Private Client Services Update – A Guide to Making Gifts for Parents and Grandparents
A Guide to Making Gifts for Parents and Grandparents
As the end of the year approaches, parents and grandparents often ask about making gifts to children and grandchildren. When discussing various ways to make gifts, the conversation typically focuses on three areas (i) the complexity of making the gifts, (ii) the level of retained control over the gifted funds, and (iii) taxes. Below are summaries of the five most common ways that parents and grandparents make gifts to children and grandchildren and how each differs with respect to those three focus areas.
Before discussing the differences between each of the gifting methods, it is important to point out a couple of issues relevant to all gifts. First is gift taxation. Most commonly, parents and grandparents want to make gifts that qualify for the annual gift exclusion. The annual gift exclusion is the annual amount, currently $14,000, that each donor can give each donee without the gift being considered taxable. Thus, a couple can give each child and grandchild a combined $28,000 per year and have the gift qualify for the annual exclusion. If a gift exceeds the annual gift exclusion amount, then the donor must file a Form 709 United States Gift (and Generation-Skipping Transfer) Tax Return. Each of the gifting methods discussed below can be structured to permit annual exclusion gifts.
A second important point relevant to all gifts is tax basis. When a donee receives a gift, his or her tax basis equals the donor’s adjusted basis in the property. For cash gifts this is irrelevant. For stocks, real estate, interests in businesses and other capital assets, however, this can significantly affect capital gains tax if the donee subsequently sells the property, thereby triggering a capital gain. Thus, from a capital gains tax perspective, it is typically advisable to gift assets with a high tax basis and to hold assets with a low tax basis until death because the inherited assets will receive a step-up in tax basis equal to the fair market value of the property at the decedent’s death.
Now let’s turn to some of the most common gifting methods and how they differ:
1. Outright Gift
a. Mechanics of Making Gift. An outright gift is the simplest method of gift giving. The parent or grandparent simply gives cash or retitles the stock, real estate, or other asset in the name of the child or grandchild.
b. Restrictions on Distributions. There are no restrictions on distributions of outright gifts. Thus, the fear is that the child or grandchild may squander the gift. The only caveat here is that if the gift is an interest in a closely held company then the governing documents for the company may impose restrictions on the child or grandchild. For example, the governing documents may contain a buy-sell provision restricting the ability to sell the interest to third parties.
c. Taxation. The child or grandchild does not pay income tax on the value of the gift received; however, any future income generated by the gift (e.g. interest and dividends) is taxable income to the child or grandchild. Parents and grandparents do not receive an income tax deduction for making an outright gift.
2. Uniform Transfers to Minor Act
a. Mechanics of Making Gift. A Uniform Transfers to Minor Act (UTMA) account is an account that a parent or grandparent can establish at a bank, credit union or with a broker for the benefit of the child or grandchild. When the account is established, a custodian is named by the parent or grandparent establishing the account. Parents or grandparents may name themselves as the custodian. When the account is opened, the parent or grandparent must also specify whether the funds will be distributed to the child or grandchild when he or she reaches age 18 or 21. The property held in the UTMA account is considered to be owned by the child or grandchild, but is controlled by the custodian. Once a UTMA account is established, parents and grandparents can make additional contributions to the account.
b. Restrictions on Distributions. State law controls the specifics of how UTMA funds can be used, but generally speaking, the custodian can use the funds for the education, care and well-being of the child or grandchild. When the child or grandchild reaches the age of 18 or 21 (depending on how the account is initially set up), the custodian must turn control of the funds over to the child or grandchild. At that point, there are no restrictions on how the child or grandchild can use the funds. This can cause concern if the account has appreciated considerably and the child or grandchild is not ready for that level of fiscal responsibility.
c. Taxation. The child or grandchild does not pay income tax on the value of the gift made to the UTMA account; however, any future income generated by the gift (e.g. interest and dividends) is taxable income to the child or grandchild. Parents and grandparents do not receive an income tax deduction for making a gift to a UTMA account.
3. 529 College Savings Plan
a. Mechanics of Making Gift. 529 college savings plans are tax advantaged accounts used for higher education expenses, including community colleges, undergraduate and graduate schools, as well as most vocational and technical schools. Virginia 529 plans can be opened through a financial advisor or directly through Virginia 529. Once a 529 plan is established, parents and grandparents can make additional contributions to the account.
b. Restrictions on Distributions. 529 plans may be used to pay for qualified higher educational expenses, including tuition, fees, certain room and board, books, required supplies and equipment. Unlike an outright gift or UTMA account, the child or grandchild never gains control over the funds. The 529 plan owner directs how the funds are used. An owner can designate a successor to control the funds if the original owner dies. The owner can also transfer account benefits to a member of the current beneficiary’s family if the child or grandchild for whom the account was established does not pursue higher education or does not use all of the funds.
c. Taxation. There are many tax advantages associated with 529 plans. The child or grandchild does not pay income tax on the value of the gift made to the 529 account. The funds inside the 529 plan grow tax free and are not taxed when the money is used to pay educational expenses. In addition, Virginia permits Virginia residents to deduct on their state income tax return contributions up to $4,000 per year with an unlimited carry forward to future tax years. Taxpayers 70 and over may deduct the entire amount in one year. Although the tax benefits are generous, the penalties are stiff if the owner does not use the funds for qualified educational expenses. Specifically, such withdrawals are subject to a 10% federal tax penalty, the owner must pay federal and state income taxes on the earnings and there is a recapture of any Virginia state income tax deduction previously taken.
4. Section 2503(c) Trust
a. Mechanics of Making Gift. A Section 2503(c) trust (named for the Internal Revenue Code Section upon which it is based) is a separate trust established for the benefit of a child or grandchild. Unlike a UTMA account, which relies on standard state law statutory provisions for administration provisions, a Section 2503(c) trust permits the parent or grandparent to draft specific trust language tailored to their own situation. A Section 2503(c) trust is created by having an attorney draft a trust instrument. Once the trust agreement is executed, contributions to the trust can be made. Once made, gifts to a Section 2503(c) trust are irrevocable. Assets held by the trust are controlled by a trustee selected by the parent or grandparent who created the trust.
b. Restrictions on Distributions. A Section 2503(c) trust gives the donor much more flexibility to control distributions than outright gifts, UTMA accounts and/or 529 plans. Principal and income distributions may be based on the trustee’s discretion or based on specific provisions inserted into the trust agreement. For example, distributions could be limited to education and medical expenses or limited to education, plus an annual percentage or fixed annual amount for spending money for the child or grandchild. Once the child or grandchild reaches the age of 21, he or she must be given the right to withdraw all of the trust assets without any restrictions on how the funds will be used. If the child or grandchild elects not to withdraw the funds, however, the trust may continue. If a child or grandchild dies before reaching age 21, the trust assets must pass to the deceased child or grandchild’s estate.
c. Taxation. The child or grandchild does not pay income tax on the value of the gift made to the Section 2503(c) trust. Future income generated by the trust assets are taxed based upon typical trust taxation principals. Generally, if the annual income is distributed to the child or grandchild, then the income is taxable to the child or grandchild. Conversely, if the Section 2503(c) trust retains the income, then the trust pays the income tax. Either way, the Section 2503(c) trust will be required to file annual state and federal fiduciary income tax returns. The parent or grandparent contributing to the Section 2503(c) trust does not receive an income tax deduction for making a gift to a Section 2503(c) trust.
5. Crummey Trust
a. Mechanics of Making Gift. A Crummey Trust (named for a famous court case involving this type of trust) is similar to a Section 2503(c) trust, except there is no requirement to give the child or grandchild the right to withdraw all of the funds at age 21; however, the child or grandchild must be given notice when a contribution is made (commonly referred to as a Crummey Letter) and the right to withdraw some or all of the contribution for a reasonable period of time (often 30-60 days) after the contribution is made. Like the Section 2503(c) trust, the parent or grandparent can draft specific trust language tailored to their own situations and desires. The Crummey Trust is created by having an attorney draft a trust instrument. Once the trust agreement is executed, contributions to the trust can be made. Once made, the gifts are irrevocable. Assets held by the trust are controlled by a trustee selected by the parent or grandparent who created the trust.
b. Restrictions on Distributions. The Crummey Trust gives the most control to parents and grandparents to restrict distributions. Parents and grandparents have the same flexibility as they have with Section 2503(c) trusts to tailor the trust language to their specific situation. The child or grandchild does not, however, have to be given the right to withdraw the funds when they reach age 21. The assets can remain in the trust as long as the parents and grandparents direct in the trust agreement. Additionally, if a child or grandchild dies before reaching age 21, the assets do not have to be distributed to his or her estate. Rather, the parents and grandparents can direct in the trust agreement who should receive the assets in such a situation.
c. Taxation. The tax characteristics of the Crummey Trust are the same as those for the Section 2503(c) trust. The trust must file annual state and federal fiduciary income tax returns. Whether the trust pays the tax or the child or grandchild pays the tax depends on whether the trust retains the income or distributes it out to the child or grandchild. An exception to this treatment occurs if the Crummey Trust is structured to be a grantor trust. A grantor trust is one where the grantor (i.e. the parent or grandparent in this case) pays the income tax regardless of who receives the income. The practical effect of this is to permit the parent/grandparent to make an additional gift (the value of the income tax liability) without having it count as a gift. Gifts to Crummey Trusts are not tax-deductible.
In sum, there are several ways for parents and grandparents to make gifts to children grandchildren. Each offers varying levels of retained control over distributions, complexity in making the gift and tax advantages. At Kaufman & Canoles, we work with our clients and their advisors to help determine which method is best for each particular situation.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2023.