By Daniel B. Evans
Copyright © 2000-2003. All rights reserved. Not legal advice.
Last reviewed or revised: 6/10/2003
Parents and grandparents are often interested in making gifts to minor children or grandchildren to help pay college expenses or for other tax planning purposes. This outline will explain some of the considerations for planning trusts and other forms of gifts to minors.
Making gifts to minors can have a number of advantages, both tax and non-tax:
For donors concerned about federal estate tax, the federal gift tax annual exclusion can be quite valuable, because it allows gifts of up to $11,000 for each child or grandchild. (The $11,000 is for 2002 and 2003, and may be adjusted for inflation in future years.) For a married couple with two children, that translates into a $44,000 exclusion each year ($11,000 for each child from each parent). And, once a donor's estate exceeds the $1,000,000 gift tax unified credit applicable exclusion amount, each $11,000 gift saves $4,100 (or more) in future federal estate tax.
Gifts to minors can shift investment income into lower income tax brackets. A child under the age of 14 can have $750 of investment income in 2003 without paying any income tax and an additional $750 of investment income taxed at only 10% (although income above that is taxed at the parent's marginal tax rates). A child that is 14 or older can have the same $750 of investment income free of federal income tax and up to $7,000 of income taxed at only 10% ($6,000 in 2005 through 2007) and $21,400 of income taxed at only 15%. (These numbers will be adjusted for inflation in future years.)
Gifts to trusts can also save some income tax if the trust is a separate taxpayer for federal income tax purposes and the grantors are in the highest income tax bracket. The grantors must be in the highest tax bracket because the income tax rates that apply to trusts are "compressed" and trust income reaches the highest bracket very quickly. For example, a married couple would need $311,950 of taxable income to reach the 35% bracket in 2003, but a trust will reach the same 35% bracket with only $9,350 of taxable income. (Even when the grantors are in the highest income tax bracket, the lower tax rates that apply to trust income can save only about $700 each year in income tax.)
Gifts to minors can increase the financial security of the minor. The savings of a parent can be wiped out by business or professional liabilities, or liabilities arising out of an automobile or other types of accidents. But assets transferred to or in trust for children as part of a regular gift program are protected from the claims of the parent's creditors.
By making gifts during lifetime, instead of waiting to distribute assets at death, grandparents (and others) can see the benefit of the gifts, and share the enjoyment of the recipients.
Donors making gifts in trust for minors must consider a number of special problems.
Most donors want gifts to the trust to qualify for the federal gift tax annual exclusion, which allows a donor to give $11,000 (as adjusted for inflation in 2002 and 2003) to each of an unlimited number of recipients, free of federal gift tax and federal estate tax. However, only a gift of a "present interest" qualifies for the annual annual, and there are only three ways for a gift to a trust to qualify as a "present interest" for the purpose of the annual exclusion:
If the beneficiary is entitled to all of the income of the trust each year, the percentage of the gift that is considered to be the present value of the income interest qualifies for the annual exclusion. (This is rarely claimed.)
A trust for a minor qualifies for the annual gift tax exclusion if certain conditions are met, one of which is that the minor must be able to withdraw all of the money in the trust when the minor turns twenty-one.
A trust can qualify for the annual exclusion if the beneficiary has the immediate right to withdraw the annual exclusion gift from the trust, even though the right lapses if not exercised within a short time (usually 30 days).
Many donors prefer the third procedure (called a "Crummey trust" because the court case which established the validity of the annual exclusion was brought by a taxpayer named Crummey), which allows the donor the most flexibility in designing the terms of the trust. However, in order for the rights of withdrawal to lapse as quickly as possible, the trust should benefit only one minor child, and the child should have a broad power to direct who gets the trust principal at the beneficiary's death. (This power also helps avoid an income tax problem discussed below.)
The selection of the trustee can have income and estate tax consequences.
The grantor (person who makes the gifts to the trust) should usually not be the trustee, because any discretion to distribute or withhold income or principal will cause the trust to be included in the grantor's estate for federal estate tax purposes.
The discretion to withhold or distribute income can also have income tax consequences to the grantor, but that is usually a secondary consideration.
Appointing the grantor's husband or wife to serve as trustee does not entirely solve the estate tax or income tax problems.
If the trustee is a parent of the minor beneficiary, and the trustee has the power to apply income and principal to the support of the minor, then that parent might have the power to reduce the parent's own support obligations using trust property, which would cause the trust property to be considered to be part of the parent's taxable estate for federal estate tax purposes. (It should be possible to eliminate this problem by writing the trust document to direct that the trustee cannot use trust property to reduce the trustee's own legal obligations, but this has never been verified by the Internal Revenue Service or the courts.)
The income tax problems caused by husband or wife as trustee are the same as for other "related parties" as trustees, discussed below in "Other Related Trustees".
Even if the grantor does not have the power to control the distributions of income from a trust, the income will be taxable to the grantor, and not the trust, if the trustee is a "related or subordinate party" such as the grantor's spouse, parents, brothers or sisters, descendants, or employees.
There are a number of exceptions to this rule, the most important of which is that the power to accumulate income is not a problem as long as the accumulated income must be distributed eventually to the beneficiary, the beneficiary's estate, or to appointees of the beneficiary (excluding only the beneficiary's own estate and creditors). This means that there must be a separate trust for each child. And, as explained above, the existence of a broad power of appointment at death also allows the annual gift withdrawal rights ("Crummey" powers) to lapse more quickly (for reasons too complicated to explain here).
Another exception is that discretion to distribute income is not a problem as long as (a) the trustee is not the grantor or the grantor's spouse and (b) the discretion is limited by a "reasonably definite external standard" in the trust document. "Reasonably definite external standards" are usually limited to health, maintenance, support, and education. However, it is usually better to give the minor a broad power to appoint at death than to limit the discretion of a trustee.
If the trustee is "independent," meaning that the trustee is not a "related or subordinate party" as described above, the discretion given to the trustee can be broader. The trustee can be given the power to distribute income and principal among a number of different children or other beneficiaries without any adverse income tax consequences.
Regardless of who serves as trustee, or what the trust says, the income of a trust will be taxable to the grantor, and not the trust or the beneficiary of the trust, if the income is applied to support a beneficiary whom the grantor is legally obligated to support. Many states (but not Pennsylvania) consider college education part of a parent's support obligation, in which case payments for college expenses may result in income that is taxable to the grantor, not the beneficiary.
As explained above, trusts can result in more income tax, not less, because trust income tax brackets are "compressed" and trust income reaches the highest income tax bracket very quickly. There are several possible strategies for dealing with the possible application of higher income tax rates:
If the trust reaches a higher income tax bracket than the beneficiary, the trustee can distribute income to a custodian for the minor under the Uniform Transfers to Minors Act (described below). The income will then be taxable to the minor beneficiary, not the trust, although the accumulated income will have to be distributed to the minor at age 21 (in Pennsylvania).
The Internal Revenue Service has twice ruled that, if a beneficiary allows a right of withdrawal to lapse, the beneficiary is then considered to be the grantor of the trust for income tax purposes. It might be possible to adopt the IRS position and report all of the trust income from a "Crummey" trust (from which the beneficiary could have withdrawn the contributions) as taxable to the beneficiary, and not the trust.
It is also possible to construct a trust of which the grantor is considered to be the owner for income tax purposes, but not gift or estate tax purposes. (This can be done, for example, if the grantor has retained the right to exchange trust property for other property of equal value.) This might be desirable if the grantor is not in the top income tax bracket and the trust will be generating significant amounts of income.
If all else fails, the trust can invest in appreciating securities, rather than income-producing investments, so that gains are taxed as capital gains and not ordinary income.
An alternative to gifts in trust for minors is gifts to a custodian under the Uniform Transfers to Minors Act (formerly known as the Uniform Gifts to Minors Act). The UTMA (or UGMA) has been enacted in some form by every state and, under the Act, the custodian (an adult acting for the minor) can invest the funds, and apply the funds as needed for the minor's support and education. There are both advantages and disadvantages to UTMA gifts compared to a trust. Among the advantages are the following:
A UTMA gift is simpler (and less expensive) because there is no trust to prepare and no separate income tax returns to prepare. (All of the income is reported on the minor's individual income tax return.)
Because the income on the UTMA investments is considered to be the minor's own income, lower tax rates may apply than would apply to a trust with the same income, particularly if the minor is 14 or older.
Because a UTMA account is not a trust, the income earned by the account is always taxable to the beneficiary, even if used for expenses considered to be a support obligation of the donor. (See discussion above on support payments from trusts.)
Among the disadvantages of a UTMA gift are the following:
The minor must get all of the property at age 21 (in Pennsylvania; most other states use age 18 for the end of UTMA accounts). However, Pennsylvania (and some other states) allow the donor to specify an age up to age 25 for the final distribution.
There can only be one custodian (a trust can have more than one trustee), and the donor cannot serve as custodian for the minor without the UTMA funds being included in the donor's taxable estate for federal estate tax purposes.
Another tax planning option is the "qualified state tuition program." It must be a program created by a state (or state agency) that allows contributions to a tuition fund for a designated beneficiary, invests the contributions, and maintains separate accounts for each beneficiary. The tax advantages include the following:
Contributions qualify for the federal gift tax annual exclusion and are no longer part of the donor's taxable estate. In addition, if the donor's gift exceeds the annual gift tax exclusion, the donor can elect to treat the gift as though made in equal installments over five years, so that the donor can use the current year's annual exclusion and the annual exclusions of the next four years immediately.
Neither the donor nor the beneficiary realizes any taxable income while the contributions are invested.
The beneficiary realizes taxable income only when distributions are made or tuition is paid from the program, and only (a) to the extent that the distributions (or payments) are in excess of the "qualified higher education expenses" (see below), and (b) in proportion to the increases in the fund over the contributions.
The undistributed tuition fund is not part of the beneficiary's taxable estate, but can be refunded to the original donor.
However, there are limitations to these programs:
Neither the donor nor the beneficiary can direct any investments of the program.
Contributions are limited to "qualified higher education expenses," meaning the amounts needed for tuition, fees, books, supplies, and equipment at an "eligible educational instutition." (The expenses of room and board can be included only under certain circumstances.)
Beneficiaries can be changed only to a new beneficiary within the same family.
Refunds can result in penalties (usually 10%).
Another tax planning option is the "Coverdell Education Savings Account" (previously known as the "education individual retirement account"). This type of account allows contributions of not more than $2,000 each year to an account for a beneficiary under the age of 18. (The $2,000 annual contribution limit is reduced--and eventually phased out--for taxpayers earning more than $95,000--$150,000 for a joint return.)
The rules for a Coverdell education savings account are similar to the rules for a qualifed state tuition program (and share many definitions):
The account must be exclusively for the purpose of paying "qualified education expenses," which are defined as "qualified higher education expenses" (the amounts needed for tuition, fees, books, supplies, and equipment at an "eligible educational instutition," as well as room and board under certain circumstances) and "qualified elementary and secondary education expenses" (similar expenses, as well as room and board, transportion, and computer and Internet expenses at a public, private, or religious elementary or secondary school).
Beneficiaries can be changed only to a new beneficiary within the same family.
The beneficiary realizes taxable income only if the distributions exceed the "qualified education expenses" of the beneficiary.
Distributions in excess of the qualified education expenses are taxable income in proportion to the increases in the fund over the contributions, and there is an additional tax of 10% for distributions that are not used for qualified education expenses (unless the distribution is due to death, disability, or special scholarship provisions).
Contributions qualify for the federal gift tax annual exclusion and are no longer part of the donor's taxable estate.
Neither the donor nor the beneficiary realizes any taxable income while the account is invested.
The undistributed fund is not part of the beneficiary's taxable estate.
The account must be distributed once the beneficiary reaches age 30.
It should also be remembered that the direct payment of tuition to a tax-exempt school is not considered to be a taxable gift, regardless of who makes the payment. (This exemption is in addition to the annual gift tax exclusion). If there are grandparents with the ability and willingness to pay for a grandchild's college tuition, it may be better to have the grandparent's pay the tuition directly, and let the grandchild keep any savings or trusts originally intended for college, in order to reduce the federal estate tax for the estates of the grandparents.
Evans Law Office
Daniel B. Evans, Attorney at Law
P.O. Box 27370
Philadelphia, PA 19118
Telephone: (866) 348-4250