Avoiding the Kiddie Tax
Parents of young children may use the gift tax annual per donee exclusion of $10,000, or $20,000 for a married couple filing a split gift tax return, to transfer funds to their children and avoid federal gift or estate taxes which can vary from 37% to 55%. But many parents are unwilling to place substantial sums of money at the immediate disposal of their children. Two options that may be used to keep the funds beyond the reach of the child until some time in the future are to set up a custodian account or to create an irrevocable trust. In Indiana, property transferred to a minor's custodial account must be distributed to the beneficiary on the child's twenty-first birthday. The use of an irrevocable trust permits the parents to keep the funds beyond the reach of the child beyond the age of 21, until some specified event or date in the future when the child is more responsible and mature.
However, in order to qualify for the gift tax exclusion, the gift must be of a present interest in property. Transfers to a custodial account are considered gifts of a present interest. But transfers to a trust can be considered gifts of a future interest because enjoyment of the funds is postponed. Therefore, unless the trust is structured carefully, transfers to the trust will not be excluded from the federal gift tax.
Transfers to a trust will qualify for the annual gift tax exclusion when the beneficiary is given what is called "Crummey" powers to demand immediate possession or enjoyment of trust income or principal. (The name Crummey comes from a case involving Mr. Crummey as the taxpayer.) A Crummey power grants the benefici-ary a present right to withdraw the money transferred to the trust which typically expires at or before the end of each calendar year. A Crummey power can be given to a minor's guardian, provided the guardian is not the grantor or a grantor's spouse who retains an interest in the trust.
A Crummey trust may provide for the following:
1. the trustee may have discretionary power to expend income and principal for a minor beneficiary as long as the expenditure does not discharge the parent's legal obligation to support the child;
2. the beneficiary may receive income after age 21, and principal at some later date, such as when the beneficiary attains age 25, 30, 35, etc.;
3. or, the beneficiary may receive principal in multiple distributions at various ages, such as in equal thirds at ages 25, 30, and 35.
If either a custodian account or Crummey Trust for minor children is used, the trust income will be taxed at the parents' top federal income tax rate if the child is under the age of 14. This is known as the "kiddie tax." Undistributed trust income which exceeds $7,500.00 is taxed at 39.6% of taxable income.
The kiddie tax can be avoided or minimized if the custodian or trustee makes investments which have little or no taxable income. Techniques to achieve this goal include:
1. buying life insurance policies in which the cash surrender value builds up free of federal income tax;
2. buying municipal bonds which generate tax exempt interest;
3. investing in growth stocks which pay low dividends relative to market value;
4. or, buying land which produces just enough income to cover taxes and miscellaneous expenses, but has the prospect of appreciating in value. For example, in southern Indiana, land classified as forest under Indiana law has the assessed value for property taxes of $1.00 an acre. The costs of forest improvement (tree planting, removal of low quality trees, etc.), can be deducted under current federal income tax rules over a seven-year period.
A Crummy Trust may be used for minors by parents who wish to avoid or minimize the "kiddie tax," avoid mandatory termination of the trust at age 21, and still take advantage of the annual federal gift tax exclusion. Care should be taken that all of the requirements set forth by the Internal Revenue Service are met in order to qualify for the exclusion.
If you are interested in learning about other estate planning techniques, a non-credit course, entitled "Planning for the Future-Estate Planning," is being offered this fall by the Indiana University - Bloomington School of Continuing Studies. The course meets at the Law School, on Monday evenings at 7 p.m., for 4 sessions, beginning September 29. Professor Emeritus of Law William W. Oliver teaches the course, and will provide background and general information regarding important estate planning techniques. You can call (812) 855-1171 for more information regarding this class. §
