Using Trusts--Minors' Trust v. Custodial Account
If you're considering making large cash gifts to your young children, you probably will want to delay their ability to get at the funds. Of course, you also will want the gifts to be gift-tax free, that is, to qualify for the gift tax exclusion. This allows you and your spouse to give up $20,000 a year (plus an inflation adjustment) to each child gift-tax free. That creates a problem: The annual exclusion is available only for gifts of what are called present interests. So by restricting the children's ability to get at your gift, the transfer won't be gift-tax free. With some planning, however, there are ways to make tax-free transfers without giving the child immediate access to the gift.
One of these is a so-called minor's trust (known more formally as a Sec. 2503(c) trust). Contributions to this kind of trust can qualify for the annual gift tax exclusion if the property and its income may be used by or for the benefit of the child before age 21, and the remainder will go to the child when he or she reaches age 21. Until recently, these trusts were popular devices that had a number of tax advantages over custodianships for children. But unfavorable changes in the income tax brackets for trusts have made them less desirable.
Gifts to custodial accounts under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) also qualify for the annual gift tax exclusion, even though the custodian manages the property until it must be turned over to the child when he or she is no longer a minor.
Income from custodial accounts avoids the compressed income tax brackets that apply to trusts. Instead, the income is taxed directly to the child. If the child is under age 14, the income may be subject to the so-called kiddie tax, which taxes the child's income at the parent's marginal rate. However, there are many techniques for avoiding that tax, such as placing growth stock into a custodianship, or giving the child EE bonds. By waiting to sell the stock or cash in the bonds until the child is 14 or older, the kiddie tax is avoided. Custodianship income that relieves a parent's support obligation also may be taxed to the parent. But planning steps, such as early termination of the custodianship, may help avoid this tax problem.
Before deciding between a minors' trust and a custodianship, there are many other tax and non-tax factors to consider. A custodianship has fewer formalities and administrative costs than a trust, and the tax advantages may be better, but the custodianship is not as flexible as the trust can be.
We can help you evaluate the pros and cons of trusts, custodianships, and other devices to make transfers to your children, and to decide which is right for you. Please call us if we can be of assistance.