Giving Away the Farm
How Parents Can Make Gifts to Young Children

April 19, 2007

Published in the AICPA Wealth Management Insider

Most of us are lucky enough to work with clients who are truly interested in passing along some of their good fortune to their families.  Let's review some of the techniques that you can share with these clients when they ask you the age-old question:

How can I give assets to my minor children now, but still make sure that the gifts won't be wasted or squandered?

This article will review a few tried-and-true ways for a parent to make a gift to a minor child.  This article won't be a review of the rules for qualifying a gift for the gift tax annual exclusion amount, or a review of the current gift and estate tax exclusions and exemptions.

• Outright gift to a minor, held in a Uniform Transfers to Minors Act account.  This is a simple technique where a parent can open a Uniform Transfers to Minors Act account at a bank or brokerage firm to hold gifts made to a minor child.  In California, these accounts may be established to hold one or more gifts for a minor child until age 18 or age 21.  Gifts to a Uniform Transfers to Minors Act account, often referred to as a custodianship account, qualify for the annual exclusion from gift tax, meaning that the first $12,000 of the gift will not be a taxable gift.
  
  The pros:  It's usually quite easy for a parent to open a custodianship account for a child at the parent's bank or brokerage firm.  An adult is named as the custodian, or manager, of the account.  That person has the power to invest and distribute the account assets.  The custodian could be the parent, or any other trusted adult.  The assets may be used any time for the benefit of the child, in the discretion of the custodian.  The income earned on the account is taxed to the child.
  
  The cons:  The gift is irrevocable, and the parent can't retrieve the gift after it's made.  If the parent is the custodian and dies while the account is in effect, the assets in the account will be included as part of the parent's taxable estate.  And watch out.  The account will terminate when the child reaches the age designated on the account, and he or she will receive all of the assets in the account at that time.  An 18- or 21-year old may not be mature enough to deal with the receipt of the assets received from the account. 
  
  
• Gift to a 2503(c) Trust. One way a parent can provide for the management of gifted assets beyond the age of 21 is to create a Section 2503(c) Trust for a child's benefit.  Here a parent creates a trust for the child's benefit, and then makes one or more gifts to the trustee of the trust.  The trustee holds, manages, and distributes the gifted assets according to the terms of the trust.  In order to comply with the provisions of Section 2503(c), the trust must provide (a) that the trust assets will be distributed to the child upon reaching the age of 21, or (b) that the trust assets will be distributed to the child at age 21 only if the child demands a distribution of the trust assets.  If the trust uses option (b) just described and the child does not demand a distribution of the trust assets at age 21, then the trust may continue on for the child's benefit, even until the child's death.
  
  The pros:  The trust has the potential to continue well past a child's 21^st birthday simply by giving the child the demand right to the assets at age 21.  The time frame during which the child may exercise the demand right may be limited; for instance, the trust could provide that the child must exercise the right during the 60 days following the child's 21^st birthday, after which the right would expire.  Gifts made to a Section 2503(c) Trust while the child is under the age of 21 will generally qualify for the gift tax annual exclusion.  In addition, after the child reaches the age of 21 and after the child no longer has any power to demand the withdrawal of the trust assets, the trust assets may be protected from a child's creditors, including a divorcing spouse.
  
  The cons:  The parent will incur legal expenses for the preparation and implementation of the trust, the expense of a gift tax return to report any gift over the annual exclusion amount, and the ongoing expense of an annual income tax return for the trust.  The trust is irrevocable after it is created and it may not be modified or amended by the parent.  Therefore, the parent should be careful in designing the trust, taking into account a child's changing circumstances while the trust may be in effect.  If the parent designs the trust to last beyond the age of 21 by giving the child a demand right at age 21, there's always the chance that the child will exercise the power! 
  
  
• The Gift Trust.  A parent may also create a more standard Gift Trust for a child, which can last to any age, or until a child's death.  Under a standard Gift Trust, there is no requirement for a child to be given a demand right over the trust assets upon reaching the age of 21, or any age for that matter.  As with the Section 2503(c) Trust, a trustee manages and invests the trust assets, and distributes the assets for the child's benefit according to the terms of the trust as designed by the parent.  Gift Trusts are often designed to benefit a child during the child's lifetime, after which the trust may continue on for the benefit of that child's children (the parent's grandchildren).  Gifts to these types of trusts generally do not qualify for the annual gift tax exclusion because the child does not have the right to immediately use and enjoy the gifted assets.  If it's important to qualify the gifted assets for the annual exclusion, then the trust can include a "Crummey" withdrawal power, which allows the child to withdraw the gift from the trust for a particular time period after the gift is received, usually about 30 to 60 days. 
  
  The pros:  A parent can design a Gift Trust to meet a child's particular needs, without the need to allow the child access to the trust assets at age 21.  Some trusts are designed to make significant distributions to a child upon achieving certain successes in life, such as a college degree, or they may provide assistance for a child to purchase a home or to start a business.  The trust can provide income, and principal for a child's support, for any number of years selected by the parent, or for a child's lifetime.   The trusts can be designed to continue on for the benefit of grandchildren after a child's death.
  
  The cons:  The expense of creating the trust and preparing tax returns is the same as that for the Section 2503(c) Trust.  Again, the trust is irrevocable, and cannot be modified or amended by the parent after it is created and implemented.  Because the trust is irrevocable, the parent should take time to carefully design the trust for the long-term benefit of the child, and perhaps future grandchildren.  Due to the potential length of time that the trust may be in effect, the selection of a trustee is all the more important.  The parent should not serve as trustee of a Gift Trust to avoid having the assets included in the parent's taxable estate at death.  Gifts to such a trust will not qualify for the gift tax annual exclusion unless the child is given a power to withdraw the gift soon after it is made to the trust.  In addition, if the potential exists that the trust assets will eventually pass to grandchildren or below, then the parent should allocate generation-skipping tax exemption to the gifts as they are added to the trust.

With this information at hand, and with your knowledge about your client's family, assets and financial situation, you can get the conversation started.