There are numerous considerations for parents and grandparents when contemplating making gifts to minor children. Outright gifts are frowned upon because, under the eyes of the law, children are under a legal disability, which means that they do not have the legal capacity to own property. That means that, without some planning, a guardian is necessary to hold or manage property for a minor child.
But, that doesn’t mean parents don’t have options when it comes to making gifts to minor kids. There are a few options worth exploring depending on why the gifts are being made, including 529 plans, UTMA custodial accounts, and gifts in trust.
529 plans get their name from the section of the Internal Revenue Code that gives them their unique characteristics. Each state has a plan with terms and investment goals varying slightly by state with some making more sense than others.
The way a 529 plan works is that parents, grandparents, or any other generous person makes gifts to the 529 plan account much as one would make a deposit to an IRA. The difference is that the beneficiary of the deposits is not the individual making them. Instead, it is a minor child. The contributions then grow free of federal income tax burden for the benefit of the child of grandchild named as beneficiary of the plan. Previously, the funds in the account had to be used for higher education expenses once the beneficiary child turned 18 (including trade and technical schools). Under the Tax Cuts and Jobs Act of 2017, funds in the account can be used for elementary and secondary private school tuition as well, giving parents an option for saving for private school education.
Of course, the drawback of 529 plans is that the funds must be used for qualified educational expenses. So, if the goal of making gifts to a minor child is something other than to fund his or her education, other options are worth exploring.
UTMA Custodial Accounts
Another option for parents is to create custodial accounts under the Uniform Transfers to Minors Act (UTMA). Making gifts to a custodial account setup under UTMA is fairly straightforward. Instead of the child being the actual owner of the account, an adult is the custodian on the account in charge of managing the funds until the child reaches adulthood, and in the case of UTMA, 21 years of age.
Prior to reaching 21, the custodian can make expenditures for the child’s well-being on the child’s behalf—specifically, the custodian has the discretion to pay any amount for the “support, maintenance, general use, and benefit of the minor.” Perhaps most beneficially, the custodian can act without court supervision or oversight and has very few accounting requirements.
But, upon the child reaching the age of 21, all funds are required to be distributed outright. While 21 isn’t 18, it is still a relatively young age to receive a potentially significant financial gift outright. Think back to when you were 21 and ask yourself if you realistically had access to a significant sum of money whether you would have been responsible with it. The issue is magnified when the beneficiary may have spendthrift issues or substance abuse problems. So, while UTMA custodial accounts are a simple way to leave gifts to minors, they do come with some downside.
An alternative to a UTMA custodial account is the creation of an irrevocable gifting trust. Many people assume that trust funds are only associated with the super wealthy, however there is no requirement that any minimum amount must be contributed. Understanding the concepts of a trust can do wonders for a family with some proper planning. If education is the goal, an irrevocable trust can be set up with children or grandchildren as the beneficiaries. A trust has an added benefit over a 529 Plan in that it can make distributions to the beneficiary (i.e. a child or grandchild) not only for college, but for other educational needs, health, maintenance, support or any other legitimate reasons, such as a down payment on a house or to start a business. And, unlike UTMA custodial accounts, if drafted effectively, there is no requirement that trusts distribute assets outright to the minor when he or she turns 21.
Many times in estate planning situations arise in which an individual wishes to place property in trust but does not necessarily want the beneficiary to have the ability to completely withdraw the property or accumulated income of the trust right away. At the same time, the grantor is looking for a vehicle in which to make a gift free of any gift tax (currently gifts up to $15,000 per year, per individual are permitted without the obligation to pay any gift tax under §2503(b) of the Tax Code).
The most common situation in which the desire to structure a trust in this manner arises is when a grantor parent wishes to make gifts to minor children (or non-minor children under a certain age) but does not want the child to have the ability to access the funds immediately, whether out of fear that they will be spent on something foolish or otherwise. In order to prevent the money from being wasted by the child restrictions are drafted into the trust agreement which prevent him from accessing all of the funds until such date as the parent believes he will be responsible with the money.
However, in order to qualify for the exclusions from gift tax the gift must also be one of a present interest, meaning that the person who is receiving the gift has the immediate ability to enjoy the gift. Therefore, in order for a Crummey trust to serve the dual purposes of making tax free gifts to beneficiaries and restricting how those transferred assets are accessed, certain precautions must be taken.
The first requirement in order to ensure that the grantor’s contributions to the trust are considered gifts, thereby removing the wealth from his estate, is that the Crummey trust must be irrevocable. As I discussed in an earlier post, irrevocable trusts provide some great tax advantages in that they are viewed for tax purposes as a separate entity over which a grantor has no control or ability to modify or revoke. Therefore, any contribution a grantor makes to an irrevocable trust will no longer be considered owned by him, and he will not be subject to estate tax on it upon his death.
2) The beneficiary must have the right to receive something of value immediately at the time a gift is made to the trust.
As discussed above, a gift must be one of a present interest in order to qualify for gift tax exemption. According to the IRS, simply giving the beneficiary the right to receive the gift at some point in the future, even if it is only in a year or two, is not sufficient to qualify a gift for gift tax exemption. Naturally, then, a beneficiary must have some sort of present ability to receive the gift. According to the IRS, the present right to receive something of value must not be subject to a contingency or the will of some other person, the right to receive the property must exist at the time of the gift, the beneficiary’s present interest must be clear and unambiguous and it must be possible for the beneficiary to actually receive the property . That means that a Crummey trust must permit a beneficiary to withdraw annual contributions that are made to the trust when they are made. If the beneficiary does not withdraw the contribution, then it will become part of the trust principal and will be protected against future withdrawals unless made consistent with the trust agreement.
3) The beneficiary must have notice that he or she has a right to demand to receive property.
It may seem like a good idea to simply not inform a beneficiary of the fact that a contribution has been made to the trust for which he has a withdrawal right, however, the IRS has made clear that a demand right can’t exist unless the beneficiary has knowledge that he may exercise such a right. It is ambiguous as to whether the existence of a demand right must be given upon each addition to a trust or only upon creation of the trust, however, in order to ensure that the IRS doesn’t such gifts to the trust back into the grantor’s estate, a cautious planner would consider giving notice each time a contribution is made to the trust.
4) The beneficiary must be given a reasonable time to exercise the demand right.
Perhaps a natural corollary to giving notice of a demand right is giving the beneficiary a reasonable amount of time to exercise a demand. Again, there is no steadfast requirement for how long “reasonable” may be, however, the IRS has indicated that as little as 30 days has been sufficient numerous times.
While a Crummey trust offers benefits as an estate planning tool some goals are best accomplished through other means. An estate planning attorney can discuss the Crummey trust option in much more depth along with other possible tools like 529 plans and UTMA custodial accounts to accomplish your estate planning goals.