As the end of the school yeardraws near, you may bethinking about gifts to childrenand grandchildren. Aside fromthe personal satisfaction you receivefrom these gifts, there are also valuabletax and financial benefits. First,gifts to children and grandchildrenreduce the size of your estate forestate tax purposes. In addition, youmay save on income taxes, becausesome or all of the income on thetransferred property may be shiftedto the child or grandchild.
The way a gift is structured canmake a big difference in both thetax consequences and the amountof control a child or grandchild hasover the property and its income.Let's look at some alternatives.
The simplest way to make a giftis to transfer stock, mutual fundshares, cash, or other property outright.But, here's the rub—if yourchild or grandchild is a minor, theywon't be able to transact any financialbusiness with the gift without acourt-appointed guardian. Chancesare, there will also be restrictions onwhat the guardian can do with theproperty on the minor's behalf. Forexample, the guardian may not evenbe able to use the property to payfor college if the parents have adequateresources.
When the child or grandchildreaches the age of majority, 18 to21 depending on the state, theguardianship lapses and the childhas complete control over theproperty. That raises another concern.Many parents and grandparentsare reluctant to grant theiryoung adult offspring the ability tospend large sums of money withoutrestriction. Think about it—howresponsible were you at age 20?
One benefit of an outright giftis that it clearly qualifies for thegift tax annual exclusion ($11,000in 2003, $22,000 if your spouseconsents). If the child or grandchildis under age 14, income onthe gift is subject to the "kiddietax."Under the kiddie tax, the first$750 in unearned investment incomeescapes tax. The next $750 issubject to the child's tax rate, however,any investment income above$1500 is taxed at the parent's rate.For minors aged 14 or older, investmentincome is taxed at theirmarginal rate, which is usuallylower than the parents'rate.
Gifts to grandchildren may alsobe subject to Generation SkippingTransfer Tax (GSTT), which willbe repealed in 2010 (for 1 yearonly). If you are considering a trustfor the benefit of a grandchild, youshould discuss the details with yourtax advisor to make sure you takesteps to qualify for the GSTTannual exclusion in addition to theannual gift tax exclusion.
One way to transfer property to aminor and avoid the hassle of aguardianship is to establish a custodialaccount under the UniformTransfer to Minors Act (UTMA).With this type of transfer, you set upan account for the benefit of a minorand name a custodian. The custodiancan be a parent, adult, sibling, orother person. The custodian mustinvest the funds and use them solelyfor the education, medical care, support,and benefit of the minor.
With a custodial account, there isno trust to prepare and no separate taxreturn. In addition, the gift qualifiesfor the gift tax annual exclusion. Againwith the kiddie tax, investment incomein excess of $1500 is taxed at the parents'rate, if the minor is under the ageof 14. For minors age 14 and older,income is reported on the child'sincome tax return—no separate returnfor the custodianship is required.
One disadvantage of a custodialaccount is that when the minor reachesthe age of majority, the parent orgrandparent no longer has any controlover how the money is spent.That child or grandchild who looksyoung enough to still be in highschool can spend their money anyway they want. Another disadvantageinvolves a potential tax trap. If youname yourself as the custodian anddie before the child reaches the age ofmajority, the assets are included inyour estate for estate tax purposes.
Another approach to making giftsto minors is to use a trust. If the trustmeets the requirements of a "minor'strust"under Section 2503(c) of theInternal Revenue Code, transfersqualify for the gift tax annual exclusion.The trustee is required to usetrust income and principal solely forthe minor's benefits and distributethe assets to the beneficiary whenthey reach age 21.
An advantage of the minor's trustis that it can be set up so that theassets remain in trust even beyondthe child or grandchild reaching age21, as long as they can demand distributionof the assets at age 21. Adisadvantage is the complexity involved.Your lawyer will need to draftthe trust, and although the trust filesits own tax return, the kiddie taxrules apply to amounts distributed tominor beneficiaries.
Another type of trust is theCrummey Trust. Its main advantageis flexibility. With this type of trust,you decide when assets are distributed.For example, the trustee mightdistribute a third at age 35, a third atage 40, and the balance at age 45.You could give the trustee discretionto distribute income and principalbefore all final distribution of assetsfor things like college, buying a firsthome, or starting a business. Qualifyinggifts for the annual exclusion isa bit tricky. Basically, the beneficiarymust be given the right to withdrawcontributions for a limited period oftime, usually 30 days. If the beneficiary fails to exercise the withdrawalright, the assets remain in trust.
A drawback to the CrummeyTrust is that, like the minor's trust,a separate tax return must be filedeach year for the trust. The trustpays taxes on undistributed income;if the income is distributed to thebeneficiary, though, it will be taxableto the beneficiary.
There are a variety of ways tomake gifts to children and grandchildren.Choosing the wisest approachfor you is not easy. Seek theadvice of a qualified professional tohelp you decide.
Marc S. Levitt, financial advisor, and Louis M.
Bell, financial advisor, are a team at Prudential Securities
specializing in financial advisory and investment management
services for individuals, medical practices,
foundations, and trusts. They welcome
questions or comments at 212-303-8724,
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of future results.