Gifts to Minors

By Eric M. Kramer

There are many tax reasons to make gifts to children and grandchildren. Taking advantage of the annual $10,000 gift tax exclusion is one. But what is the best way to make the gift? The author explains the options.

Annual gift giving to multiple beneficiaries within the limitations of the $10,000 annual exclusion is an essential estate planning technique. With combined Federal and state estate tax brackets approximating 65%, there can be a savings on death of $6,500 or more, plus appreciation, for each $10,000 given. For elderly persons, with several children and many grandchildren, it would not be unusual to remove $100,000 or more from an estate on an annual basis. That amount could easily double if the donor has a spouse who consents to split gifts. Many of these gifts will be to or on behalf of minors. There are a number of special considerations when making gifts involving minors.

Outright Gifts

There is no question that an outright transfer is simple and qualifies for the annual exclusion. There is a loss of control over the property, however, since in general, except for bank accounts and Series E Government Bonds, minors cannot sell or dispose of assets in their name. In addition, with the age of majority at 18, many donors would be hesitant to give substantial interests in a way that the minor would have complete control over them at that age.

Uniform Gifts to Minors Act

A gift under the Uniform Gifts to Minors Act (UGMA) is generally created by grandparents and parents as a means to give a child money, which is usually held in a bank, brokerage firm, or mutual fund. The account is established in the child's name and bears the child's Social Security number, but is held by one adult who is otherwise known as a custodian. Under the New York version of the law, which is typical of other states and is the basis for this discussion, the child is entitled to the account at the age of 18. If the donor prefers, the law provides that the donor can extend the entitlement date until age 21. Once the gift has been made it is irrevocable and conveys all of the donor's rights to the child with no rights to the child's guardian except as provided for in the law.

There are numerous questions, however. What if the custodian dies before the beneficiary attains 18? Should the custodian be the parent? What if the funds are used to support the child? What are the gift, estate, and income tax consequences?

Successor custodian. In the event of death, disability, or incapacity, the custodian should have a named successor in place by dating and executing an instrument of designation. If the custodian does not designate a successor and the child attains the age of 14 years, the child may designate a successor. Without a designated successor, if the minor has not reached the age of 14, the court will appoint a successor. In most instances the court will appoint a parent as successor custodian.

Who shall act as custodian? The parent should not act as the custodian. Although the parent will then lose control of the account, certain tax consequences may result if the parent is custodian. First, if the parent dies before the child attains 18, the property may be included in the parent's gross estate. However, in one revenue ruling, the decedent was appointed successor custodian for a custodianship created by her spouse. The spouse had transferred separate property to the account, but the decedent had consented to split the gift. The IRS ruled that the property was not included in the decedent's gross estate.

Can the custodian use custodial property to support the minor? Everyone is aware that a parent has a legal obligation to support a child. If the custodian under UGMA is also the parent of the minor, use of the custodial funds by the custodian-parent would be improper. In certain states, such support includes the cost of a college education if the child so requests. Although this issue rarely reaches litigation, nonetheless it should be considered when contemplating a UGMA gift.

What are the tax consequences? For income tax purposes, the minor is required to report all income from the UGMA account. This gift will qualify for the annual exclusion for gift tax purposes. Should the minor die prior to attaining 18, the account balance will be included in the minor's gross estate and be subject to an administration proceeding in court. If the parent is the custodian of the UGMA account and the parent dies before the child reaches age 18, the account balance could be included in his or her estate.

Totten Trusts

The name "Totten Trust" (or as they are generally referred to as "in trust for" or "ITF" bank accounts) was derived from the case In re Totten, a New York case that led to the law as now practiced. The Totten Trust is generally established by a parent or grandparent for the benefit of a minor. However, the beneficiary is not entitled to the funds until the depositor dies and, provided the beneficiary survives, is at least 18 years of age. But if the beneficiary does not survive the depositor, the beneficiary's estate is not entitled to the funds.

The Totten Trust raises numerous practical questions. What if the beneficiary is entitled to receive payment and is under the age of 18? Does it matter as to the amount in the account? What are the gift, estate, and income tax consequences? Is there any loss of control? Finally, is this a practical method of making a gift or should it be through a will?

Beneficiaries under 18. If a beneficiary survives the depositor, he or she is entitled to receive the funds provided he or she is at least 18 years of age. However, the law provides in part--"if the beneficiary is under 18 years of age at the time demand for payment of any part or all of the funds is made, the funds may be paid to the order of the parent or parents of the beneficiary to be held for the use and benefit of such infant beneficiary or to the order of the duly appointed guardian of the property of the beneficiary, if the funds are equal to or are less than $5,000; but if the funds are more than $5,000, the funds may be paid only to the order of the duly appointed guardian of the property of the beneficiary."

Can the depositor revoke the Totten Trust account? Absolutely. Although other alternatives exist, there are basically three different methods to revoke the account. First, the withdrawal of funds is a revocation and the beneficiary may not inquire unless unusual circumstances exist. A second method is an acknowledged writing filed with the financial institution indicating such a revocation. A third method to revoke the account is through the last will and testament of the depositor. However, the will should list the financial institution, the account number, the beneficiary and the alternative disposition.

Tax consequences. The tax consequences are easily interpreted. First, as to the gift-tax consequences, the creation of this account is not a completed gift and a gift-tax return is not required. A gift, however, may be completed by the delivery of the bankbook to the beneficiary.

For estate-tax purposes, the Totten Trust is included in the depositor's estate. With respect to the income tax consequences, the depositor reports all income on his or her tax return since it is the depositor's Social Security number that is used to create the account.

IRC Sec. 2503(c) Trust

A trust offers many advantages over outright gifts, custodian gifts to minors, and Totten Trusts. For probably that reason, the trust is the most frequently used device when a series of annual gifts is contemplated. There is better control over the assets, the trustee can be given discretionary power over income and principal, professional investment advice can be made available, and there are no restrictions on the type of property that may be transferred into such a trust.

The problem with trusts in general is that gifts in trust are gifts of a future interest that do not qualify for the annual exclusion. Fortunately, some exceptions exist, and IRC Sec. 2503(c) is one of them. That section provides that a gift to a trust for the benefit of a person who is under 21 shall not be considered a gift of a future interest if--

* both principal and income may be expended by and for the benefit of the donee prior to attaining age 21;

* to the extent not so expended, income and principal will pass to the donee on reaching age 21; and

* in the event the donee dies before attaining age 21, the assets are payable to his or her estate or as may be appointed under a general power of appointment.

The first and third requirements have generally been easy to comply with. The requirement for termination at age 21 seems relatively simple; but drafters have provided various devices for extension of the trust beyond age 21. Much litigation has developed on this issue. The regulations specifically allow a continuation if the donee affirmatively elects to extend the term of the trust. However, language that provides for automatic continuation, absent an active action by the donee, is not permitted. The IRS now allows the extension if the beneficiary upon reaching age of 21 has either (i) the continuing right to compel distribution from the trust or (ii) a right during a limited period of time to require distribution from the trust by giving written notice and on the failure of which the trust will continue on its own terms. The notice to the beneficiary must be reasonable, 60 days for example, and preferably should be in writing.

For income tax purposes, the income of a IRC Sec. 2503(c) trust will not be taxable to the grantor unless it is actually utilized to defray support obligations of the grantor. Until the beneficiary attains age 21, ordinarily, income accumulates and is taxed to the trust as a separate income taxpayer. After the beneficiary reaches 21, the lapse of the withdrawal right by the beneficiary will cause the beneficiary to be treated as a grantor, and the trust as a grantor trust, with the result that all income, ordinary as well as capital gains, will be taxable to the beneficiary whether or not the income is actually distributed.

Income distributed to a beneficiary under age 14 is subject to the "kiddie tax" rules with the possibility that some of the income will be taxed at the parent's highest marginal income tax rate.

The Present Income Trust Under
IRC Sec. 2503(b)

Many grantors have strong reservations about even giving a 21 year old the window of opportunity to draw down the trust. They want to ensure the trust will last beyond age 21, and yet they are still motivated to obtain an annual exclusion. With such a trust, the grantor chooses the age of the beneficiary that will cause termination of the trust. The trust can run for the life of the beneficiary. The trust will, however, require that income be distributed currently. No accumulation of income is permitted, although the instrument may permit the trustee to pay the income to a custodian under a UGMA account until age 21. The annual exclusion will be available for the value of this income interest, which is a present interest, although no exclusion will be available for the value of the principal interest. However, depending on the term of the trust and age of the beneficiary, the value of the income interest under IRS actuarial tables will allow annual exclusion of a high percentage of the overall gift.

Income of the trust is, of course, taxable to the beneficiary as it is required to be distributed currently. Capital gains income, however, will be taxable to the trust as a separate tax payoff.

The Crummey Power Trust

For those donors troubled by the mandatory age 21 termination requirement of the IRC Sec. 2503(c) trust or the present income distribution requirements of the IRC Sec. 2503(b) trust, various devices have been utilized that take advantage of the annual gift tax exclusion by virtue of the so-called Crummey Power. The Crummey Power, named after the Ninth Circuit case, Crummey v. Commissioner, has evolved into a power of a beneficiary to withdraw from the trust on an annual basis an amount equal to the annual exclusion in any year where transfers are made to the trust. Since the beneficiary has the power to withdraw, even if not exercised, the gift of a future interest problem is obviated, and the gift will qualify for the annual exclusion.

The person having the right to withdraw from the trust must be given notice by the trustee of the existence of this power. That notice must be reasonable in time. The IRS has ruled that a 30-day notice is reasonable. The fact that the holder of the Crummey Power is a minor does not prevent the use of the power. Notice of the existence of the power may be given to a guardian. Although it may be determined that a waiver of future notices is permissible, the IRS's national office has set forth its position that notices should be given annually.

The use of a Crummey Power to obtain annual exclusion qualification is typical of the "form over substance" philosophy often found in the tax law, since it is rarely expected that the holder of the Crummey Power will exercise his or her power to withdraw assets from the trust. The clause is simply put in to satisfy the present interest requirement and qualify the contribution for annual exclusion.

Having obtained the annual exclusion, another tax trap awaits. The lapse of the power of withdrawal by the power holder can be deemed a taxable gift to the remainderman of the trust in and of itself, since in effect, the withdrawal power is a general power of appointment. Fortunately, IRC Sec. 2514(e) provides partial relief, creating a taxable gift only where the value of the property subject to the lapse of the power in any calendar year exceeds the greater of $5,000 or 5% of the property from which the power could be satisfied. If the gifts contemplated are under $5,000, there is little question that the withdrawal power should be limited to the greater of $5,000 or 5% and thus avoid the lapse problem completely. If the gifts, however, exceed $5,000 annually, the lapse constitutes a taxable gift by the holder of the power.

As a solution to this lapse problem, planners have developed various techniques as an attempt to avoid the lapse. One is the so-called "hanging power," where a typical Crummey Power is created, but the power lapses only to the extent of the greater of $5,000 or 5% of the value of the trust principal. The remaining portion of the power "hangs" until, by the build up of the corpus of the trust, the 5% prong of the statutory exception exceeds the maximum annual gift amount ($10,000) and allows further lapses until the power ultimately begins to decrease and, in fact, eventually disappears. Nonetheless, if the beneficiary holding the power dies prior to the disappearance of the hanging power, the unlapsed portion will be included in the beneficiary's estate. Because of the advantages of sheltering the annual contribution to the trust by the annual exclusion, taxpayers have tried to create as large a class as possible of persons who have withdrawal powers and that could give rise to an additional $10,000 gift tax exclusion.

Another method to avoid this problem is to create a trust with one beneficiary and to provide in the trust document that the beneficiary has a general power of appointment. This will avoid any of the above problems.

With respect to the income tax consequences, generally the income from the trust, though not distributed, should be included on the beneficiary's personal income tax return pursuant to Sec. 678. Here, the child is now considered the grantor of the trust by having the right of withdrawal.

Not suprisingly, the IRS has issued TAM 9628004 that now sets forth the IRS's position that they do not accept Crummey withdrawal powers as a gift of a present interest. Although the beneficiaries were notified, there was insufficient time to exercise their right of withdrawal. The IRS considered these gifts a future interest since there was a prearranged understanding that the rights of withdrawal would not be exercised.

Wind Out of the IRS's Sails

The IRS has been fighting this concept for some time, holding that persons who have withdrawal powers, but who have no interest or only a contingent interest in the trust, are merely inserted as a sham to obtain gift tax exclusion and indeed the exclusion has been disallowed in some cases. A Tax Court case, Cristofani v. Commissioner, 97 TC 74 (1992), however, takes some of the wind out of the IRS's sails in this regard. In that case, the decedent created an irrevocable inter vivos trust under which his two children were to receive the entire trust income, and at his death the trust was to be divided into two shares for each of the two children and distributed to each child who survived the decedent by at least 120 days. If any child predeceased or failed to survive the 120 days, his or her share would be used to establish separate trusts for the deceased child's children. Both the children and grandchildren were granted Crummey Powers to withdraw an amount not to exceed the annual gift tax exclusion. The decedent contributed an interest in real property to the trust for two successive years, the value of which was $70,000. None of the grandchildren exercised the withdrawal power and the decedent did not report the transfers on her Federal gift tax return, claiming seven $10,000 exclusions. The Tax Court viewed the matter simplistically, and allowed the annual exclusions for each grandchild because each grandchild's right of withdrawal was a present interest. The court pointed out that under Crummey the trust beneficiaries are not required to have a vested present interest or a vested remainder interest to qualify for the exclusions. This case would suggest that you can get multiple exclusions if the power holder has an interest in the trust. Giving withdrawal powers to people who have no such interest, however, would be risky. The IRS made an announcement that they have acquiesced the Cristofani decision (IRB 1996-294, 4, July 15, 1996).

The Right Vehicle for the
Circumstances

The right approach for making
gifts to minors depends on the
circumstances. Because trusts are more complicated and exacting, they should only be used where the gifts are
expected to reach sizeable proportions. The UGMA and ITF approach makes more sense where gifts are not as large and the potential for misuse by the child upon reaching age 18 is minimized. *

References to applicable individual code sections, regulations, etc. related to this article are available on request.