Abstract: A parent or grandparent has many tax and nontax reasons to make lifetime gifts to a minor child or grandchild. Tax-related motivation for many transfers includes estate tax and income tax savings. A common nontax reason is to provide for the minor’s college education, support and maintenance in the event of any future family adversity. Another desire: To provide for a smooth and orderly transfer of family business control. This article explores options for initiating a gifting strategy.
Gifts to Minors
Know your options before you decide
As a parent or grandparent, you have many tax and nontax reasons to make lifetime gifts to your minor child or grandchild. Tax-related motivation for many transfers includes estate tax and income tax savings. A common nontax reason is to provide for the minor’s college education, support and maintenance in the event of any future family adversity. You may also intend to provide for a smooth and orderly transfer of family business control. If you decide to implement a gifting strategy, the details of effecting those transfers must be considered.
Gifting Decisions
As part of your gift strategy, you must decide:
How much should you give? You may give up to $11,000 per person per year with no gift tax cost. A married couple may give up to $22,000 per person gift tax free. This amount may be leveraged by making gifts of interests in property, the value of which may be subject to discounts for lack of marketability or for minority interests.
When should the transfers be made? The transfer’s timing depends largely on your tax and nontax motives for making the transfer. For tax purposes, it is better to give early in the year to ensure use of your annual exclusion.
What specific assets should you give? The selection of assets to give depends on your objectives. Cash is the simplest form of property to give. If you give appreciated assets, the donee acquires your cost basis. If the asset is then sold, he or she must pay the capital gains that you would have paid had you kept and sold the asset yourself. In addition, you may transfer a life insurance policy on your life, or on the joint lives of you and your spouse, to a trust you create for your descendants.
Ways and Means
If a gift is advisable, there are many options for making it. If an outright gift is inappropriate, your other options include:
1. Uniform Gifts (and Transfers) to Minors Act (UGMA or UTMA). Effecting an UGMA or UTMA transfer is quite simple. The transfer instrument simply must declare that the property is transferred to the custodian “as custodian for” the minor. However, the UGMA account terminates when the minor reaches the age of majority, while an UTMA account must be distributed when the beneficiary reaches 21. Dispersing a large sum of money to an 18-year-old (the age of majority in most jurisdictions) or 21-year-old may be problematic. For estate tax purposes, the donor should not be the custodian, because the property could be included in the donor’s estate if the donor-custodian predeceases the donee.
2. Minor’s trusts. There are three statutory requirements that must be met to qualify as a minor’s trust. First, principal and income must be available for distribution while the beneficiary is less than 21 years of age. Second, when the child or grandchild reaches age 21, the entire amount must be distributed to him or her. Third, if the beneficiary dies before reaching age 21, all income and principal must be paid either to his or her estate or to the beneficiary’s appointee pursuant to a general power of appointment. A minor’s trust is quite similar to an UGMA or UTMA account except:
o There are no restrictions on the property transferred to it, and
o The transferred property can remain in trust until the beneficiary is 21.
If only a modest sum will be available to the child or grandchild at 21, or if the principal will most likely be exhausted before the trust will terminate because of the expected payment of the beneficiary’s educational and other expenses, a minor’s trust may be appropriate. If more substantial sums are to be transferred to the trust, the outright distribution of all trust property to the child or grandchild upon reaching age 21 may pose problems.
3. Mandatory income trusts. A mandatory income trust is another type of trust to which you may give property for the benefit of your minor child or grandchild. Under this arrangement, the trust need not terminate on the child’s or grandchild’s 21st birthday. Typically, under this trust arrangement, your child or grandchild must receive all current income each year, but the trustee is given discretion to make distributions of principal while the child or grandchild is a minor. After the beneficiary attains majority, the trust instrument can provide for principal distributions at prescribed ages or give the beneficiary the power to demand, at specified ages, portions of the principal. Alternatively, the trust may grant the beneficiary an inter-vivos or testamentary power to appoint the trust property to an assigned class, such as his or her descendants. The value of the beneficiary’s income interest qualifies for the annual gift tax exclusion, while the value of the remainder interest doesn’t. The value of the gift for gift tax purposes is the value of the transferred property less the value of the beneficiary’s income stream, and setting up the trust will require you to file a gift tax return to use some of your estate tax exemption.
4. Crummey trusts. This type of trust avoids the mandatory termination requirement of a minor’s trust while also avoiding the current income distribution required by a mandatory income trust. However, to obtain the annual exclusion for the gift, you must grant the beneficiary a demand or withdrawal right over your trust contributions. This type of trust takes its name from the tax case Crummey v. Commissioner that was decided in 1968; it does not reflect the type or quality of the rights conferred upon the minor.
Due to the withdrawal right requirement, many Crummey trusts hold an insurance policy on the life of the parent or grandparent because there is no ready source of funds accessible for the minor beneficiary until after the parent or grandparent dies. However, the beneficiary can withdraw his or her proportionate premium share up to the annual exclusion amount.
5. Section 529 education savings plans. You may contribute cash to a Section 529 plan or prepaid tuition savings plan to pay your child’s or grandchild’s higher education expenses. These accounts function as a tax-advantaged investment account. You also may contribute up to $55,000 (five times the annual exclusion amount) in one year without incurring gift tax, provided you elect to treat the gift as being made ratably over five years.
Rather than making a large outright transfer to a minor, you can create a family limited partnership (FLP) or limited liability company (LLC) to hold your investment assets. In turn, you transfer an interest in that entity to your child or grandchild, or to a trust created for the minor’s benefit. By transferring a limited partnership interest or LLC membership interest to a minor, you may retain control of the underlying partnership or LLC assets. As general partner or LLC manager, you can also control the distributions to the minor or the trust created for the minor as a partner or member.
One To Grow On
Both tax and nontax considerations bear on gifts to minors. If you decide to make gifts to your minor child or grandchild, you must decide what and how much to give as well as how and when to give it. If a gift is appropriate, there are many forms the gift may take. We stand ready to assist you in determining whether a gifting strategy should be part of your overall wealth transfer plan. If you have any questions, please call.
Sidebar: Don’t Let Your UGMA or UTMA Account Get Ugly
So the Uniform Gifts (and Transfers) to Minors Act (UGMA or UTMA) account you established for your child or grandchild years ago has grown considerably in value. What if you don’t want to make an outright distribution of such a substantial sum when your child or grandchild reaches age 21? Well, you have a few options, including:
Pay down the account. To avoid having too much money available to the beneficiary, pay expenses while he or she is still a minor.
Invest in illiquid assets. Your beneficiary can still withdraw the assets, but he or she will not be able to convert them to cash. A family limited partnership is an excellent example.
Establish a Section 529 plan. Because this plan is still subject to UGMA and UTMA rules, the custodian may not change the designated beneficiary of its account except as may be permitted by appropriate law, and it must notify the program manager when the custodianship ends, at which time the minor will become a participant. Because only cash contributions are permitted under Section 529, noncash investments in UGMA or UTMA accounts may first need to be sold, which could potentially incur capital gains tax. Because the UGMA and UTMA assets have already been given to the beneficiary, there are no additional gift tax consequences to contributing the UGMA or UTMA assets to a Section 529 plan.
Convert the UTMA account to a minor’s trust. In some states, an UTMA custodian can transfer the assets to a minor’s trust that permits the assets to remain in trust until the beneficiary is older. The beneficiary will have the unrestricted right to withdraw all trust assets for a reasonable period of time (for example, 60 days) on reaching age 21. But if the beneficiary doesn’t exercise that right within the allotted timeframe, the assets will remain in trust and can no longer be withdrawn. Once the withdrawal right expires, assets will remain in trust unless distributed at the trustee’s discretion or at the prescribed ages listed in the trust instrument. This strategy, however, doesn’t guarantee the assets will remain supervised after the beneficiary reaches age 21.
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