Estate Planning: Trusts Come to the Rescue

Education funding, the subject of Registered Rep.'s cover story this month, is only one reason to put aside funds for a child. Funds put into a minor's account of the proper type can be used not just for education, but for support of the child, maintenance, health and a wide variety of other purposes. Unfortunately, perhaps the most common device for passing wealth to children or grandchildren, created

Education funding, the subject of Registered Rep.'s cover story this month, is only one reason to put aside funds for a child. Funds put into a minor's account of the proper type can be used not just for education, but for support of the child, maintenance, health and a wide variety of other purposes. Unfortunately, perhaps the most common device for passing wealth to children or grandchildren, created under the Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA), can be a trap.

On the surface, these vehicles appear to be the height of simplicity. You create an account, name an individual or institution as custodian and wait for the beneficiary to reach majority and claim the assets. State laws vary on what the custodian can and cannot do and at what age (18 or 21) a minor reaches majority.

But here, the simplicity ends. If the custodian (say, the father of the child) dies while acting as custodian, the entire account balance is included in the custodian's estate. If, to avoid this result, the father names his spouse (the mother) as custodian and she dies at a time when state law imposes upon her the duty to support the child (most often after the father's death), the account balance may be included in her estate.

Furthermore, the beneficiary has the responsibility to pay the federal and state income taxes generated by the management income and capital gains taxes generated by the account. If the beneficiary is under age 14 (with some exceptions), the federal income taxes are at his or her parents' tax rate. If the beneficiary dies while the account exists, you may have a probate estate, and since persons under age 18 cannot have wills, the property frequently passes (intestate) in part back to the parents or the siblings. If the siblings are minors, often you must create guardianship estates for them and be subject to court supervision and distribution for the siblings at age 18.

The parents cannot loan money to or borrow money from these accounts in many states and state statutes specify what the custodian may invest in, sometimes drastically limiting your ability as an investment advisor. And, if the parents, after discovering all of this, still want to transfer the account balance to trusts, they cannot, except in the state of Illinois.

Trust in Trusts

Trusts, in fact, are what you can use to avoid the tangles of UGMAs or UTMAs. In a trust, you can invest in what you wish, and your client can loan money to, and borrow from, a trust account. There are other advantages as well, including postponing distribution of principle to the beneficiary at any age your customer picks.

There are many kinds of trusts, but here we will talk about two simple ones: the Minor's Trust and the Crummey Trust.

The Minor's Trust, a creature of the Internal Revenue Code Section 2503(c), is a simple trust document to draft and its advantages over UTMAs or UGMAs are manifold. First, your customer names the trustee. And the trust can be authorized to invest in virtually any prudent investment. The customer can loan to, and borrow from, the trust at adequate interest rates, and even retain the right to change the trustee within limits. (Changing custodians under an UTMA or an UGMA can be difficult.)

The principle purposes of the trust must be education, support and maintenance of the beneficiary. Expenditures for routine support can be made, but will be taxed as income to the child's parents.

The Minor's Trust ends when the minor is 21, by federal law, even if state law puts majority at 18. Furthermore, if the child is given a right to withdraw the trust property at 21 for a 30-day period and chooses not to withdraw the trust property, the trust can retain that property until a later age specified in the trust document (yes — even age 60, if you want). And the child cannot, without the consent of the parents, make withdrawals from the trust property before the age of distribution specified in the trust.

If the child dies before receiving all that is in the trust, the property can pass to other beneficiaries, like other children or grandchildren, and be added to their Minor's Trust. This avoids the probate problem mentioned before with custodial accounts.

Income taxes are paid by the trust at very compressed rates. The first dollar over $7,500 of income is paid at the income tax rate of the highest income tax in effect at that time or the highest capital gains tax rate in effect at that time. You can control this tax phenomenon by investing heavily in growth stocks with low income, or municipal bonds — you certainly need no advice from me on this score, and it would not be worth anything anyway. Others manage my modest resources.

The next lesson is about the Crummey Trust. It's named after the courageous taxpayer who did not want his children to get the trust property at age 18 or 21. This is a much more complicated trust to draft and administer than a Minor's Trust, but I believe it is worth the effort. First, the age of distribution of the principle to your customer's beneficiary is set by the trust document, like half at age 35 and the balance at age 40, or any variation, including in trust for the beneficiary's lifetime.

If the beneficiary dies, the property can go to others, much like the Minor's Trust without probate or without guardianship for the other beneficiaries of a deceased beneficiary. Your customer can pick the trustee of his or her choice and can remove the trustee (again, within limits). The customer can borrow from, and loan to, the trust at adequate interest rates. Investments can be in whatever the trust document provides.

Income taxes are paid much like they are for UTMAs or UGMAs. The child's tax rate can be used only after the child is 14 or older, but beforehand the tax rate of the parents is applicable to the income taxes paid by the beneficiary of the Crummey Trust.

Contributions to a Crummey Trust can qualify for the annual gift-tax exclusion (usually $11,000 for a single person and $22,000 for a married couple; higher amounts can sometimes be allowed, as in the case of closely held stock or non-voting shares). But there are conditions: The beneficiary, if 18 or older (or the custodian for a younger beneficiary), must have 30 days after the property is contributed to withdraw any portion — or all — of it. Otherwise, the very important gift tax exclusion is unavailable. There is no such rule with the UTMA or the UGMA account or the Minor's Trust in order to obtain the annual exclusion.

Although a more complicated option, the Crummey Trust is perhaps the most popular choice over the Minor's Trust, UGMA or UTMA accounts. The reason: Folks just can't warm up to distributions being made to young people, or young people having the option to take money out of trust at age 21 or earlier.

Writer's BIO:
Roy M. Adams
is head of the Trust and Estates Planning Group at law firm Kirkland & Ellis.

Minor's and Crummey Trusts Untangle UGMA and UTMA Web. They let:

  • Advisors invest in whatever they want.

  • Clients loan money to, and borrow money from, an account.

  • Clients postpone distribution of principle to any age.

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