Tax, Trusts & Estates Law Monitor : Estate Planning Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Gift Tax & Trust Issues

We recently posted a blog article on the choice between gifting to a 529 Plan or a Minor’s Gifting Trust.  There is a third option – transferring assets to a custodial account for the benefit of a minor.  In New Jersey and New York, these gifts would be made under the Uniform Transfers to Minors Act (“UTMA”).

A donor can create an UTMA account for the benefit of a minor beneficiary, and can gift annual exclusion gifts (or larger amounts which would then utilize a portion of the donor’s lifetime applicable exclusion amount).  The account is owned by the minor and as a result the minor is the taxpayer.  While the beneficiary is a minor, the designated custodian is in control of the account and makes all investment and distribution decisions.  Unlike a 529 Plan, the growth inside the UTMA account is subject to income tax and distributions are not limited to higher education.  Interestingly, if the custodian has a legal obligation to support the beneficiary, and the custodian dies while the beneficiary is a minor, the custodial account will be included in the custodian’s taxable estate.

The major disadvantage of gifting to an UTMA account is the minor beneficiary becomes entitled to the account upon attaining age 21.  Under most circumstances, it is not advisable for a 21 year old to be the recipient of a sizeable sum of money at the time when maturity, life experience and knowledge all are just beginning to develop.  The much better alternative is a Gifting Trust that can prescribe restricted but flexible terms for the beneficiary to receive assets.

Prior to 1987, one of the advantages of transfers to UTMA accounts was that, by transferring assets to these accounts, the assets were then taxed at the child’s generally lower income tax rate, rather than the parents’ tax rate.  Congress adopted the “Kiddie Tax” in 1986 which eliminated this tax benefit.  The Kiddie Tax today provides that for investment income for children under age 18 (and dependent children under age 24 who are full time students), amounts in excess of $1,900 will be taxed at the parents’ tax rate.  The age was originally 14 but Congress changed the age to 18 in 2006.

Thus, the income tax advantage of the UTMA account has largely been eliminated.  As a result, gifting to Gifting Trusts and/or 529 Plans (for gifting for higher education expenses) is generally preferable.

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In February 2011 the IRS announced the Offshore Voluntary Disclosure Initiative (OVDI) for taxpayers with undisclosed foreign accounts.  This program was a follow up to a program initiated by the IRS in 2009 on the same topic following civil and criminal cases brought by the Department of Justice against Swiss bank UBS AG seeking the release of information concerning secret accounts maintained by U.S. persons with the Swiss bank.  Approximately 15,000 taxpayers came forward under the 2009 program which required the payment of taxes on omitted income going back to 2003, a 20% penalty on those back taxes and a 20% miscellaneous penalty on the high balance of the undisclosed foreign account between 2003 and 2008. 

Under the 2011 OVDI, subject to limited circumstances where a reduced penalty may apply, the miscellaneous penalty has been increased by 5% to 25% of the high balance and taxpayers must still pay the taxes on omitted income going back to 2003.  The new program expires August 31, 2011, but can be extended by up to 90 days under certain circumstances.

The February 2011 OVDI is similar to the 2009 program with some exceptions including an increase in the penalty from 20% to 25%, and an eight year lookback rather than a six year lookback on back taxes.  Taxpayers who do not come forward face much more severe penalties including a fraud penalty equal to 75% of the back taxes and a miscellaneous penalty equal to 50% of the high balance each year (potentially 300% in the aggregate) as well as possible criminal prosecution.

Guidance issued in June 2011 expands eligibility for a 5% penalty (in lieu of a 25% penalty) and clarifies the procedure for individuals choosing to “opt out” of the OVDI.  Those who "opt out" are subject to a more detailed audit and penalties will be determined following the completion of that exam. Cole Schotz Partner Jeffrey Schechter was recently quoted on this issue in the following article titled, "IRS Guidance on Offshore Asset Disclosure Program Perceived Beneficial to Taxpayers" published by BNA Daily Tax Report, which provides some insight into the new guidance. Also, all of the updated frequently asked questions pertaining to the OVDI can be found here.

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Gifting is an integral part of estate planning and the incredible rise of education costs has made gifting to fund educational expenses an important consideration for many families.

One common technique implementing this planning is the creation of a 529 Plan for a benefit of a child or grandchild.  After-tax dollars are contributed to these accounts which then grow federal income tax free for the benefit of the beneficiary of the account.  The funds must be used for college tuition and related expenses.  If the beneficiary does not use all the funds, the beneficiary can be changed to another child.  To the extent funds are used for non-educational purposes, they are subject to income tax and a 10% penalty on the earnings of the account.  The penalty can be avoided if the beneficiary dies, becomes disabled or receives a scholarship.

529 Plans are limited in that they only can provide for higher education expenses.  An alternative to a 529 Plan is the creation of an irrevocable gifting trust to be the recipient of gifts for your beneficiaries.  The gifting trust can permit the trustee to make distributions to the beneficiary (i.e. a child or grandchild) not only for college, but for other educational needs, health, maintenance, support or any other legitimate reasons, such as a down payment on a house or to start a business.  The trust could extend out for a term of years (i.e., until the beneficiary attains age 35), or can even be for the lifetime of the beneficiary.  While the trust is irrevocable so that it is not included in the donor’s estate, it can be drafted in a very flexible manner to permit distributions over a longer period of time.  In this way, the donor (through the trustee) maintains control over the distribution of the assets

The major disadvantage to the gifting trust when compared to the 529 Plan is that the funds in the trust do not grow income tax free.  Each year, to the extent income is not distributed, the trust will be required to pay income tax on its earnings.  

Lastly, it is also important to note that a donor can pay for a child or grandchild’s educational expenses directly as a tax-free gift, which is in addition to (and not limited by) the $13,000 per donee per year gift tax annual exclusion.

When considering gifts to minors and other beneficiaries for educational purposes, it is important to consider 529 Plans and their tax benefits and compare this to the advantages of a gifting trust and its flexibility to make a wider range of distributions to make an informed decision as to which approach is more appropriate.

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