In my August 2015 column, “Charitable Income Gift Options to Produce a Debt-Free (or Nearly) College Graduate,” I discussed naming the college bound student as the beneficiary of a trust to receive payments for 18 years. I introduced mother Irene, age 40, who was planning for college for her 5-year-old daughter, Audrey.
Now, let’s acknowledge the role many grandparents assume in the financing of the college education of a grandchild. Many grandparents will accelerate the inheritance of a grandchild pursuing a course of study likely to leave him with the prospects for a career and decent paying job. Many of the income and transfer issues are identical, while new ones emerge, depending on whom the grandparents name as beneficiary. Another option in structuring the charitable remainder unitrust (CRUT) is to name the parent of the child as the beneficiary of unitrust payments either for a fixed term or a measuring life such as a parent’s. For those grandparents who must navigate the generation-skipping transfer (GST) tax because of naming the grandchild the beneficiary of a trust, the health education and exclusion trust (HEET) is a possibility.
Income Tax Consequences
The primary goal in the design of the CRUT is maximizing the amount of payments to be received by the college student during a fixed term of years. Mother Irene chose a payout rate of 12.007 percent to satisfy the 10 percent residuum rule. That would still be the rate chosen by Irene’s mother, Serena, because the term of trust remains unchanged at 18 years. If Serena were interested in maximizing the income tax deduction for herself, she would select the identical statutorily imposed rate of 5 percent, yielding the same income tax deduction. The payments from the grandmother-funded trust will be still subject to the kiddie tax at Irene’s marginal rate of 33 percent. Whether Serena’s marginal rate is higher or lower than 33 percent is irrelevant to the taxation of the payments.
But, what if Serena seeks to hedge against the risk of committing funds for college when the grandchild might be an indifferent or an incapable student? Serena could name Irene the beneficiary of the unitrust amount payment for the 18-year term or for the life of Irene. This approach would result in an identical amount of payments, assuming a payout rate of 5 percent and the identical investment performance of a total return of 7 percent, 4.5 percent from capital appreciation and 2.5 percent from income. More importantly, Irene has the payments for the rest of her lifetime, estimated to be another 20 years past the original term of the trust. And interestingly, the amount of the tax deduction is only $22,475 less than that of a term trust paying 5 percent.1 So the “cost” of selecting a measuring life for the CRUT is only $7,417, representing Serena’s marginal tax rate of 33 percent, multiplied by $22,475. The income taxation of the payments to the parent is essentially identical, though slightly higher compared to the income taxes owed by the grandchild under the kiddie tax.2
Gift/Transfer Tax Consequences
The gift and estate tax issues are identical whether the parent or grandparent is funding a CRUT for a term of years. The charitable remainder interest qualifies for a charitable gift tax deduction. The gift tax treatment of the non-charitable recipient will depend on if there’s an immediate right to the payment of the unitrust amount. If the funder doesn’t retain any rights of revocation, there’s a completed gift. So long as the grandparent hasn’t consumed the unified gift and estate tax credit, no gift taxes will be owed on funding of the trust.
If the grandparent has consumed the transfer tax credit or seeks to use it for other non-spousal beneficiaries in the future, she must retain a right of revocation. Of course, if the grandparent hasn’t relinquished this right before her death, Internal Revenue Code Section 2036(a)(2) mandates inclusion. While this is less of a risk when 40-year-old Irene held the right of revocation, it’s greater when held by 70-year-old Serena. Should Serena decide to relinquish this right, she must do so more than three years before her death, as required under IRC Section 2035.
The direct payment of the unitrust amount to Audrey would be a generation-skipping taxable distribution. So long as there’s an exemption remaining for allocation, no GST tax will be owed.
However, if grandmother Serena has consumed her GST tax exemption, the taxes of 40 percent on the amount of any distribution may be onerous enough to discourage gifts to grandchildren. Is there an alternate strategy using a trust vehicle benefiting a grandchild without incurring a GST tax? There is indeed. A HEET is a type of dynasty trust avoiding taxation as either a direct skip or taxable termination by benefiting a perpetually nonskip taxpayer; namely, a charity. Because a charity isn’t a skip person, the trust won’t be a skip person as long as a charitable beneficiary exists.3 The HEET directly pays the provider of health care and education for the benefit of a skip person like a grandchild. So long as the trust provides for a substantial present interest for distributions to charity, any distributions to grandchildren will be exempt from gift taxes.4 The distributions also avoid gift tax because they’re directly paid to the educational institution. IRC Sections 2611(b)(1) and 2642(c)(3) will exclude the distributions from the GST tax.
Design issues. Neither the IRC nor its regulations provide guidance as to minimum payouts as is the case for CRUTs. It would seem reasonable that a variable unitrust payment of 5 percent to charity should be acceptable in creating a sufficiently substantial and current interest for the charity. Such an arrangement should create a right to receive income or corpus within the meaning of IRC Section 2652’s definition of an interest in property held in trust. But, the terms of the trust mustn’t violate the “separate share rule.” If a single trust consists “solely of substantially separate and independent shares for different beneficiaries,” each share will be treated as a separate trust. Designating a charity the beneficiary of a specific percentage of income and principal likely would be deemed a separate share from the creation of the trust.5
Although distributions from the HEET to charity aren’t income tax deductible by the grandparent, they are by the irrevocable trust. Additionally, the grandparent isn’t taxed on the income from the HEET, which is like getting an income tax deduction without the possibility of curtailment for exceeding adjusted gross income limitations.
Any of the undistributed income from the trust is subject to high marginal rates, as well as net investment income tax of 3.8 percent.
If one of the planning goals of the HEET includes estate tax minimization, the trust must be irrevocable. If revocable, its value will be included in the grandparent’s gross estate.
The Treasury has acknowledged the attractiveness of the HEET, noting that it “allows substantial amounts transferred to the trust to appreciate with no estate, gift, or generation-skipping transfer tax after the initial funding of the trust.”6
For the 2014-2015 and 2015-2016 budget cycles, the Obama administration has proposed that distributions from a trust for qualified education expenses wouldn’t qualify for the exclusion from the meaning of a GST under IRC Section 2611(b)(1).7. Though interestingly, this provision is a net revenue loser of $84 million for fiscal years 2016 through 2020.8
Funding a CRUT for a term of years will help the philanthropically minded grandparent underwrite much, if not all, of a grandchild’s education. The measuring life of a parent may also be a viable option, especially if the likelihood of the grandchild completing college is in doubt. This flexibility may well be worth the cost of a smaller income tax deduction. For those grandparents whose GST tax exemption has already been exhausted, a HEET is an attractive though complicated alternative that may not be viable for much longer.9
1. The difference between the deduction of $39,913 for a 5 percent payout during a fixed 18-year term as compared to a deduction of $17,438 based on the life of Irene.
2. The first $1,050 of each year’s payment to Audrey is taxed at a rate of zero and the next $1,050 at 15 percent.
3. See Internal Revenue Code Section 2651(f)(3), assigning certain charitable trusts the transferor’s generation, thus assuring there’s neither a direct skip nor a taxable termination.
4. See IRC Section 2503(e).
5. See Treasury Regulations Section 26.2654-1(a)(1)(i). If the share benefiting the grandchild was deemed separate, it would be a generation-skipping transfer.
6. See Joint Committee on Taxation, “Description of Certain Revenue Provisions Contained in the President’s Fiscal Year 2014 Budget Proposal” (JCS-4-13) (December 2013), at p. 109.
7. Department of Treasury, “General Explanations for the Administrations’ Fiscal Year 2014 Revenue Proposals” (April 10, 2013), at p. 148.
8. See Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2016 Budget Proposal” (JCX-50-15) (March 6, 2015) at p. 8.
9. See Dep’t. of Treasury, “General Explanations of the Administration’s Fiscal Year Revenue Proposals” (February 2015), at p. 203. The proposed change would apply to both trusts created after the introduction of legislation and to currently existing trusts receiving transfers.