In addition to end-of-life planning through wills, trusts, and powers of attorney, our estate-planning group can assist clients with lifetime wealth transfer planning. Here, we discuss six alternatives for lifetime gifting to a grandchild. Each alternative is founded on Washington and U.S. federal tax law principles that establish the parameters of each gifting technique. Lifetime gifting generally utilizes either the lifetime gift exemption amount of $1 million per donor or the $12,000-per-recipient annual gift tax exclusion ($24,000 with gift splitting between spouses) to maximize tax savings. Consideration is given to the generation-skipping transfer (GST) tax that can be imposed in addition to the estate or gift tax. Each donor currently has a $2 million lifetime GST tax exemption, which can be allocated during the donor’s life, and in some cases, an additional $12,000-per-recipient annual GST exclusion. These six options can also work for a client’s children.
The Uniform Transfers to Minors Act (UTMA)
Gifts under this structure are made to a special UTMA custodial account. Such gifts can qualify for the annual gift tax exclusion and the annual GST exemption. As long as the donor is not the custodian, the gifted amounts plus future income and appreciation will be removed from the donor’s taxable estate. The gifted amounts can be used for the grandchild’s benefit until he or she reaches 21 years of age. Gifts of cash or securities can be held in almost any financial institution or investment vehicle, with the custodian acting as the fiduciary.
The UTMA structure has some downsides. The donor has no control over the usage of the funds after the grandchild reaches 21 years of age and the custodianship ends. Each account benefits only one grandchild, so the funds cannot be reallocated for future needs among grandchildren. In addition, the income is taxable to each grandchild annually as earned.
2503(c) Trust Gifts
These trust accounts are very similar to UTMA accounts but are established with a formal trust agreement. Any type of asset can be given to, held by, and distributed from these trusts. Gifts to these irrevocable trusts can qualify for the annual gift tax exclusion and the annual GST exemption. No donor can be the trustee (equivalent to the UTMA custodian) to have gifted assets removed from the donor’s taxable estate. The trust assets pass outright to the grandchild at age 21 or the grandchild must have a right to withdraw all funds from the trust at age 21.
An advantage over an UTMA account is that the trust can continue if the grandchild does not demand complete distribution within a specified period after his or her 21st birthday. The trust can also specify the remainder beneficiaries upon the grandchild’s death if the grandchild does not exercise a testamentary general power of appointment.
Like an UTMA account, each trust must have only one beneficiary, and gifts cannot be reallocated among grandchildren for future needs. Trust income is taxable to the trust or to the recipient beneficiary as distributed.
“Crummey” Trust Gifts
This structure relies upon an old tax case called Crummey v. Commissioner. “Crummey” trusts are irrevocable trusts established for grandchildren that can specify the ages, amounts, and purposes for distributions. To qualify for the $15,000 annual gift tax exclusion for gifts to such a trust, beneficiaries must be given a right to withdraw the gifted amount for 30 days following each addition to the trust (just like a life insurance trust). Crummey letters (notice of such rights of withdrawal) are also required to qualify each gift for the annual gift tax exclusion. Any type of asset can be gifted but must be in $15,000 or smaller increments to avoid gift tax consequences.
Crummey trusts can be used for generation-skipping tax (GST) planning but only for the grandchildren’s generation. To additionally qualify for the GST annual tax exclusion, the trust (or each separate share of a trust) must have only one grandchild in whose estate the trust assets must be included at his or her death, and the trust cannot benefit any person other than the one grandchild during the grandchild’s life. A testamentary general power of appointment can cause the necessary inclusion in the grandchild’s taxable estate to avoid the GST tax, while not distributing all of the trust assets to the grandchild during the grandchild’s life. Trust income from any assets over which a Crummey power was granted is taxable to the beneficiary granted the withdrawal right. The rest of the trust income, if any, is taxed to the trust or the recipient grandchild as distributed.
GST-Exempt Trust Gifts
An alternative to a Crummey trust is a GST-Exempt Trust. Here, the donor’s lifetime gift tax exemption (currently $11.2 million) and GST tax exemption (currently $11.2 million) can be allocated to an irrevocable trust that benefits multiple grandchildren and more remote descendants. Such trusts increase the flexibility to benefit multiple descendants for multiple generations and can still specify the ages, amounts, and purposes of distributions. These trusts are also protected from any future estate or GST tax at a grandchild’s death. It is not advisable to combine lifetime GST exemption gifts with annual GST exclusion gifts. Annual exclusion gifts will not qualify under the multiple beneficiary and multiple generational features of these GST-exempt trusts since annual exclusion gifts must be taxed in the grandchild’s estate and benefit only one grandchild during his or her life. Any type of asset can be gifted to, held by, or distributed from these trusts. Trust income is taxed to the trust or to the recipient beneficiaries as distributed.
Health and Education Exemption Trust (HEET) Gifts
A Health and Education Exclusion Trust (HEET) will not be subject to the GST tax and does not use the donor’s lifetime GST tax exemption amount. These irrevocable trusts require that the funds be used only to pay educational or unreimbursed medical providers directly for the benefit of any specified descendants. Only tuition at any educational level, including extra-curricular classes and prepaid tuition plan purchases, is a qualified educational expense. Medical expenses must be unreimbursed qualified expenses under section 213(d) of the Internal Revenue Code, but can include health insurance premiums and necessary related travel expenses.
One additional requirement, however, is that the trust have a significant charitable beneficiary (receiving 10% of the benefit) to accomplish the GST protection. A family foundation, permanent charitable trust, list of named charities, or charities to be named by the trustee can be the charitable beneficiary. Therefore, multiple family goals can be accomplished through a HEET. The donor’s lifetime gifts to the trust are made gift tax-free by utilizing either the Crummey rights for annual exclusion gifts of $12,000 per recipient ($24,000 per year per recipient with donor spouses gift splitting) or the $1 million-per-donor lifetime gift tax exemption. Unlike the Crummey trusts, annual exclusion gifts to a HEET will not be taxed in a grandchild’s estate or have distributions limited to only one grandchild because of the HEET distribution requirements.
Advantages of this structure are that the funds cannot be used for anything other than direct payments for a beneficiary’s health and education (and the charitable distributions), and the trust does not distribute or end when a beneficiary reaches age 21 and can, in fact, benefit several generations free of future gift, estate, and GST taxes. The gifts can be allocated by trustee distributions among grandchildren and even more remote descendants as future needs arise. Any type of asset can be contributed to the trust. Funds held in the trust can be invested in any asset deemed prudent to the trustee but distributions must be in cash to the providers. Income will be taxable to the trust or to the beneficiaries for whose benefit distributions are made.
Educational Savings (529) Accounts
Gifts to these accounts qualify for the annual gift tax exclusion and can be exempt from the GST tax. Gifts for prepaid tuition do not use the donor’s lifetime or annual GST exclusion amounts. Each account can be front-loaded with a maximum $55,000 gift per donor and qualify for five years’ future annual gift tax exclusions. A total of $110,000 per grandchild is permitted with spousal gift splitting, but each state plan will limit the total contribution to approximately the equivalent of a five-year college education cost. A front-loaded gift is prorated over the five-year period and the donor must survive all five years to utilize all of the future annual gift tax exclusions, even though the gifted amount is removed from the donor’s estate as a completed gift on the date of transfer. Careful planning is required for additional gifts where the initial gift was more than $12,000 but less than the full $60,000.
Only cash can be contributed to these special accounts, and investments are determined by the brokerage firm chosen by each state. Unlike the HEET gift discussed above that limits educational distributions to tuition at any educational level, a 529 account permits distributions for books, fees, supplies, equipment, and room and board along with tuition, but only at post-secondary accredited institutions (college or equivalent).
Although each account is established for only one beneficiary, the gifted funds can be rolled over tax-free to various family members if the initial beneficiary does not utilize the funds for college. A 10% penalty, plus income tax on earnings, is imposed if the funds are distributed for nonqualified purposes, but does not apply if the beneficiary dies or receives a scholarship. The earnings on these accounts are not taxed while invested or when distributed for qualified educational expenses. This is the only option that avoids income tax on the earnings of the gift.
Dille Law, PLLC represents many parents and grandchildren’s with their Estate Planning needs. Please call us at 360-350-0270 to set up an appointment today.