Let's assume that you would like to make a lifetime gift to a child or a grandchild. The purpose may to be to help pay for higher education or to move assets out of an estate so as to reduce estate taxes. What are the options, and which is best?
Most of the time you will want the gift to qualify for the gift tax annual exclusion, which is $11,000 this year. Gifts that fall within the annual exclusion amount do not require the filing of a gift tax return and do not use up any of your lifetime exemption equivalent, which is presently $1,000,000.
There are five ways to make the gift. Some are more economical and flexible than others, so we will first review the options and then discuss which might work best in different situations.
Conservatorships . A conservatorship is a parallel proceeding to a guardianship. While a guardianship is designed to appoint someone who can make personal decisions for a minor, a conservator is appointed to manage the minor's assets. The conservator is appointed by a court, usually must post a bond, and must file annual accountings with the court. Conservatorships must end when a minor reaches the age of majority, which in Oregon is 18. At that point all assets held in the conservatorship must be distributed to the minor. Because conservatorhips are expensive to establish and maintain and involve public, court proceedings, they are generally used only as a last resort.
2503(c) Trusts . Certain trusts can also qualify for the annual exclusion. One type is a Section 2503(c) trust. All assets which are transferred to the trust qualify for the gift tax annual exclusion. The trust must either terminate at age 21 or the beneficiary must be given the right to withdraw the assets for a period after the beneficiary reaches age 21. The trusts are private and do not involve any court supervision. Their principal disadvantage is the expense involved in having a lawyer draft the trust, and the beneficiary has the right to withdraw the assets at age 21.
Crummey Trusts . Another form of trust is one which gives its beneficiaries the right to withdraw any assets contributed to the trust at the time of the contribution. These withdrawal rights are popularly known as "Crummey" withdrawal rights after a taxpayer who prevailed in a court dispute back in 1969. Even if the beneficiary who has the withdrawal right may be a minor, the gift will still qualify for the gift tax annual exclusion. Once the beneficiary does not withdraw the asset, the asset can remain in the trust for an indefinite period. Crummey powers are most frequently seen in irrevocable life insurance trusts. Their use in trusts which have income producing assets presents a number of income tax issues which have not been fully resolved.
Custodianships . A popular alternative for making gifts to minors is a custodianship, which is also known as a transfer under the Uniform Transfers to Minors Act. The custodianship is created when an asset is registered in the name of the custodian for the benefit of a minor. The proceeding is entirely private, as with a trust, and no accountings need to be made to any court. The principal disadvantage of a custodianship is that, until this year, it ended when the minor reached age 21.
The most recent Oregon legislature amended the law to allow a custodianship to last until the beneficiary reaches age 25. Because of federal estate and gift tax law, there is a question as to whether a gift to a custodian that is to last until the beneficiary reaches age 25 will qualify for the gift tax annual exclusion. We can only wait until this question is resolved.
Taxation . One of the disadvantages of all four techniques is that the income from the asset may be taxed to the beneficiary or at trust income tax rates. If income is taxed to a beneficiary and the beneficiary is under age 14, the "kiddie tax" will apply, which means that in 2002 any income from the assets in excess of $1,500 will be taxed at the parents' rate. Trust income tax rates are generally less favorable than personal tax rates.
Section 529 Plans . Against this backdrop Congress adopted Section 529 of the Internal Revenue Code. Section 529 is an enabling statute which provides a framework within which states can adopt education savings programs. Oregon and many other states have done so. If the gift to the minor is for education purposes, a 529 program will provide a highly advantageous method of making the gift. The primary advantages, compared to the methods described above, are as follows:
Transfers to a 529 program qualify for the gift tax annual exclusion, and a donor can use up his or her annual exclusion for a donee for this year and the next four years (a total of $55,000) in one transfer. The donor must live the five years to avoid having part of the transfer included in his or her estate.
Income generated by the assets is not subject to current income taxes. In this respect its taxation is similar to an IRA.
If the funds, including accumulated income, are used by the beneficiary for qualified education expenses, the accumulated income is never taxed. The funds do not have to be used at schools in the state sponsoring the plan.
Various money managers have been chosen by states which have 529 programs, and an account is established by filling out a form. No trust agreement is necessary.
The donor may change the beneficiary.
There are some disadvantages to a 529 program, as follows:
Only cash may be contributed.
Management of the investments is by the money manager with very little control by the donor.
When the donor desires to transfer a particular asset to a child or a grandchild, a 529 program is not a substitute for a conservatorship, a trust or a custodianship. On the other hand, when the primary purpose of the gift is to fund education, the 529 program offers significant gift and income tax advantages.
As shown above, the best vehicle for making lifetime gifts to minors will depend on the purpose of the gift and the extent to which the donor wishes to exert influence over the investment of the gift assets.