In Chief Counsel Memorandum 201208026, the IRS has indicated its hostility to the use of testamentary powers of appointment to avoid gift tax through the creation of incomplete gifts in many circumstances.
Facts. Two donors transferred property to a trust. Their adult child is the sole trustee. The trust beneficiaries are the donors' children, other lineal descendants, and their spouses. The trust is irrevocable, and the donors have no power over income or principal. However, they do have testamentary limited powers of appointment. The trustee has absolute and unreviewable discretion to administer the trust for the beneficiaries or a charitable organization.
The Issue. Whether the retained testamentary powers of appointment resulted in incomplete gifts. More particularly, did the grantors depart with sufficient dominion and control over the transferred property to constitute a completed gift?
Treas. Regs. § 25.2511-2(b) provides the general rule as to what is a complete (or incomplete gift). It provides:
As to any property, or part thereof or interest therein, of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another, the gift is complete. But if upon a transfer of property (whether in trust or otherwise) the donor reserves any power over its disposition, the gift may be wholly incomplete, or may be partially complete and partially incomplete, depending upon all te facts in the particular case.
Who Cares? Before diving into the issue, the question is who is affected? Using a power of appointment to create an incomplete gift is a popular planning device that allows a transfer of assets to an irrevocable trust without incurring a current gift tax. It is heavily used in asset protection trust planning - that is, to move assets into a trust that is protected against the donor's creditors. This protection may arise from general creditor protection principles as an irrevocable transfer that does not otherwise run afoul of fraudulent conveyance concerns. Or perhaps it involves a transfer to a creditor protection trust in a state or foreign jurisdiction that provides explicit creditor protection for the grantor, even if the grantor retains a discretionary term interest in the trust. Anyone who has used a testamentary power of appointment to avoid a current gift on such transfers has cause for concern, since what was thought to be a nontaxable transfer may now be a taxable gift.
IRS Methodology. The CCM analyzed the income and remainder interests separately. The CCM concluded that the powers of appointment only affect the remainder interests. They have no impact on what beneficiaries will receive distributions during the term interest nor which beneficiaries will receive distributions. Therefore, the portion of the gift relating to the term interest is complete.
What About Treas. Regs. §25.2511-2(b)? A major source of authority that a retained testamentary power of appointment creates an incomplete gift is Treas. Regs. §25.2511-2(b). That Regulation provides:
…if a donor transfers property to another in trust to pay the income to the donor or accumulate it in the discretion of the trustee, and the donor retains a testamentary power to appoint the remainder among his descendants, no portion of the transfer is a completed gift. On the other hand, if the donor had not retained the testamentary power of appointment, but instead provided that the remainder should go to X or his heirs, the entire transfer would be a completed gift.
This language is clear, at least if the donor as the only term income beneficiary. However, in the CCM, the donors had no retained interest in the term interest. Presumably, this was enough to distinguish away the Regulation, although the Chief Counsel Memorandum did not discuss the application (or nonapplication) of the Regulation.
But is failing to have a retained discretionary income interest in the grantor enough of a fact change to warrant the rejection of the Regulation's incomplete gift finding? On the one hand, one can argue yes. Looking at the term interest, if the donor is the sole discretionary income beneficiary, at the time of the gift it can be said with certainty that nothing will be going out to third parties during its term, so there should be no gift. While accumulated income will eventually go to the remaindermen, the remainder interest is clearly incomplete per the testamentary power of appointment. If the grantor is not the beneficiary of the term interest, then a different result like the CCM may be called for. Thus, there is an argument that the identity of the term interest beneficiaries is relevant to this analysis. However, it would seem that these matters go more towards the value of what is given away (i.e., the AMOUNT of the gift) rather then retained dominion and control (i.e., whether the gift is complete) since in either situation the grantor is not making the decisions on distributions during the term interest.
On the other hand, the Regulation provides that if there was no testamentary power of appointment, there is still a gift of the "entire transfer." The retained interest of the donor is ignored - but again, it may enter into the value of the gift. Since in that situation there is a gift of the "entire transfer," one can craft an argument that it is not the retained interest of the grantor that is relevant to a complete or incomplete gift - instead it is ONLY the presence or absence of the testamentary power of appointment that dictates whether there is a completed gift. Stated another way, the retained donor interest did not avoid a gift of that portion of the trust when there was no testamentary power of appointment, so it appears to be irrelevant to the completed gift analysis.
This retained interest of the grantor factor is relevant not just for the facts of the Chief Counsel Memorandum, but as to many asset protection trusts when the donor retains a discretionary interest in income and/or principal during the term interest, along with other beneficiaries. Since there are now other beneficiaries that share the term interest with the donor, is that enough to create a completed gift notwithstanding a testamentary power of appointment? These facts fall inbetween the Regulation where the donor is the only term interest beneficiary, and the CCM where third parties are the only term interest beneficiaries. Which analysis controls - the incomplete gift conclusion of the Regulation or the complete gift conclusion of the Chief Counsel Memorandum?
The Real Kick in the Teeth - Section 2702. While the term interest may constitute a gift under the IRS analysis, the CCM advises that the gift of the remainder interest is incomplete. This means that the taxable gift is only of the portion of the value of the transferred property allocable to the term interest - right? Well, if the trust beneficiaries are family members of the donor, then, according to the Chief Counsel Memorandum, 100% of the value of the transferred property is taxable - ugh!. The Memorandum provides:
Generally, under § 2702(a)(2), the value of any retained interest which is not a qualified interest shall be treated as being zero. Section 25.2702-2(a)(4) provides that an interest in trust includes a power with respect to a trust if the existence of the power would cause any portion of a transfer to be treated as an incomplete gift. Accordingly, under § 25.2702-2(a)(4), the Donors' retained testamentary powers are interests, and the value of their retained interests is zero. Therefore, the value of the Donors' gift is the full value of the transferred property.
What We Know. The CCM raises a lot of questions. Whether the analysis is correct under its facts, and whether the holding will also apply when the grantor also has a retained discretionary interest during the term period may require a court determination.
What we do know is that relying on a testamentary power of appointment to create an incomplete gift is more risky than it was before, except if the only term beneficiary is the grantor. Planners should include some other method to bolster the incomplete gift status. Possibilities of additional methods include a lifetime limited power of appointment in the donor or a retained power to veto trust distributions - but such powers should be squared with creditor protection objectives and relevant state law, and grantor trust rules if those are an issue.
Chief Counsel Memorandum 201208026