As the end of the year approaches, parents and grandparents often plan to make gifts to younger family members. Annual gifts that qualify for the $11,000 gift tax exclusion can reduce his or her taxable estate. Rather than making such gifts outright, or to a Uniform Transfers to Minors (“UTMA”) account, making the gift to a trust can provide substantial benefits, including preventing a child from spending the money foolishly rather than for education or a worthwhile purpose.
A gift to a trust will generally qualify for the annual gift tax exclusion only if it is a gift of a present interest. While a gift in trust for a child or grandchild who is prohibited from having access to the principal for many years will not usually qualify for the annual exclusion because it is not a gift of a present interest, Internal Revenue Code (Section 2503(c)) permits gifts to a qualifying trust to be considered gifts of a present interest provided the beneficiary has the right to withdraw the principal in the trust when he or she reaches age 21. If the beneficiary does not withdraw the principal within a fixed period of time thereafter – generally, three months – the trust may continue and distribution of the principal to the beneficiary can be delayed until an age designated by the grantor in the 2503(c) trust agreement. That age can be later than the required distribution age under UTMA, which requires principal to be distributed to the beneficiary at age 21 (in some states other than Illinois, the age may be 18). Another method to qualify the gifts to the trust for annual gift tax exclusion is to provide that the beneficiary has a “Crummey” right of withdrawal for a specified period of time after each gift is made to the trust.
Gifts between spouses are a customary way to assure that both parties may take maximum advantage of the applicable credit available to both of them. However, one overlooked estate planning method is to make gifts to one’s spouse that intentionally do not qualify for the marital deduction. Proper use of such gifts can result in substantial reductions in the taxable estate of the donor spouse while assuring the gifts (and the appreciation in the gifts after the transfer) are also excluded in the donee spouse’s taxable estate.
The simplest form of such an arrangement is an annual gift to a trust for the benefit of a spouse, which would be structured generally as follows: the client creates an irrevocable trust for the benefit of his or her spouse, which provides the spouse has the annual right to withdraw the gifts made to the trust up to $5,000 or 5% of the value of the trust property. Each year, the donor makes a gift of $5,000 to the trust, but the donee spouse does not exercise the right to withdraw the gift. Because the donee spouse has the right to withdraw principal under a tax rule known as the “5 and 5 power,” the gift to the trust qualifies for the annual gift exclusion under the Internal Revenue Code. Upon the death of the donee spouse, the principal of the trust will not be included in his or her gross estate because the donee spouse had the right to withdraw the gift at the time it was made and declined.
Under this arrangement, the trust agreement should also provide that income from the trust may be paid to the donee spouse in the trustee’s discretion. This creates another advantage to this type of trust: trust income is taxed to the donor because the income may be paid to the donor’s spouse. Thus, the trust principal can grow without being reduced by income taxes paid from the trust. In effect, the donor’s annual payments of the taxes on the trust income accumulated and not distributed are additional tax-free gifts to the trust.
Please do not hesitate to telephone us if you have any questions regarding the use of trusts to take maximum advantage of tax laws in your year-end gift planning.