Gifting to Minors free of Gift Tax
As a parent, grandparent, uncle, or aunt, you may want to make a sizeable financial gift to your minor child, grandchild, niece, or nephew, but are concerned about the tax implications. The federal gift tax exclusion allows you to make a gift of $15,000 to any single individual, or $30,000 if you are a married couple, free of gift tax, for each year. This means that if you and your spouse were able to gift $30,000 per year to a child or grandchild from birth to age 18, the child would have approximately $927,170 at age 18 (assuming a before tax annual return of 6%).
If you are thinking of gifting large sums to minors, however, certain questions should be considered before the gift is made. If the donee is a minor, and you are thinking of making a financial gift of thousands of dollars to him or her, you may wish to put certain controls or strings on such gifts. To qualify for the federal gift tax exclusion, however, the IRS requires that the recipient of the gift have a “present interest” in the funds and not a future one. Techniques to consider with the advice of your estate planning attorney so you can qualify for the federal gift tax annual exclusion include:
Federal Gift Taxes
There is a Federal gift tax system. There is no Wisconsin gift tax. A gift will not be subject to gift tax unless the gift exceeds the donor’s unified credit amount. For 2018 the unified credit amount is $11,200,000.
If a gift is in excess of the annual exclusion amount, however, a gift tax return must be filed. In other words, if you gift over $15,000, there may be no gift tax, but you still may be required to file a return. In 2018, the federal gift tax annual exclusion allows a donor to give up to $15,000.00 to any individual in any calendar year without using any of the donor’s unified credit exclusion amount and without filing a gift tax return. If the donor is married, then the donor and spouse can give $30,000.00 each year. The annual exclusion is indexed to the inflation rate.
Gifts to a Custodian under the Uniform Transfers to Minors Act
Under the Uniform Transfer to Minors Act (UTMA), recognized by the state of Wisconsin, you may set up a custodial account in which to deposit your gift, which can be funds, real property, or any other type of tangible or intangible property. The custodian of the account holds the property for the benefit of the minor and can distribute the income or principal from the account for the minor’s benefit or welfare.
In Wisconsin, the custodianship ends when the minor attains the age of 21.
The custodian of the account may be any person, including the donor or a Trust Company. However, you should consider appointing someone other than yourself or the minor’s parent as custodian.
If the donor acts as a custodian, the custodial property will be included in the donor’s gross estate for federal estate tax purposes if the donor dies before the termination of the custodianship. This is problematic because one of the reasons the gift was established was to remove the gift from the estate of the donor. In addition, if the custodian has a legal obligation to support the minor, such as a parent, then if the custodian dies before the termination of the custodianship, there is a risk that the IRS may make a determination that the parent’s gross estate will include the custodial assets.
If the minor is under the age of 14, income to the minor from the custodial account is taxed at the parent’s marginal rate (“kiddie tax”), but no separate tax form needs to be filed. This makes custodianship taxation and preparation less complex than the 2503(c) Trust and Crummey Trust. UTMA accounts are generally prefered for smaller gifts, as most trusts are only practical if a significant amount of property or funds is to be included in the trust.
The 2503(c) Trust
Another technique for gift giving to minors is through a 2503(c) trust. A section 2503(c) Trust is a separate legal entity (an irrevocable trust) established to hold gifts in trust for a minor until the minor reaches age 21. The trust is named after the section of the Internal Revenue Code upon which it is based.
A 2503(c) trust must meet certain requirements. First, like any other trust, a trustee is appointed, but in this case the trustee must have unlimited discretion to make distributions from the trust for the benefit or “comfort” and “welfare” of the minor. In other words, you cannot place restrictions on the trustee’s decision regarding the reason distribution are to made. Second, if the minor passes away before the age of 21, the trustee must pay the remaining assets to the minor’s estate, or as the minor directs pursuant to a general power of appointment. The third and most problematic requirement for this type of trust is that the principal and income of the trust must pass to the donee on attaining age 21. This is a similar disadvantage in the custodial accounts.
The third requirement poses a problem. In many instances, the donor may not want someone who is barely an adult to possibly squander thousands of dollars on luxury items, expensive trips, or in other frivolous ways. For the trust to qualify for the annual gift tax exemption, however, the donee must have the power to terminate the trust at age 21. The most common way to address this problem is to provide in the Trust Instrument that the beneficiary may elect to continue the trust, or to provide in the Trust Instrument that the Trust will continue unless the beneficiary elects to terminate it. Because of the lack of published authority, the Trust Instrument should require the Trustee to provide the beneficiary with notice of his or her right to terminate the Trust when he or she reaches age 21. Upon reaching age 21 and assuming the beneficiary does not elect to terminate the Trust, then the Trust can continue under the terms of the Trust (for example, until age 35). The beneficiary must have an unfettered opportunity to terminate the Trust, however, and there is always the risk that the beneficiary may terminate the trust.
As with a custodian account, the donor and/or parents should generally not be the trustee. Again, if the donor serves as Trustee of a 2503(c) Trust and dies before termination of the Trust, the donor’s gross estate will include the Trust assets because of the donor’s ability to make discretionary distributions of the Trust assets. In addition, as discussed with a custodial account, the IRS believes that a similar result will occur if the Trustee is a parent or other individual who has a legal obligation to support the beneficiary. Therefore, neither the parent of the beneficiary nor the donor should serve as a Trustee. The minor’s parents, however, could serve as a co-Trustee without adverse tax consequences provided that the Trust Instrument gives the nonparent Trustee the power to make distributions that might satisfy the parent’s legal obligation.
No, these are not “crummy” trusts that should be avoided, but rather they are another estate planning tool that was named after Mr. D. Clifford Crummey. Mr. Crummey cleverly invented this type of trust in 1968 so as to create a “present interest” in the gift that would not otherwise be available to a minor.
Gifts to trusts other than a 2503(c) Trust generally do not qualify for the federal gift tax exclusion because the minor does not have a “present interest”. If, however, the Trust Instrument provides that a beneficiary has a presently exercisable right to withdraw property transferred to the Trust, the IRS will consider the gift to the Trust to be a gift of a present interest and will allow an annual exclusion for the gift. These powers are known as “Crummey Powers”.
The biggest advantages advantages of Crummey Trusts are that they do not have the same restrictions as UTMA accounts or Section 2503(c) Trusts. Specifically, you can set it up so that the trust need not terminate until the beneficiary reaches any age you designate, which is usually set up as age 30 or 35, but sometimes longer depending on the situation and objectives. Additionally, unlike a 2503(c) trust, you can limit the trustee’s discretion to make distributions only for specified purposes, such as only for education, or only if certain prerequisites are met.
The most significant drawback of a Crummey Trust compared to a 2503(c) Trust or custodianship is its administrative complexity. The IRS requires that every time a donor makes a gift to a Crummey trust, the Trustee must notify the holder of a Crummey power. Documentation, proof of notices, and recordkeeping are essential.
When each gift is made to the trust, the beneficiary must have the right to withdraw the assets for a period of time, which is generally at least 30 days. To exercise this limited power, the beneficiary or guardian of the minor is to give or at least acknowledge receipt of the notice of the right to withdraw whenever a gift is made.
If the time period for the right of withdrawal lapses, the value of the gift remains in the trust until the beneficiary attains the age when the trust is to be terminated, which can be after age 21. The trust is set up this way because you do not expect the beneficiary to make any withdrawals by himself or herself until the time the trust is terminated. No express agreement to this effect may exist, however, or else the IRS would consider the power to be illusory.
Lapse of Withdrawal Rights
When utilizing a Crummey Trust, one must plan around the lapse of the withdrawal right. If a power to withdraw more than $5,000 (or 5% of the trust principal, if greater) lapses, then the excess is deemed a taxable gift made by the beneficiary to the other beneficiaries of the Trust. For example, if a beneficiary allows a $20,000 Crummey withdrawal power to lapse, he or she may have been deemed to have made a $15,000 gift.
One approach is to make gifts so that the lapse does not exceed the $5,000 or 5% rule. This may require multiple beneficiaries.
Another approach is to prepare a Trust Instrument so that no person other than the beneficiary has an interest in the Trust because the only possible gift made is by the beneficiary to himself or herself. The lapse will not result in a taxable gift. To accomplish this result, the Trust Instrument should provide that the Trustee may make distributions from the Trust only to the beneficiary. If the beneficiary dies before termination of the Trust, the Trust Instrument should direct the Trustee to pay the trust principal to the beneficiary’s estate or as the beneficiary appoints under a general power of appointment. If the donor is worried that the beneficiary may exercise the power of appointment in an inadvisable manner, the Trust Instrument can, for example, limit the class of potential appointees or make the power exercisable only with the consent of a non-adverse third party.
We hope that you have found this information helpful. If you are considering gifting to minors, please call one of our experienced estate planning attorneys at 262-334-3471 to discuss this decision and how best to achieve your objectives.
If you are interested in learning more about gifting for educational objectives, you may also be interested in reading our blog on this topic, Give the Gift of Education.
Disclaimer: The information contained in this post is for general informational purposes only and is not legal advice. Due to the rapidly changing nature of law, Schloemer Law Firm makes no warranty or guarantee concerning the accuracy or completeness of this content. You should consult with an attorney to review the current status of the law and how it applies to your unique circumstances before deciding to take—or refrain from taking—any action. If you need legal guidance, please contact us at 262-334-3471 or [email protected]