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Making gifts to minors can pose special challenges. While you can make an outright gift of cash or property to a minor, for obvious reasons that is not always a sensible thing to do. All states permit some form of custodial accounts for minors, which can often be the most economical way of giving gifts to minors while still keeping some adult oversight. Other families choose to set aside funds for minors in trust. Either way, the gift tax, income tax and generation-skipping transfer tax consequences of such gifts should be considered.

Custodial Accounts under the Uniform Transfers to Minors Act.

Some form of the Uniform Transfers to Minors Act (UTMA) or its predecessor, the Uniform Gifts to Minors Act (UGMA), has been enacted by all of the states. These Acts provide a mechanism for establishing bank or brokerage accounts that are beneficially owned by a minor, but under the control of a custodian until the minor attains age 21 (or, in some states, age 18). Transfers to these accounts are treated as completed gifts of present interests for gift tax purposes, and so qualify for the $10,000 gift tax annual exclusion.

The donor can select anyone to serve as custodian of the account, but for estate and income tax purposes, it is generally better if the donor is not the custodian because this may cause the account to be treated as the donor’s. If a parent wishes to make a gift to a child, the other parent may serve as the custodian. A grandparent may choose to name his or her child as custodian for a grandchild’s account. The custodian is expected to manage the account in a fiduciary capacity, but, subject to that standard, can use the account for the child’s education or support or for other purposes the custodian deems to be in the child’s interest.

Custodial accounts are easy to open and do not require much administration. One drawback to the accounts, however, is that the child is given absolute control over the account when he or she attains age 21 (18 in some states). Many children are able to appropriately handle funds at that age, but many are not. Particularly if there is a large amount of money involved, it may be better to set up a trust for the child’s benefit, which can be managed by a trustee until the child is older.

Gifts in Trust for Minors.

Trusts can be individually designed to address virtually any situation. Trusts can provide for fixed income and principal distributions at certain times or when the beneficiary attains certain ages, or can leave all such matters to the full discretion of the trustee. One fairly common scenario is to establish a trust as a vehicle to save for a child’s education, but to include provisions in the trust agreement to the effect that if the trust funds are not needed for educational expenses, they can be used to pay for wedding expenses or for the purchase of a home. Children with special needs can also be accommodated, either through lifetime trusts or through special “supplemental needs” trusts that are intended to supplement, but not replace, any governmental assistance a disabled child might be entitled to.

Trusts offer the greatest flexibility in terms of design, but also require on-going administration. Also, unless structured correctly, gifts made in trust do not qualify for the gift tax annual exclusion. The two primary ways of avoiding this gift tax problem are through the use of Code §2503 trusts or trusts with powers of withdrawal.

Code §2503(c) Trusts.

Like gifts under the UTMA, gifts to Code §2503(c) trusts are treated as gifts of present interests to the child. As such, gifts of up to $10,000 per year (or $20,000 per year if made by a married couple splitting gifts) can be made to the trust for the benefit of a child with no gift tax consequences. However, like gifts under the UTMA, a Code §2503(c) trust must permit the child to have full control of the trust property when he or she attains age 21. The reason for using such a trust, rather than a UTMA account, is usually to have professional trustee management of the account or to hold unusual assets.

Trusts with withdrawal powers.

To avoid a gift in trust being characterized as a gift of a future interest to a beneficiary, the beneficiary can be given a limited power to withdraw the amount of the gift from the trust. Typically, such a power of withdrawal (sometimes called a “Crummey power” after a court case involving trust withdrawal powers) will lapse if it is not exercised within a stated period of time (e.g., 30 days). Under current tax law, if the beneficiary has the right to withdraw the amount of the gift, the beneficiary is deemed to have a present interest in the gift, and so, up to $10,000 of the gift will qualify for the gift tax annual exclusion. Except for the period of time a withdrawal power is in effect, the trust can limit the beneficiary’s access to the trust assets until a given age is attained or for life.

Qualified tax-exempt gifts for medical or educational expenses.

Payments made on behalf of a minor (or on behalf of a person of any age) for certain medical or educational expenses are not subject to gift tax, and so can be made without regard to the $10,000 per year gift tax annual exclusion limit. In order to qualify for the exception for medical expenses, payment must be made directly to the health care provider, and neither the donor nor the beneficiary can be reimbursed for the expense by medical insurance. To qualify for the exception for educational expenses, payment must be made directly to a tax-exempt educational institution and must be for tuition only. The educational expenses exception does not apply to payments made for room and board or for other ancillary costs of education. Donors wishing to prepay for a broader array of educational expenses may want to consider investing in a qualified state tuition program. See discussion of Connecticut’s qualified state tuition program, called CHET.

Income and GST Tax Consequences.

In addition to gift taxes, donors need to consider the income tax consequences that may flow from a gift and, in some cases, the generation-skipping transfer tax consequences.

Income Taxes: the “Kiddie Tax.”

Although a full discussion of the Kiddie Tax is beyond the scope of this Advisory, donors should realize that if a child under the age of 14 has investment income over $1,400 per year (as of 1999), the amount over $1,400 will be taxed at the parents highest marginal income tax rate. Thus, parents making gifts of substantial value to a child are unlikely to reap any noticeable reduction in their income tax liabilities until the child attains at least age 14. Also, grandparents should take into consideration this income tax rule when making gifts to grandchildren. If gifts are made to a child in trust, however, there may be an opportunity to modestly reduce a family’s overall income tax burden by retaining some taxable income in the trust (up to the limit of the 15% income tax bracket for trusts, presently, $1,750) and having the trust pay the applicable income tax.

Generation-Skipping Transfer Tax.

The generation-skipping transfer tax (GST tax) was enacted to curb dynastic trusts that might otherwise continue for generations without ever being subject to federal estate tax. For that reason, the GST tax rate is 55%, the same as the top federal estate tax rate. The GST tax may apply to any gift that passes to a skip person, which is defined as a person two or more generations below the donor. (A special generation assignment rule may apply if a child predeceases a parent.) For non-family transfers, a recipient who is 37-1/2 or more years younger than the donor is deemed to be a skip person.

Like the gift tax, outright gifts of up to $10,000 in value are exempt from the GST tax, as are qualified educational and medical expenses. However, most gifts in trust, even if the beneficiary has a power of withdrawal, are subject to the GST tax if a trust beneficiary is a skip person. Each person is allowed to give up to $1,010,000 ($1,000,000 prior to 1999) of gifts to skip persons during life or at death free of the GST tax. This is a cumulative total, regardless of the number of individual beneficiaries.