Gifts Through Custodial Accounts
Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) are the simplest long-term method of funding future college costs. Any income generated by the assets in these custodial accounts is taxed to the beneficiary (child), regardless of whether it is distributed. However, the “kiddie tax” rules apply to income earned on UGMA/UTMA assets if the child is under age 24 and is a student. For children age 24 or older, the kiddie tax rules do not apply, and income-shifting benefits are still possible. In addition, if a legal obligation (in most states a college education is not considered a legal obligation of parental support) to support a minor child is satisfied from the income from the UGMA/UTMA account, the donor must recognize the income (regardless of the custodian) under the grantor trust rules. However, if tax-exempt income were generated from the custodial account assets, the parent would not have taxable income even when used for child support items. Earned income for the child is key to escaping the kiddie tax.
A custodian takes title and holds property for the child’s benefit and must distribute the assets to the minor upon his reaching the age of majority (age 18 to 21, as determined by state law).
An UGMA is not allowed to hold real estate and various other investments. However, the UTMA is allowed to hold real estate, personal property, limited partnership units, and other investments. UGMA accounts usually terminate when the child reaches 18 years of age. Whereas, the UTMA account generally terminates at age 21. In some states the UTMA account can be extended until age 25. The UTMA’s longer life may be an advantage over the UGMA.
To avoid the kiddie tax rules for children under age 24, the UGMA/UTMA account could invest in tax-free or tax-deferred investments (e.g., EE bonds, municipal bonds, annuities, life insurance, growth stocks, stock in a closely held business, land, or other growth assets) until the children reach age 24.
The annual $14,000 gift tax exclusion is available for transfers to UGMA/UTMA accounts. However, UGMA/UTMA transfers will be included in the donor’s gross estate if he dies while serving as the account custodian. This situation can be avoided if the donor does not name himself custodian of the account.
Example: One grandparent could make a gift of money to the other grandparent. The grandparent then gives the money to an UGMA/UTMA for the grandchild. The other Grandparent can, therefore, act as custodian without adverse potential future estate tax consequences.
The main advantage of an UGMA/UTMA account is its:
- low cost, and
- ease of administration.
The disadvantages are:
- loss of control by the donor,
- inflexible distribution requirements at the age of majority,
- questions about education and other account expenditures as “parental support” items,
- the kiddie tax rules that can reduce the income tax savings,
- the prospect of the child receiving more money than he needs for college costs, and
- the negative effect they will have on the child’s financial aid (should the child qualify for financial aid).
Minor’s Trusts to Shift Income
Minor’s trusts [(IRC Sec. 2503(c)], also known as 2503(c) trusts, can be used for income shifting to a child. The federal gift tax law permits certain gifts to a minor in trust to qualify for the annual $14,000 gift exclusion even though the beneficiary’s right to use the gift is postponed until age twenty-one. For the gift to qualify for the annual exclusion, the principal and income of the trust must be available for the child’s benefit during its term, at the trustee’s sole discretion, for the purposes specified in the trust document. In addition, the beneficiary must have the right to a full distribution of all income and principal at age twenty-one (This right may be a continuing right or a right for a limited period, such 30 days after the 21st birthday.) If the child does not choose full distribution after his 21st birthday, the trust may be continued for an additional period specified in the trust. This feature can be attractive if the state of residency, under its UGMA/UTMA laws, gives the beneficiary a right to demand distribution at age eighteen.
If more than one child is to benefit from the trust, a separate share must be set aside for each child. A $14,000 annual gift exclusion will then be available for each child benefited by the trust.
If income is accumulated in the trust for future distributions, such as college expenses, the income is taxed to the trust. The disadvantage to this scenario is the trust’s tax rates are highly compressed. Thus, the trust will shelter only limited amounts of income at low tax rates. From a tax perspective, if the beneficiary would pay tax at a lower rate than the trust, the trustee may want to consider accelerating some distributions. Any distribution could be deposited in a UGMA/UTMA custodial account until it must be spent or distributed to the beneficiary. As an alternative to making distributions to the beneficiary, the trust could invest in assets that are expected to appreciate but that will produce little current income (such as growth stocks) or in assets whose income is deferred (such as Series EE bonds) or exempt (such as municipal bonds) and then sell these assets when it is time to pay the child’s college expenses. Since the child will be over 17 years old at this time, the income generated at this time would avoid the kiddie tax.
The donor can serve as trustee of the trust. However, this is not recommended because if the donor/trustee has discretionary power to control distributions (i.e., beneficial enjoyment of property) and dies while the trust is in force, the trust property will be included in the donor’s estate. Alternatively, if the donor’s spouse is expected to live longer, that spouse could be named trustee and avoid gross estate inclusion upon the donor’s death.
Also, if the donor names himself as trustee and maintains control over distributions, IRC Sec. 674 may cause the trust to be treated as a grantor trust for income tax purposes, with trust income taxed to the donor. Grantor trust status may be preferable when the grantor is in a lower income tax bracket than the trust. If the donee/child has the power to demand complete distribution at age 21 but allows the trust to continue, the trust becomes a grantor trust to the child and subsequent income earned by the trust will be taxed to the child.
Another alternative to avoid distribution of the trust assets to the beneficiary at age 21 is to structure the trust so that the gift of the income interest qualifies for the annual exclusion while the gift of principal does not. In this situation, the trust instrument must require distribution of the income interest at age 21. The trust principal can remain in the trust for distribution after the child attains age 21 or can be redirected to other trust beneficiaries. In this arrangement, the assets transferred into the trust should produce income and be susceptible to valuation.
Since assets in a minor’s trust do not have to be distributed until the student is 21, the bulk of the trust’s funds may have been expended for college and the student would not receive control of a large amount of assets.
A 2503(b) trust can also be used as an income-shifting device. The income from this type of trust is required to be distributed at least annually to the beneficiary. It also limits the amount eligible for the annual gift exclusion to the value of the income interest. To avoid the income being distributed directly to a child, the distributions could be made to a UGMA/UTMA account.
Crummey Trusts to Shift Income
A Crummey trust should be considered as an income-shifting tool. In cases where the amount of funds is sufficiently large as to make distributions to a child at age 21 undesirable, a Crummey trust may be preferable to a minor’s trust or UGMA/UTMA. If properly structured, the annual gift exclusion can be used, and if the beneficiary/child did not exercise his Crummey withdrawal rights, the trust assets could be maintained by the trust well beyond age 21. (In a typical Crummey trust, a periodic contribution of assets to the trust is accompanied by an immediate withdrawal power that gives the beneficiary/child the right to withdraw the contribution for a limited time. However, there is an expectation that the child will not exercise this right although there should be no express agreement to this effect). The beneficiary must be given actual notice of the withdrawal right along with a reasonable time period to exercise the right, generally considered to be 30 days or longer. The trust instrument may limit the withdrawal right to the amount of the annual gift tax exclusion or the fair market value of the property contributed to the trust, whichever is less.
Until a Crummey power is exercised or allowed to lapse, the beneficiary is treated as the owner of any income attributable to contributions made to the trust that are subject to the Crummey power. Such income is reported directly to the beneficiary under the grantor trust income reporting rules. If the beneficiary allows the Crummey power to lapse, but retains an interest in the trust property (the usual case), the beneficiary will continue to be treated as owner of that portion of the trust and will be taxed on the income.