By Stephen Liss and Hallie Aronson
Making annual exclusion gifts to children and grandchildren is a simple and highly effective way to reduce estate taxes. Deciding what form such gifts should take, on the other hand, is not quite as simple.
Coverdell accounts, UGMA/UTMA accounts, 2503(c) trusts, Crummey trusts and 529 plans are just a few of the possibilities. What follows is a summary of some of the factors that should be considered when selecting the best gifting vehicle and the advantages and disadvantages of different options.
Annual Exclusion Gift
The gift-tax annual exclusion-which is subject to annual cost-of-living adjustments-allows every individual to give away $13,000 ($26,000 for a married couple) to an unlimited number of persons each year without any gift tax consequences. While this may seem like a modest amount, consider a married couple with three married children and six single grandchildren. They could each make 12 annual exclusion gifts and give away as much $312,000 a year tax-free. Gifts in excess of the annual exclusion amount are considered taxable gifts and count toward the $1 million lifetime gift tax exemption.
A number of factors should be considered when deciding on an annual exclusion-gifting vehicle. While there is no single solution for maximizing the benefit and impact of an annual exclusion gift, a donor can best achieve his objectives by considering the following factors:
1. Purpose: What will these funds be used for? Is the primary motivation of the gifts a desire to save for college tuition in a tax-efficient manner? Some of the options discussed below, such as Coverdell accounts and Section 529 accounts, are excellent vehicles to pay educational costs, but penalties are triggered if the funds are used for any other purpose.
2. Control: How much control do the donors wish to retain? Does the donor want to be able to toggle the funds between family members? Does the donor object to having the child be the outright owner of the property at age 18 or 21?
3. Investments: How does the donor want the money invested? Some of the techniques we will discuss leave the entire universe of investment options open, including life insurance and family partnerships. Others are limited to defined investment "pools" or are subject to statutory restrictions.
4. Financial Aid: What impact will these accounts have on a child's ability to apply for financial aid? For many high-net-worth individuals, this will not be an issue, but for some it can be critically important.
5. Taxes: What are the tax consequences of the chosen vehicle? Some provide an income-tax deduction for the donor or the ability to grow their assets tax-free. Some remove assets from the donor's estate while leaving him with substantial control. Others pose greater risk of estate tax inclusion.
6. Cost: What are the costs of establishing and operating the chosen vehicle, both in money and time?
Annual Exclusion Gifting Options Section 530 Coverdell Education Savings Accounts
The assets in a Section 530 Coverdell Education Savings Account grow tax-free and distributions are tax-free so long as the money is used for qualifying education expenses. A Coverdell account may be established at a bank or mutual fund company or with any stockbroker.
Before establishing a Coverdell account, the donor must consider whether the beneficiary should receive control of the funds at age 18. The donor must also decide if he wants to preserve the right to change the designated beneficiary after the account is created. All of the funds in the account must be distributed within 30 days of the beneficiary's 30th birthday or rolled over into a Coverdell account for another family member who is under age 30.
Anyone can contribute to a Coverdell account, including the child himself. The total annual contributions from all contributors to a Coverdell account is limited to $2,000 per beneficiary.
Custodial Accounts - UGMAs and UTMAs
The Uniform Gifts to Minors Act (UGMAs) and Uniform Transfers to Minors Act (UTMAs) are similar, with subtle but important differences. Under both acts, the minor is considered to be the owner of the account and property is controlled by a custodian. The money may be used for any expense related to the child. When the minor reaches the "age of majority," the property passes to the beneficiary outright. The age of majority is determined by the minor's state of residence and whether the custodial account, was created as an UGMA or UTMA.
Both UGMA and UTMA accounts are simple to set up and administer and have access to a wide range of investments. While usually only cash, mutual funds, securities and insurance policies can be held in an UGMA, the UTMA is more flexible and generally allows almost any asset, including real estate, to be gifted to the minor.
Neither UGMAs nor UTMAs permit the reallocation of assets among descendants, however, as such assets are deemed to belong to the named child. The account must terminate in favor of the child between the ages of 18 and 21. This can be problematic since it can result in a child receiving several hundred thousands of dollars at a young age.
On the income-tax side, these accounts will generally be subject to the "kiddie tax," which means that any income they earn will be taxed at the rates that would apply if the parent had earned it.
Minors Trusts - Section 2503(c) Trusts
Establishing a 2503(c) trust generally requires the assistance of counsel, so the expenses associated with formation exceed those of a Coverdell account or an UGMA/UTMA account. In order to be a valid 2503(c) trust:
(1) the trust must have only one beneficiary;
(2) the principal and income of the trust must be available to the trustee for the benefit of the child during the term of the trust;
(3) the assets must be distributed to the child's estate if he dies before age 21; and
(4) all undistributed principal and income must be distributed to the child once he reaches 21 years of age.
Many people who use a 2503(c) trust attempt to address the 21-year termination age by giving the child a window, generally 30 to 90 days, to withdraw the trust property after attaining age 21. If the child does not exercise this right, the money will remain in the trust for as long as the trust document dictates. However, after the child turns 21, gifts to the trust will no longer qualify for the gift tax annual exclusion.
A 2503(c) trust shares many of the advantages and disadvantages of an UGMA/UTMA account. The trust funds can be used for a range of purposes and invested freely. A 2503(c) trust offers the ability to retain assets in trust after the child turns 21, although there is a risk that the child will exercise his rights during the withdrawal window. The income of these trusts is generally subject to the kiddie tax.
Crummey Trust/Insurance Trust
Contributions to trusts generally do not qualify for the annual exclusion because they are considered gifts of future interests. A Crummey Trust solves this problem by giving beneficiaries the right to withdraw contributed property for a certain amount of time, generally 30 to 60 days. The trustees must notify each beneficiary in a timely fashion of his or her right to make such a withdrawal each time a contribution is made to the trust. If the beneficiary does not withdraw the gift within the prescribed window, the withdrawal right lapses and the contributed funds will be held pursuant to the terms of the trust.
Crummey Trusts have become a very popular choice for annual exclusion gifting and are also the preferred method for funding insurance trusts, which allow life insurance death benefits to be excluded from the taxable estate of the insured. As a result, many high-net-worth individuals make gifts of the full annual exclusion amount to their insurance trusts each year, even if only a fraction of that amount is needed to pay the insurance premiums.
Crummey Trusts offer complete flexibility in how trust funds are spent and allow the donor to benefit multiple beneficiaries within the same trust.
With regard to income taxes, Crummey Trusts are generally established as "grantor" trusts, which means the person who contributes the funds to the trust reports any income or capital gain earned by the trust on his personal income tax return and pays the associated taxes. This provides an additional gift tax benefit as the payment of the trust's income taxes is equivalent to an additional gift to the trust beneficiaries, but is not taxable because it is the grantor's legal obligation.
Section 529 Savings Accounts
Section 529 savings accounts are an excellent vehicle for donors who are committed to using their annual exclusion gifts to pay for higher education expenses. Assets in these accounts grow free of federal income tax and are generally exempt from state income tax as well. Withdrawals for "qualified higher education expenses" are also exempt from federal income tax, although a state income tax can apply depending on a number of variables. "Qualified higher education expenses" include tuition, fees, books, supplies, room and board. A beneficiary of a Section 529 plan must be a family member of the donor. Distributions for any other purpose are subject to income tax on the earnings portion of the distribution and a 10% penalty may apply.
Section 529 savings accounts give donors the unique opportunity to front-load up to five years of annual exclusion gifts in one year. By making five years of annual exclusion gifts, a married couple can immediately remove up to $130,000 per beneficiary from their taxable estate and have that money start growing tax-free. No other annual exclusion vehicle provides this benefit. It should be noted, however, that if the donor dies within this five-year period, a pro rata amount of such gifts (i.e. the gifts that the donor did not live long enough to make had he only made one annual exclusion gift each year) will be included in the donor's estate.
The donor of a Section 529 savings account can change the beneficiary of the plan or even take the money back. However, if the donor takes the money out of the plan for his or her own benefit, such distributed funds will be subject to income tax and penalties. What is remarkable is that even though the donor has the right to take the money back from the plan, it is still excluded from the donor's taxable estate for estate tax purposes.
Donors may only contribute cash, not property, to a Section 529 Savings Account. Some states allow for a limited state income tax deduction for contributions made to an in-state 529 account. Such tax savings, however, should be weighed against the contribution limits, expenses and other features available in out-of-state accounts.
The principal disadvantages of Section 529 savings accounts are their limited purpose and limited investment options. Further, each of the plans charge different fees in addition to the regular expenses incurred by the individual mutual funds in which the money is invested. These fees mean lower growth rates for participants.
Although annual exclusion gifting can be a powerful estate-planning tool and an effective way to provide for children and grandchildren in a tax-efficient manner, there are a number of factors to consider when determining the gifting vehicle that is most appropriate for one's particular financial and familial circumstances. There is no one-size-fits-all solution, but using the factors set forth above as a rubric for evaluating each option is a good starting point for determining which vehicle most fully accomplishes a donor's needs and objectives.
Stephen Liss and Hallie Aronson practice in the international law firm, Withers Bergman LLP, out of the firm's Greenwich and New Haven, Conn., and New York offices.