Throughout history people have sought to provide for their decedents in one way or another and the various laws on Wills, Trusts and Probate provide uniquely beneficial ways for parents to gift to their children, grandchildren, etc. Significant tax benefits can accrue if the gifts are made in the correct manner but the very nature of gifting assets to a minor or to possibly immature children requires the wise donor to carefully consider how the gift should be made. Good legal and tax planning can achieve protection for children and grandchildren and very valuable tax benefits being available.
The reader should first review our basic article on Wills and Trusts as well as Section 529 College Savings Plans and Life Insurance Trusts before reading further.
Gifts To Minors
To provide for your child or your grandchildren's future educational costs, or just to provide the child with a nest egg, you may wish to transfer assets to a minor. As a bonus, there can be useful tax advantages in the estate, gift and income taxes that could be saved as a result of the gift.
There are many ways to transfer ownership of assets to minors.
1. The easiest way to transfer property to a minor is to transfer the asset to the child's name. However, this transfer is usually undesirable because it may be difficult for the minor to sell the property based on the general law of contracts which limit the ability of minors to own and transfer property and assets. Alternatives to such outright transfers are the use of guardianships or custodianships.
2. Guardianships involve court appointed guardians that manage property for minors. They are expensive and are usually used when minor children are orphaned and trusts have not been established for property left to them.
3. Custodianships are created under the Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA). As a donor you may transfer money, securities, and insurance contracts under the UGMA. Under the UTMA, which has been adopted in several states, you may also transfer real and personal property, partnership interests and other property interests.
Transfer of property under the UGMA and UTMA allows the donor to retain control of and handle the property for the benefit of the child. It does not require any legal document. Accounts established under UGMA or UTMA should bear the child's social security number. The assets placed in the account qualify for the annual gift tax exclusion and the gift is irrevocable at the time of the transfer. When the minor reaches majority (which differs from state to state) all property must be delivered to the child.
In some states, as in Delaware, although the age of majority is 18 you can specify that the account be maintained until the child reaches age 21.
Generally, income earned on UGMA accounts is taxed to the child. However, if the income is issued to discharge a legal obligation of someone else, such as the child's parent, the income will be taxed to that person. Some states consider college education to be an item of support. For example, in New Jersey, college is a support item while in Delaware it is not. This will affect the taxation of the income earned on a UGMA account.
The main advantage to a UGMA account is its simplicity, low cost and ease of administration.
There are potential disadvantages including:
a. its inflexible distribution requirement at age of majority,
b. inability to transfer certain assets to such accounts,
c. questionability of education as a support item and
d. loss of the parents' control over assets if the parent is not the custodian.
Use of Trusts
The most common estate planning tool after a Will to achieve transfers to others in the United States is the Trust and, as could be expected, they can be remarkably useful when used in gifts to minors. Most of the disadvantages listed above are avoided and, further, the donor can include numerous clauses that can give particular guidance and protection for the child receiving the gift. Thus, when you want to transfer assets to a minor child you should explore the use of trusts. Trusts provide an opportunity to meet your objectives since they are very flexible and can be structured to provide for your needs.
Also, there is no restriction on the types of property that can be transferred to a trust. The Tax Reform Act of 1986 significantly limits the income tax benefits of trusts for children under age 14, but there are still income tax benefits to be derived. Trusts continue to be advantageous for estate planning purposes.
When transferring property to a trust it is usually important for the gift to qualify for the annual gift tax exclusion. Currently, that allows twelve thousand dollars a year to be transferred to a person without using up the lifetime gift tax exemption of one million dollars. (See our Newsletter Number 9 on the Tax Relief Act for details on these taxes.) In order for a gift to qualify for the annual exclusion, it must be a gift of a present interest. This means that the donee must have the present right to use, possess or enjoy the property. Therefore, the trust must be carefully drafted to provide for this present interest.
1. Section 2603 (c) Trust. The Internal Revenue Code provides for several types of trusts which qualify as gifts of a present interest. One of these trusts is a Sec. 2503 (c) trust. To comply with Sec. 2503 (c) the principal and the income from the trust must be available for distribution while the donee is under age 21; accumulated principal and income must be distributed when the donee reaches 21; and if the donee dies before reaching 21 all principal and income must be paid to either his estate or to the donee's appointee. In effect, this statute waives the present interest rule for donees under the age of 21 who use this type of trust.
2. Sec. 2503 (b) Trust. In this trust income must be distributed annually to the donee. The trustee can be given the discretion to make distributions of principal while the donee is a minor.
The principal may be distributed to the beneficiaries at a prescribed age after majority or the donee can demand portions of the principal at certain ages. Since this type of trust is considered to have a present interest and a remainder interest, only the present interest qualifies for the annual gift tax exclusion. The donor would use a small part of the unified estate and gift tax credit to transfer the remainder into the trust.
3. Crummy Power Trust. In this Trust, named after the Ninth Circuit Case Crummey v. Commissioner, the terms try to circumvent the restrictive provisions of Sec. 2503 (c) & Sec. 2503 (b) trusts. It neither requires the distribution of principal at age 21 nor the mandatory annual income distribution. The Crummy Power gives the beneficiary the power to demand the trust property, when transferred to the trust for a specific period of time, i.e. 30 days. The IRS has conceded that if the beneficiary has a sufficient withdrawal period and the beneficiary is a given notice of this right, the gift will qualify as one of present interest. Therefore, the Crummy Trust provides the donor with more flexibility in his planning.
As discussed, the trust provisions are very technical but any experienced estate planning attorney can create a Crummy Trust which maximizes the tax benefits and yet gives tremendous flexibility to the donor.
It is true that the beneficiary will have to have a finite period of time to obtain what has been donated that year and cannot be stopped if the donee wishes to seize those particular assets. However, most donors make it clear that future donations to the Trust will depend on the donee not invading the trust assets until final distribution and thus the risk is relatively minor. Indeed, this writer has not heard of a single instance of a donor being foolish enough to cut off future donations by seizing the annual donation! The key is that the donor parcels out the assets evenly over the years, not making the next donation until the time limit for the claiming of the previous donation has passed. Attached below is a typical Crummy Notice sent annually to a beneficiary to start the deadline for losing the right to retrieve assets running.
The Crummy Trusts do, however, provide protection and limited control over assets with great flexibility. Most persons wishing to make gifts in Trusts to children and other dependents or descendents select the Crummy Trust as the most useful.
TYPICAL CRUMMY ANNUAL NOTICE:
Name and Address
CERTIFIED MAIL RETURN RECEIPT REQUESTED
AND FIRST CLASS MAIL
RE: Notice to Beneficiary
Dear Mr. X:
On ______________, a gift of ________________ was made by __________________________ to _____________________ Irrevocable Trust _____________________________.
Under Article Two, paragraph E., section 1. of the Trust, you have, the power to withdraw from the Trust by giving written notice to the Trustees, an amount not to exceed (1) the amount which had been contributed to the Trust during such calendar year or (2) an amount equal to the maximum annual gift tax exclusion allowable under Section 2503 (b) of the Internal Revenue Code, or any corresponding provision of any subsequent federal tax laws, or (3) an amount equal to the maximum allowable under Section 2514(e) of the Internal Revenue Code, or any corresponding provision of any subsequent federal tax laws, and the lapse of any power of appointment herein shall not be considered a release of such power.
The right to withdraw shall be exercisable for a period of forty (40) days after the Trustees give the notice by first class mail, return receipt requested. A request for withdrawal must be in writing and delivered to the Trustee before the right expires. Please consider this document the formal notice of your right to withdraw and note this right shall terminate forty days from the date of this letter.
We would appreciate you indicating your receipt of this letter by dating and signing the enclosed copy and returning it in the enclosed self addressed stamped envelope. If we do not receive a signed copy, we shall, instead, rely on the certified mail receipt.
Please call if you have any questions.
Very truly yours,
I acknowledge receipt of this letter.
Carefully structured, a planned program of gifting to the next generation can save tens of thousands of dollars in taxes and allow the parent or grandparent the joy of watching a beloved child or grandchild benefit from the use of the funds. But as one wise client once put it to the writer, “Giving a chunk of money to my kid can be a good idea or a bad idea, depending on how it is given. My duty is to make sure I give it the right way and not spoil a great kid.” He did that and now this office is doing the same type of Trust…for the grandkids!