I. Minors’ Trusts: General Concepts
A. Transfers to Minors
Most estate plans include provisions for the transfer of assets to individuals in succeeding generations. Typically those individuals are the children or grandchildren of the transferor, who often have not attained the age of majority. When the children or grandchildren attain the age of 18 or 21, they are generally unprepared to manage what could be a substantial transfer of assets. Intergenerational transfers also present tax problems that can erode a family’s wealth. A prudent planner will seek to devise a strategy that will carry out the transferor’s wishes while addressing these taxation and control considerations.
B. Why Create a Trust?
Property can be transferred directly to a minor through use of the Maine Uniform Transfers to Minors Act, 33 M.R.S.A. §§1651 et seq. Under the UTMA, a person may make a transfer by gift or otherwise to a custodian for the benefit of a minor. The UTMA, however, does not provide a structure for the management of the transferred property, and a direct gift can cause undesirable tax consequences.
Creating a trust for the benefit of minor children allows for the transfer of wealth to succeeding generations in a way that effectuates the transferor’s intent, minimizes adverse tax consequences to the extent possible, and allows a measure of supervision and control over the trust assets. A properly drafted trust can allow an individual to begin making tax-free lifetime transfers to minor children or grandchildren, while providing for the prudent management of the transferred assets for the minors’ benefit and minimizing income tax obligations.
C. Common Types of Trusts
There are two types of trusts commonly used for the benefit of minor children: (1) a section 2503(c) trust, and (2) a Crummey trust. Both kinds of trusts are created primarily to take advantage of the annual gift tax exclusion provided in the Internal Revenue Code, currently $12,000. This presentation will discuss the distinguishing features of each kind of trust, their advantages, disadvantages, and tax considerations.
D. Gift Tax Exclusion
Use of the annual gift tax exclusion is a feature of estate planning involving transfers to minors. Gifts are taxed to the transferor at the federal level, but present interest gifts not exceeding $12,000 (in 2007) to any person during a calendar year are excluded from taxable gifts. IRC §2503(b)(1). The gift exclusion amount is adjusted annually for inflation. IRC §2503(b)(2).
Accordingly, in 2007 a donor may make gifts of up to $12,000 each to any number of individuals, free of any federal gift taxes. Maine has no gift tax. If annual gifts greater than $12,000 are made to any person, the first $12,000 is excluded from gift taxation, and the remainder must be reported on a gift tax return.
The $12,000 annual limit is cumulative for all gifts to a person during the calendar year, including the value of gifts for that person’s birthday, graduation, Christmas, etc. Accordingly, the amount of the gift to a trust should be determined by considering the value of other gifts to the same person that year, to avoid exceeding the gift tax exclusion amount.
A married person can split gifts with his or her spouse, effectively doubling the gift exclusion amount for each donee. Therefore, if the spouse consents, a married person can make tax-free gifts every year in the amount of $24,000 to each of the minor children or grandchildren (or any other person, for that matter).
In order to qualify for the annual gift exclusion amount, the gift must be a present interest gift. It cannot be a gift of a future interest in property. IRC §2503(b)(1). It is this "present interest" requirement that makes the use of properly drafted trusts essential. A trust must be irrevocable so that the gift is completed in order to avoid estate tax consequences.
Generally, annual exclusion gifts are not subject to the generation-skipping transfer tax. IRC §2642(c)(3).
II. Section 2503(c) Trusts
A. General Features
Recall that in order to qualify for the annual gift exclusion amount, a gift must be (1) less than or equal to the annual exclusion amount (currently $12,000) and (2) a present interest gift. Ordinarily, funds transferred to a trust for the benefit of a minor would be considered a gift of a future interest in property, because the minor child has no present right to use and control the funds.
However, IRC §2503(c) provides as follows:
No part of a gift to an individual who has not attained the age of 21 years on the date of such transfer shall be considered a gift of a future interest in property for purposes of subsection (b) if the property and the income therefrom —
(1) may be expended by, or for the benefit of, the donee before his attaining the age of 21 years, and
(2) will to the extent not so expended —
(A) pass to the donee on his attaining the age of 21 years, and
(B) in the event the donee dies before attaining the age of 21 years, be payable to the estate of the donee or as he may appoint under a general power of appointment as defined in section 2514(c).
By this provision, the Code transforms future interest gifts into present interest gifts qualifying for the annual gift exclusion, provided that the requirements of the statute are met. Those requirements are:
-- the donee must be younger than 21 years old on the date the gift is made;
-- the gifted property and the income it generates may be expended by or for the benefit of the donee until the donee reaches age 21;
-- the property and accumulated income not so expended must be distributed to the donee at age 21; and
-- if the donee dies before age 21, the property must pass to the donee’s estate or as the donee appoints.
Accordingly, the present interest gift to a minor can be made in trust, thereby preventing the minor’s unfettered use and control of the funds. This kind of trust has advantages and disadvantages, as will be discussed below.
B. Advantages and Disadvantages
The principal advantage of a 2503(c) trust is its simplicity. It is a straightforward arrangement in which the trustee manages the assets for the beneficiary, who receives the trust assets when the trust terminates.
The 2503(c) trust has a number of disadvantages, however. First and foremost is the requirement that the assets must be distributed to the beneficiary at age 21, an age that is younger than is generally preferred by most estate planners and their clients. This statutory requirement can be partially overcome by inserting a trust provision that gives the beneficiary a limited withdrawal period at age 21.
Under such a provision, at age 21 the beneficiary has 30 or 60 days to withdraw some or all of the trust assets. If all of the trust assets are withdrawn, the trust will terminate. If the beneficiary does not exercise the withdrawal right during the allotted time, or withdraws only part of the trust assets, the trust continues until a specified later age. The inclusion of such a provision in a trust does not disqualify a gift as a present interest gift under section 2503(c). Rev. Rul. 74-43; Treas. Reg. §25.2503-4(b)(2).
Another disadvantage of the 2503(c) trust is that it may have only one beneficiary. If more than one minor child is the object of the donor’s bounty, multiple trust instruments must be created. This can become cumbersome if several children or grandchildren are involved.
One feature of the 2503(c) trust to keep in mind is the requirement that the assets pass to the beneficiary’s estate if the beneficiary dies before age 21 without exercising a power of appointment. Under Maine law, a person under age 18 cannot make a will. 18-A M.R.S.A. §2-501. Accordingly, the trust instrument should contain language specifying how the trust principal and income should be paid if the beneficiary should die without exercising the power of appointment. Such a trust provision does not disqualify a gift as a present interest gift. Treas. Reg. §25.2503-4(b)(3).
III. Crummey Trusts
A. General Features
A Crummey trust is named for D. Clifford Crummey, a California resident who had a creative tax attorney. Crummey made annual gifts to a trust for four children, three of whom were minors. Each of the children, or the child’ s guardian, was given the right every year to withdraw up to a specified amount from the trust. If the right was not exercised it would lapse, and the money would remain in the trust. No guardians had actually been appointed. The Ninth Circuit Court of Appeals held that as long as there is no impediment under the terms of the trust or applicable state law to the appointment of guardians, the gifts qualified under section 2503(b) as present interest gifts. Crummey v. Commissioner , 397 F.2d 82 (9th Cir., 1968).
The salient feature of a Crummey trust is that each beneficiary has the right to demand distribution after a donation is made to the trust, regardless of whether the other beneficiaries so choose. Because the beneficiary has an immediate right to withdraw, the donation is a present interest qualifying for the annual gift tax exclusion, to the extent of the withdrawal right.
The Crummey trustee must notify each beneficiary of each contribution to the trust and the beneficiary ’s right to make a withdrawal within a specified limited time (typically 30 days). The notification should be in writing, and the trustee should retain records of all such communications indefinitely. If the beneficiary is under 18 years of age, the notification should be directed to the beneficiary’s parents. If the grantor is a parent of the minor beneficiary, the trustee’s notification should be directed to the other parent.
The assets subject to the right of withdrawal should be limited to a fraction of the donation to the trust if there are multiple beneficiaries, so that all beneficiaries who have a right to withdraw at the time the donation is made are entitled to withdraw equal or stated amounts. Each beneficiary’s annual withdrawal right should also be limited to the annual gift exclusion amount, although the "five and five rule" should be taken into consideration, as described below.
A trust beneficiary’s withdrawal right is regarded as a power of appointment under the tax code. IRC §2514(c). The "release" of a power of appointment constitutes a transfer of property by the person who had the power. IRC §2514(b). If a Crummey beneficiary allows the withdrawal right to lapse (which, after all, is the anticipated result), the lapse constitutes a "release" of the power, and therefore a transfer of property, but only to the extent that the withdrawal power exceeds the greater of (1) $5,000, or (2) 5% of the aggregate trust assets from which the withdrawal could have been made. IRC §2514(e). This is the so-called "five and five rule."
In the years since section 2514 was enacted, the annual gift exclusion amount has increased so that it far exceeds the $5,000 limit. Unless the trust corpus is large enough so that the gift exclusion limit does not exceed 5% of the trust assets, the "five and five rule" has the potential for causing gift or estate tax problems for the beneficiaries. Those potential problems might not be of great concern in the case of a minor beneficiary who is not expected to have a taxable estate before the trust terminates.
A grantor’s spouse may also be a beneficiary of a Crummey trust. If that is the case, the spouse’s withdrawal rights should be limited to the amount imposed by the "five and five rule" in order to avoid the inclusion of trust assets in the spouse’s estate for estate tax purposes. One of the estate planning goals in creating trusts for minors is to prevent assets from being included in the estates of the grantor or the grantor’s spouse.
The intricacies of dealing with the "five and five rule" will depend upon the circumstances of the case at hand, and are beyond the scope of this outline. It is an issue that should be considered if the use of a Crummey trust is contemplated.
B. Advantages and Disadvantages
One advantage of the Crummey trust is that it may have more than one beneficiary. A grantor with multiple minor children or grandchildren can make gifts to one trust, rather than creating separate trusts for each minor. Each beneficiary can be given a withdrawal power, or not, as the grantor may choose. The Crummey trust can last well beyond age 21, and can have adult beneficiaries as well as minor beneficiaries. It offers a great deal of flexibility, and is a good vehicle for creating an irrevocable life insurance trust.
One obvious disadvantage of the Crummey trust is that if a beneficiary has the power to withdraw a donation, the beneficiary might do so, frustrating the grantor’s wishes. In particular, at age 18 a child reaches majority, and can make his or her own decisions. A section 2503(c) trust will exist at least until age 21. However, if a beneficiary elects to make a withdrawal from a Crummey trust, only the recently donated amount may be withdrawn. The remaining assets continue in trust, and the grantor may choose not to make further gifts to that beneficiary.
The "five and five rule" might be regarded as a disadvantage of a Crummey trust, to the extent that a donor might choose to limit the size of annual gifts in order to observe its limits. It also creates the potential for estate tax complexity for the beneficiary.
There are tax considerations applicable to each kind of trust, which will be discussed below.
IV. Tax Considerations
A. Estate and Gift Tax
One major reason for creating trusts for minors is to avoid or minimize gift and estate taxes. As discussed earlier, transfers of property, either during lifetime or at death, are subject to gift and estate taxes if they exceed the lifetime exemption equivalent. In 2007 an individual’s federal estate tax exemption equivalent is $2 million. Maine has decoupled its estate tax from the federal estate tax, and the Maine estate tax exemption equivalent is now $1 million. The federal gift tax exemption equivalent is $1 million.
Barring amendments to the tax code, in 2010 the federal estate tax will be abolished, but in 2011 it will return at 2002 levels. Therefore, beginning in 2011 the estate and gift tax exemption equivalent will both be $1 million.
The donor’s taxable estate can be reduced during lifetime by making tax-free gifts up to the annual exclusion amount discussed earlier. By making annual gifts to a Crummey trust or a section 2503(c) trust of up to $12,000 for each minor beneficiary (or $24,000 each if split with a spouse), a donor’s taxable estate can be reduced substantially over time. The trust assets become the beneficiary’s property, and are not included in the donor’s estate.
It is essential, however, that the trust be irrevocable and the gifts be completed. The donor cannot retain a life estate in the transferred property, the transfer cannot take effect only upon the grantor’s death, and the grantor may not have the power to amend or revoke the transfer. Otherwise the transferred property will be included in the grantor’s estate for estate tax purposes. IRC §§2036-2038.
B. Income Tax
Section 2503(c) trusts are usually complex trusts; i.e., the trustee has the power to distribute or accumulate income at the trustee’s discretion. Distributed income is taxed to the beneficiary. Accumulated income is taxed to the trust. Trust income is generally taxed at a higher rate than individual income, with a maximum tax rate of 45%. Because of the "kiddie tax," unearned income of children under age 18 in excess of $1700 is taxed at the parent’ s rate. Imposing income taxes on the trust or the beneficiary has the net effect of reducing the amount of wealth that is transferred to the succeeding generation.
For these reasons, minor trusts are often made "intentionally defective." An intentionally defective irrevocable trust is one that is valid for estate and gift tax purposes but deficient for income tax purposes. Since the trust instrument does not violate the requirements of IRS §§2036-2038, the trust assets are not included in the grantor’s estate for estate tax purposes. However, the trust document intentionally includes powers that will make the grantor the owner of the trust for income tax purposes.
Under IRC §§673-677, a grantor will be treated as the substantial owner of a trust if the trust instrument contains provisions that give the grantor certain powers or beneficial interests in the trust. Under those circumstances, the trust income is taxed to the grantor. Some, but not all, of those provisions would also defeat the estate planning purposes of the grantor by requiring the inclusion of the trust assets in the grantor’s estate under IRC §§2036-2038 (i.e., giving the grantor a power of revocation or a right to trust income). The essential feature of an intentionally defective irrevocable trust is that it contains a provision described in §§673-677, but not described in §§2036-2038.
One such provision reserves to the grantor a power to reacquire the trust corpus by substituting other property of equivalent value, without the approval or consent of a person in a fiduciary capacity. Such a provision does not require the inclusion of the trust property in the grantor’s estate under §§2036-2038, but it results in treatment of the grantor as the substantial owner of the trust under IRC §675(4)(C). Accordingly, the trust income is taxed to the grantor.
This is generally viewed as a desirable result for a number of reasons. First, the gifts to the trust are not depleted by income taxes. Second, the grantor’s income tax rate is typically lower than the trust’ s tax rate, which would apply if the income were accumulated by the trust. Third, if the grantor is the beneficiary’s parent, the grantor’s tax rate would apply anyway if income were distributed to the beneficiary under the kiddie tax rules.
The use of intentionally defective irrevocable grantor trusts was controversial for a time, but in 2004 the IRS issued a revenue ruling addressing their use. Rev. Rul. 2004-64. Under that ruling, the income tax paid by the grantor is not deemed a gift to the beneficiaries for gift tax purposes because the grantor, not the trust, is liable for the taxes.
The trust instrument should not be drafted to require reimbursement of income taxes paid by the grantor. If the trust instrument or state law requires the trustee to reimburse the grantor for the income tax payment, all of the trust assets at the grantor’ s death are included in the grantor’s gross estate for estate tax purposes. However, if the trust instrument gives the trustee the discretion to reimburse the grantor for the income tax payments and the trustee does so, the trust assets are not included in the grantor’s estate, provided that there is no understanding or pre-existing arrangement between the grantor and the trustee regarding the exercise of that discretion. Rev. Rul. 2004-64.
A trust beneficiary with a withdrawal power such as a Crummey withdrawal power is treated as the owner to the extent of the withdrawal power. IRC §678. In a section 2503(c) trust, the withdrawal power applies to the entire trust after the beneficiary attains age 21. Thus, if the trust is not defective, the beneficiary with the withdrawal power must report the trust income and pay the income tax. However, if the trust is defective because the grantor holds a power under §§673-677, and the beneficiary holds a withdrawal right over the same income, the beneficiary’s power is disregarded for income tax purposes, and the grantor is taxed as the owner of the trust income. IRC §678(b).
Tax issues relating to intentionally defective irrevocable trusts can be complicated. Estate planners are encouraged to consult a tax professional concerning the needs of a particular client.
Practice requirements set forth in Internal Revenue Service Circular 230 regulate written communications from our firm about federal tax matters. Such communications can be either "opinions" or other written communications. Nothing set forth herein is intended to be an opinion for purposes of Circular 230. As a result, nothing set forth herein may be relied upon to avoid any federal tax penalties.
