Gifts for Minors

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.

Advantages of Gifts to Minors

Making gifts to minors can have a number of advantages, both tax and non-tax:

Gifts in Trust

Donors making gifts in trust for minors must consider a number of special problems.

Annual Gift Tax Exclusion

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:

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.)

Selecting the Trustee

The selection of the trustee can have income and estate tax consequences.

Grantor as Trustee

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.

Grantor's Husband or Wife as Trustee

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".

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.

Independent Trustees

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.

Payments for Support and Education

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.

Minimizing Trust Income Tax

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:

Uniform Transfers to Minors Act

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:

Among the disadvantages of a UTMA gift are the following:

Qualified State Tuition Programs

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:

However, there are limitations to these programs:

Coverdell Education Savings Accounts

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):

Direct Tuition Payments

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