . . . pursuant to the exercise of D's power to withdraw trust corpus for her own benefit" and were accordingly excluded from her gross estate. Sections 2038 and 2035 do not therefore apply.

The most recent ruling is 9018004, January 24, 1990. A funded, revocable living trust directed the trustee to pay income to the grantor and such principal to the grantor as he may in writing request. Additionally, the grantor reserved the right to "direct the trustees as to the retention, acquisition, sale or other disposition of the trust assets by an instrument in writing". Annual exclusion gifts were made. Held, the "disposition" powers were administrative, not dispositive. The stock could only have been transferred out of the trust pursuant to grantor's power to withdraw corpus. Sections 2038 and 2035 do not apply.

Some general conclusions can be drawn from the rulings. One is that if the language of the trust clearly authorizes principal distributions only to the grantor, the gifts will be deemed withdrawals of principal and will not be included in the gross estate, at least if the right is clearly and specifically exercised.(5)

Further, we conclude that if withdrawals of principal are involved, 2035 and 2038 do not apply. Ibid.

Moreover, the rule seems to be that unspecified distributions from a trust in which the donees are then permissible beneficiaries during grantor's lifetime will trigger the operations of Sections 2038 and 2035.(6)

And we would observe that the Service may use agency to sustain exclusion,(7) or reject it to reach inclusion in the gross estate,(8) as it chooses.

Further, it seems that treating the distribution as exercise of a general power will not help.(9)

We also could conclude that where the grantor reserves both a power of revocation and a power of direction, it makes no more sense for the service to presume the latter is being exercised than to accept that the former is being exercised, in any particular case.

The Rulings are replete with references to donated stock, indicating the horror of a 2035 inclusion at date-of-death values and the incentive on the part of the service to find inclusion under those circumstances. I conclude that if highly appreciated assets are involved, the going gets tougher.

And in every Private Letter Ruling in which the service found for the taxpayer, the trust in terms provided that only the grantor could be the beneficiary of the trust at the time of the gift.

Also, the Service always fails to distinguish between the relinquishment to the donee of a right to revoke, and the relinquishment in gross of a right to revoke with respect to an incomplete transfer to ascertained or unascertained beneficiaries. It is this error, I submit, that causes the problem, although the first ruling, 8609005, was a good excuse for making the mistake. But in my view even 8609005 was wrong. The Trustee's making of annual exclusion gifts to named permissible donees is still the relinquishment in gross of a right to revoke as to post-death transfers to others, and should not have been picked up by Section 2038.

There is little policy justification for the result favorable to the Service in any of these rulings. If the relinquishment in gross of a power of revocation is a 2038 item, then contaminated trusts may not be repairable. If the rule implicit in the Rulings is that you must have a trust that permits principal distribution only to the grantor during his lifetime, most of our living trust agreements are in trouble and are not likely to be fixed, because discretionary lifetime distributions to others than the grantor are desirable; indeed, necessary. There is just no sense in burning down the barn.

But if form is to prevail over substance, I suggest we use form to our advantage (assuming that the problem of permissible distributees is not a fatal one). An express revocation of the trust as to specific assets, the appointment of the trustee as an agent, and a direction to the agent to transfer the revoked assets should meet the analysis of the existing Private Letter Rulings,(10) but there are no guarantees.

-oOo-

Vance A. Fisher advises and represents individuals, estates, trusts, business and institutions in various matters, including wills, estates and trusts; real estate, business and banking; contracts and taxation; and computer and other technology law. With his B. A. from Northwestern (Phi Beta Kappa 1957) and his Juris Doctor Cum Laude (Michigan, Order of the Coif 1960), a background in mathematics, and an interest in computer programming, Attorney Fisher has also pioneered the application of computers to law practice. He is a member, among other organizations, of the Committee on Estate and Gift Taxation of the State Bar of Michigan's Taxation Section, its Probate and Trust Law Section, its Computer Law Section, and the Berrien County Probate Court Advisory Committee.

The instant article was originally the subject of his address to the State Bar of Michigan's Taxation Section September 12, 1990.

Table 1.

The principal estate tax sections are as follows:

2033 - Property in which the decedent had an interest

2034 - Dower or curtesy interests

2035 - Adjustments for gifts made within 3 years of death

2036 - Transfers with retained life estate

2037 - Transfers taking effect at death

2038 - Revocable transfers

2039 - Annuities

2040 - Joint interests

2041 - Powers of appointment

2042 - Proceeds of life insurance

2043 - Transfers for insufficient consideration

2044 - QTIP property (previous marital deduction property)

Form 1

Partial Revocation of Trust

Whereas, the undersigned as Grantor and ______________ as Trustee entered into a revocable living trust agreement on _________, wherein the Grantor reserved in Paragraph ____ thereof the right, among others, to revoke the same; and

Whereas, the undersigned now wishes to revoke the same as to certain property;

Now, therefore, said living trust agreement is revoked as to the following-described assets, otherwise to remain in full force and effect: ______________________________________________.

(Grantor signature, date, trustee acknowledgment of receipt and date)

Form 2

Constitution of Agent and Direction

I hereby constitute __________________________ as my agent to receive from itself in its capacity as trustee of my living trust agreement dated _______________, the following described assets, and I hereby direct my said agent to transfer title and possession of said assets on my behalf to the following persons in the following amounts:

(Principal's signature, date)

(1) November 26, 1985.

(2) Estate of Katherine H. Perkins, Dec'd v. United States, ____ F. Supp. ____, 1990 U. S. Dist. Lexis 14824 (N. D. Ohio 1:89CV1937, Sept. 20, 1990), decided the issue squarely but superficially and heavy-handedly. One Ms. Perkins, believing her death imminent (which it indeed was), late in 1982 directed her trustees under a revocable living trust agreement to make 20 just-under-$10,000 annual exclusion gifts of corporate stock to her descendants and their spouses "as soon as possible after January 1, 1983, and assuming I am still then living." She died on January 1, and the trustees issued their directions to the transfer agent 9 days after her death, but back dated the letter to January 1.

The estate tax return was adjusted by the Service to include the gifts. In an opinion by Judge Aldrich in the refund suit filed after disallowance of the Estate's claim, the Court held for the Service: the gifts were includable. No appeal was taken from the Order embodied in the opinion dismissing the Estate's complaint with prejudice.

Oddly, the Court did not find either that the gifts were never completed during Ms. Perkins' life, or that the condition precedent expressed in the gift directive had failed, but rather applied Sections 2035 and 2038, noting that the trust was "for the benefit of herself and others," and that she retained the right to revoke and withdraw. The Court rejected the Estate's suggestion that the gifts represented a withdrawal of corpus followed by a transfer to the donees: she had directed the trustees to make the transfer.

(3) I suggest that Section 2036 would also cause inclusion.

(4) I suggest that the application of Section 2038 is different from that contended by the service, and its application to the hypothetical situations discussed above is quite more clear.

(5) Private Letter Rulings 9010005 (November 17, 1989), 9017002 (January 5, 1990), and 9018004 (January 24, 1990).

(6) Rulings 8609005 (November 26, 1985), 9015001 (December 29, 1989), and 9016002 (December 29, 1989).

(7) Ruling 8940003 (June 30, 1989).

(8) Ruling 9016002 (December 29, 1989).

(9) Ruling 9015001 (December 29, 1989).

(10) See Forms 1 and 2.