Maximizing Wealth Transfers to Minors

If you wish to maximize wealth transferred to a minor child or grandchild without having to file a gift tax return, you have several choices and combinations of choices, each yielding different tax implications and levels of control. This article explores several of those choices.

Because this article frequently references “annual exclusion gifts,” here is a short explanation. The IRS only needs to know about gifts if they exceed the annual exclusion amount which is currently $15,000 per year per person. Said another way, this is the amount that can be “excluded” from the annual gift reporting requirement. Under current law, you may give this amount to an unlimited number of individuals. If you are married, your spouse may also give that same amount. Thus, a fortunate child might receive $30,000 from her parents, $30,000 from her grandparents, $30,000 from her great grandparents, and $30,000 from her neighbors each year, and nobody is required to report a gift. Furthermore, a set of grandparents blessed with fifteen grandchildren may give $450,000 per year without needing to file a gift tax return. If all fifteen grandchildren are married, including in-laws translates to $900,000 in possible annual exclusion gifts. Amounts given in excess of these amounts would need to reported on a gift tax return and would utilize a portion of your lifetime gift and estate tax exemption.

These annual exclusion gifts may be made outright or in more protective ways utilizing trusts. In addition, there are means of benefitting a minor without utilizing the annual exclusion or your gift tax exemption. Here are some of your choices for transferring wealth to a minor child without reporting a gift to the IRS and without utilizing any of your gift and estate exemption amount.

1. Pay directly for certain expenses without it being a gift and without utilizing the annual exclusion: The two methods below can result in significant amounts transferred over time and provide real support for the child without giving them access to cash:

• You may pay a child’s qualified tuition expenses. Drop off daycare likely does not count, but an educational institution as defined by the IRS is eligible. Summer camps with a heavy educational component such as “computer coding” or “art camp” likely count, but the general recreational camps likely would not. Be sure you pay the expenses directly to the institution. Private schooling at an average outlay of $17,000 per year plus private university at $60,000 per year totals over $540,000 over 22 years.
• You may pay a child’s health care expenses including their insurance premiums. Again, the payments must be made directly to the provider of the care. Also, if you pay for a service that is subsequently covered by an insurance company, you need to be reimbursed or else you’ve made a gift. An average outlay of $3,000 per year could add up to $60,000 or so over 20 years.

Note: If you tire of chasing children and grandchildren around for bills and statements, consider establishing a bank account in your name but with the child (or the parent) as a signor. If you choose this route, you still need to be sure the account is only used to directly pay tuition and medical expenses. You, the child, or the parent should keep records of the payments along with your tax information should you ever need to produce records for an IRS audit.

2. Basic gifts to a minor’s custodial (UTMA) account utilizing the annual exclusion gifts: Every child needs a basic savings account at the bank and eventually an investment account. Where else will they put all the cash from their lemonade stand and lawn mowing business?

• You may add to this stash annually, using your annual exclusion gifts. Some grandparents will give $30,000 per year starting in the year of their grandchild’s birth, investing and piling up well over $1,000,000 by the time the child is a young adult. (This is a great time to reflect on the power of compounding!) Note that the age of majority, or the age at which a minor will assume possession of an UTMA account, is typically between 18 and 21, depending on state. In North Carolina, the age of majority for an UTMA is 21.
• Though the beneficiary technically owns the account, the assets in a custodial account are included in the estate of the donor if the donor is also the account custodian and dies while the beneficiary is still a minor. Thus, if you are elderly or living dangerously, consider naming someone else as custodian of the account. (If you are a grandparent, perhaps you name the parent of the child as custodian. Just know you give up control over how the funds are used to benefit the child if you are not the custodian.)
• The ease of this technique is obvious. The flaw in this strategy is equally obvious: what if your grandchild is a knucklehead at age 21 when they assume control over the account with a sizeable balance? The solution with a compliant child who has reached the age of majority is to “help” him commit the funds to a self-settled irrevocable trust until a later date. The trust assets would, of course, still be available to him per the trustee’s discretion.

3. Mitigating the minor’s account “Knucklehead Risk” with the use of a trust to receive, hold, and manage your annual exclusion gifts: Qualifying for the annual exclusion while using a trust requires the beneficiary child have a present interest in the gifted property or else the trust must comply with an exception to that rule provided by Section 2503(c) of the Internal Revenue Code.

• Crummey Trusts: Working around the knucklehead risk in the 1960s, Mr. D. Clifford Crummey devised a trust that solves the “present interest” problem. He did so by giving the beneficiary of the trust a window of time during which she could withdraw gifts recently made to the trust. The child is given notice—a “Crummey letter”—typically through their parent or legal guardian if underaged, and upon the lapse of the withdrawal right, the gift remains in trust, subject to its distribution terms thereafter.
• 2503(c) Trusts: This strategy provides an exception to the present interest requirement, so no withdrawal right is required—no “Crummey notice” required—with each gift to the trust. However, a conspicuous window must open when the child reaches age 21, not unlike the minor’s custodial account described in Item 2 above. The child must have unfettered access to ALL the assets of the trust during that window, after which the window closes and the trust continues per its terms. How does this mitigate the knucklehead risk better than a custodial account? The event at age 21 is simpler and smoother. There is not a new trust to draft, explain, and execute, only a letter acknowledging the withdrawal right. Note, 2503(c) trusts have specific requirements necessary to qualify for the exception to the gift tax return. The trustee must have broad discretion to provide for the beneficiary, for example. Also, the donor/grantor to the trust may not serve as trustee. If you do name yourself as trustee, this measure of control will cause the trust assets to be included in your estate—something we are clearly trying to avoid.

4. 529 College Savings Plans: As you can see from this article written by Mary Lou Daly, 529 plans offer superior income tax advantages over normal taxable accounts and especially over trusts, which are subject to compressed tax rates. Further, based on the advantageous flexibility and control attributes, we are convinced that the committee that designed these plans never met with any IRS staffers.

• A gift to a 529 plan qualifies for the annual exclusion even though the child does not have a present interest, meaning no immediate access to the dollars, unlike the access provided in the Crummey Trust example above.
• The owner of the 529 plan account can change the beneficiary and even take the money back to himself, subject to taxes and penalties if not used for education. This happily violates the “completed gift” concept referenced above that requires assets be outside the reach and control of the donor if it is to be fully removed from their estate for estate tax purposes.
• Therefore, we absolutely must include 529 plans high on the list because significant dollars can be shifted out of your estate in this manner. They can grow tax free, may be used for education without triggering taxes, and they can be controlled beyond the gift by you as donor. Some state-sponsored 529 plans allow maximum funding in excess of $500,000. Incidentally, you may fund the 529 plan with five years’ worth of annual exclusion gifts at once, which means you will not be able to make additional annual exclusion gifts to or for that child for four more years. This particular front-loading strategy requires a gift tax return be filed, so it departs from the theme of this article—keeping it simple and avoiding filing of a gift tax return—but is certainly a good strategy.

5. Implementing multiple strategies to maximize wealth transfer or to serve different purposes:

• You might consider paying directly for education and health care expenses while also using your annual exclusion with one of the strategies listed above. For example, it may make sense to max out a 529 plan, enjoy the income tax deferral for years, and then not actually use the plan when the child attends college; instead, you would pay their tuition directly and let the 529 plan sit. Under current law, the unused 529 balance can be transferred to another beneficiary. If the new beneficiary is down a generation from the current beneficiary, this triggers a gift from the old beneficiary to the new one, although if these transfers are capped at the annual exclusion amount and thus done incrementally over time, it may be possible to transfer the entire 529 plan without requiring a gift tax return. Of course, there is a chance the child has no children or too few children to effectively transfer the balance subject to limitations. If this is the case, the owner may end up having to withdraw funds subject to income tax and a ten percent penalty on the gain. This may still be an optimal result when compared to other accumulation strategies that involve loss of control and/or high trust income tax rates which encumber the growth of the assets. Under current law, the ownership may be changed without triggering a reportable gift. (If you plan to pursue aggressive wealth transfer via 529 plans, it is important you do so with an eye on Washington and with thoughtful planning.)
• You might want different sources of support for different purposes. For example, the minor’s custodial account might be an ideal account for the child to practice saving and investing and could fund the first home purchase. Meanwhile, the Crummey or 2503(c) trust might be a vehicle with a distant time horizon, meant to establish a foundation for retirement while protecting assets from creditors or failed marriages.

All of the methods detailed herein have assumed you wish to transfer wealth without being required to file a gift tax return. There is certainly no rule that says you can’t implement multiple wealth transfer strategies that do require a gift tax return or the use of your gift and estate tax exemption. Further, each of the strategies described needs a deeper conversation; the introductions above are not meant to be comprehensive or taken as “advice” outside of a broader conversation about your plans and objectives. Let us know if you’d like to review whether you are taking best advantage of the opportunities available to you as donor.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.