Trusts for Minors
Trust can provide financial support for minors, and they provide more flexibility than other means of financial support, such as under the Uniform Transfers to Minors Act (UTMA), or the older, more restrictive Uniform Gifts to Minors Act (UGMA). Trusts can have more than one trustee and the trustees can easily be changed. Under custodial accounts, such as UTMA or UGMA, only one person may be custodian and there are specific requirements for naming a successor custodian. There are several specialized types of trusts that can provide support for children or other minors or as a means of transferring an inheritance to them. Gifts to these trusts can usually qualify for the gift tax annual exclusion, or up to $14,000 can be given to each beneficiary annually, free of gift tax and free of the generation-skipping transfer tax.
Trusts For Children And Family Pot Trusts
A child's trust is one which holds specified property for one child. A separate trust can be set up for each individual child. However, all the property can also be put in the family pot trust, which provides for more than one child. Both trusts are legal in all states.
The trust document sets out the trustee's responsibilities and the beneficiaries' rights, and it can be established by either will or living trust.
The trustee pays for the education, medical needs, and living expenses of the beneficiaries. The one advantage of a pot trust is that the trustee can spend differing amounts on each beneficiary, depending on their needs.
The main advantage of the trusts over the UTMA is that the children can be prevented from receiving the trust property until they reach an older age such as 30, 35 or 40, when, presumably, they will be more mature and financially savvy. However, the pot trust exists until the youngest child reaches the age of majority — 18 or 21, depending on state law, in which case, a pot trust can be converted into an individual child's trust. A pot trust is less desirable when there's a large difference in the ages of the children, since the oldest child must wait a long time to receive his remaining entitled property from the trust until the youngest beneficiary reaches 18 or 21.
If the trust only becomes effective after the children are no longer minors or beyond the age when they were supposed to get the trust property, then the trust is never created, so the property will simply pass to them.
For older children or when there is not much property, a UTMA custodianship may be preferable to a trust since it is cheaper and simpler to create. Because the UTMA is specified by state law, financial institutions know about it and understand how it works, thereby making it simpler to convey property. Any income that is held at the close of the tax year by a UTMA is taxed less than income in a trust, but annual income above $5,000 that is retained at the close of tax year is taxed at a higher rate than in a trust.
Another means to transfer money to a child is through an §2503(c) irrevocable trust (aka minor's trust). The primary advantage of this trust is that contributions qualify for the annual gift tax exclusion even though they are gifts of a future interest. Contributions will also be exempt from the generation-skipping transfer tax. Generally, only gifts of a present interest, where the child receives the gift immediately, qualify for the gift tax exclusion. However, contributions to trusts that conform to IRC §2503(c) rules qualify for the annual exclusion. The trust must be irrevocable because gifts made to the trust must be unconditional — the donor must not retain any right to revoke the gift or have the gift revert to the donor. Because irrevocable trusts are separate taxable entities, each trust will need a taxpayer identification number to file tax returns. Additionally, a separate trust must be set up for each child.
To qualify under §2503(c),the trustee must have unrestricted discretion to either distribute or accumulate trust income. Any restrictions by the trust document on the trustee's discretion may disqualify the trust under §2503(c), such as mandating that the trustee consider any other assets available to the minor before making distributions. The trustee can also distribute trust principal for reasons specified in the trust document or at the trustee's discretion. So that contributions are not treated as gifts of future interests so that they qualify for the annual exclusion, any distributions of principal or income must be for the benefit of the minor and the minor beneficiary must have an unconditional right to the trust assets when reaching age 21, regardless of state law. If the child dies before reaching 21, then the trust assets must be transferred to the estate of the child or to whom the child appointed under a general power of appointment.
However, the trust document can provide the child with a right to terminate the trust and receive the assets for a short time after reaching 21. If the child does not exercise the right, then the trust can continue (IRS Revenue Ruling 74-43). An IRS Revenue Ruling stated that 60 days was an adequate time period, but 30 days may also be acceptable. What is to prevent the child from terminating the trust and receiving all the assets? Family pressure, such as the threat of reducing his inheritance if the trust is terminated.
Income earned and retained by the trust will be subject to trust tax rates, which are much higher than the marginal tax rates for individuals for lower incomes. For instance, the top marginal rate of 37% applies to any income retained by the trust over $13,050 (2021: adjusted for inflation). However, the trust can deduct any income distributed to the child. Distributed income will be subject to the child's rate, but may also be subject to the kiddie tax.
If the donor serves as trustee, then the trust may be included in the donor's estate if the donor should die before the child reaches 21. Therefore, neither the donor nor a spouse should serve as sole trustee; however, they can serve as cotrustees. Trust assets will also be used to determine educational financial aid for the child.
A §2503(b) trust may also be used to support a minor. Its main advantages over the §2503(c) trust is that it is not required to terminate when the beneficiary reaches 21, so it can last up to the lifetime of the beneficiary, and longer, if desired. Additionally, the trust principal never has to be paid to the beneficiary or to the estate of the beneficiary. The grantor can specify another donee for the trust principal or the principal can go to a person specified by the income beneficiary.
Income from the trust can be deposited into a UGMA or a UTMA custodial account for the benefit of the minor. The income is taxed to the minor, but is also subject to the kiddie tax unless the income was to discharge a legal obligation for the support of the minor, in which case the grantor-parent would pay the tax. Gifts to the trust consists of an income portion and a principal portion. Only the income portion qualifies for the annual exclusion while the remainder is a future interest. However, to qualify for the annual exclusion, the trust document should disallow the trustee from investing in non-income producing property.
Qualified Subchapter S Trusts
A §2503(c) trust is not an eligible shareholder of an S corporation stock unless it is also a Qualified Subchapter S Trust (QSST), Electing Small Business Trust (ESPT), or a grantor trust under IRC §678.
Defined in IRC §1361(d), a QSST is a trust that owns stock in one or more S corporations, which can also include other assets, distributes income to only one individual who is a United States citizen or resident; is governed by a trust document that allows only one beneficiary at a time; any distribution of corpus will be only to the individual who is the current income beneficiary; the income interest will terminate if the income beneficiary dies or the trust is terminated; and if the trust does end before the income beneficiary dies, then all assets must be distributed to that beneficiary.
The income beneficiary, or his legal representative if he is a minor, must elect the QSST status. Once elected, the election can only be revoked with IRS consent. If there are successor income beneficiaries, then each must elect the QSST status. Additionally, a separate election must be made for each S corporation's stock held in the trust.
Income, gains, losses, deductions, and credits will pass directly from the S corporation to the minor beneficiary. This allows a grantor to distribute income among family while eliminating the gifts from his gross estate. A QSST can continue beyond age 18 or 21 to a time specified by the trust document. If the beneficiary dies, then the trust can continue for another income beneficiary. The QSST will not be included in the beneficiary's estate if only income rights were granted.
A special type of trust, called a Crummey trust, allows a wealthy grantor to fund the trust in such a way that payments are treated as gifts of present interest to the trust's beneficiaries, thereby qualifying for the annual gift exclusion. The primary benefit of a Crummey trust is that it can last much longer than 21 years, limited only by the rule of perpetuities. However, many states have eliminated the rule of perpetuities to attract trust assets to their state, so, in these states, there is no definite time limit to the duration of a Crummey trust. Furthermore, money can be restricted for particular purposes, such as funding and education. By contrast, distributions from custodianships or 2503(c) trusts cannot be restricted. The Crummey trust — named after the 1968 court case, Crummey v. Commissioner, 25 TCM (CCH) 772 - Tax Court 1966 — is designed to pass property to beneficiaries free of both gift and estate taxes. Crummey powers were expanded in 1991 by Estate of Cristofani v. Commissioner, 97 TC 74 - Tax Court 1991, which allowed contingent remainder beneficiaries, such as grandchildren, to also be considered as having present interest. The grantor makes a gift to the trust, usually equal to the annual exclusion, for each beneficiary. The beneficiaries are given some time, usually 30 days or less, to withdraw the gift. If they fail to do so, then the gift remains in the trust, where it is often used to purchase life insurance, with the proceeds going to the beneficiaries when the donor dies. Beneficiaries are notified of their gift by a letter, which is generally called a Crummey withdrawal right or Crummey notice. However, if the parties have an agreement that the current Crummey power — as it is called — will not be exercised, then the IRS considers the power to be a sham and it will not be considered a gift of a present interest, and, therefore, not eligible for the annual gift exclusion.
The Crummey Trust and the Generation-Skipping Transfer Tax
A gift made to a Crummey trust that has beneficiaries in several generations will usually not qualify under the generation-skipping transfer tax annual exclusion since deemed allocation rules will not automatically apply to the gift unless the trust is a skip person, because the IRS treats the transfer as a gift to the trust rather than to the beneficiary. Consequently, if any beneficiaries are non-skip persons, then the GSTT annual exclusion will not be automatically applied to the gift. In such a case, the grantor will either have to allocate his GSTT exemption to the transferred property by filing Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return or the skip beneficiaries must pay a GST tax on any property distributed to them at the time of the transfer. This GST tax can be avoided if the trustee directly pays providers of educational or medical services for the skip beneficiaries.
If a trust is designated as a skip person, then the deemed allocation rules will automatically apply the donor's GST annual exclusion to all gifts made to the trust. However, a trust can only qualify as a skip person if:
- trust principal or income benefits only 1 skip person during her life;
- trust assets become part of the beneficiary's gross estate if she dies before the trust terminates.
If a grantor wants to provide for more than 1 skip person and take advantage of the automatic GST exclusion, then a trust can be set up for each skip person.
IRC §678 Trust
This trust can also be an S corporation stock shareholder, but only if the beneficiary has unrestricted right to both income and corpus whenever desired. However, IRC §678 requirements can also be satisfied if the beneficiary has a Crummey withdrawal power, exercisable within a specific time.
If the beneficiary had a general power of appointment over at least some part of the trust property, then that property will be includable in his estate. If the beneficiary exercised or released the power while retaining an interest in the trust, such as a life estate, and if the property would be includable in the estate under IRC §2035 or 2038, then the property is includable in his estate. Likewise, for Crummey withdrawal powers, a lapse is not treated as a release if the value of the property subject to the lapse does not exceed the greater of $5000 or 5% of the property subject to the power.