by Bob Rywick
Taxpayers, especially comparatively wealthy taxpayers with young children or grandchildren, often want to make gifts to minors that qualify for the annual gift tax exclusion.
The annual exclusion is $11,000 a year in 2002 for each individual to whom a gift is made. This can be increased to $22,000 if the donor’s spouse joins in the gift. To the extent that the gift qualifies for the annual exclusion, the amount of the gift is taken out of the donor’s estate for estate tax purposes.
In addition, income earned on the donated amount will be taxed to the recipient instead of the donor. This will often result in the income being taxed at a lower tax rate. (Lower income tax rates may not result if the recipient is a child under 14 subject to tax on investment income over $1,500, in 2002, at his parents’ marginal rate under the kiddie tax rules).
Generally, the annual exclusion is available only for gifts of present interests. Gifts in trust for minors will qualify if the trust is a present-interest trust. To be a present-interest trust, the minor beneficiary must have an immediate unrestricted right to the income from the trust. Thus, a trust would qualify as a present-interest trust if the trustee is directed to distribute all of the trust income, at least annually, to the minor.
A gift in trust can also qualify for the annual gift tax exclusion even if the trustee has discretion to accumulate the income during the beneficiary’s minority if the requirements of IRC § 2503(c) are met.
Requirements of IRC § 2503(c) trusts
Under IRC § 2503(c), a gift in trust to a minor will not be treated as the gift of a future interest and, thus, will be eligible for the annual gift tax exclusion if:
...The principal and the income of the trust may be spent by, or for the benefit of, the minor before the minor reaches 21; and,
...Any amount not so spent will go to the minor on reaching 21, or if the minor dies before 21, will go to the minor’s estate or as the minor appoints under a general power of appointment.
The trustee may have discretion to spend principal or income for benefit of minor. A gift in trust to a minor on terms that restrict the use of income and principal to distributions made by the trustee, in his sole discretion, meets the requirements of IRC § 2503(c). This means that, as long as the trustee has the discretion to determine how much of the income or principal should be used for the minor’s benefit during his minority, the trustee may accumulate all or any part of the income until the minor reaches 21.
The trustee may also be given discretion to determine the purpose for which income or principal may be spent.
Example (1): Your client and his wife want to make annual gifts to a trust for the benefit of their 13-year-old daughter in an amount equal to the annual gift tax exclusion. They want the income from the trust to be accumulated until their daughter reaches 21 when the principal and income of the trust would be distributed to her.
If she dies before reaching 21, the principal and income would be distributed to her estate. They would like the trustee to be required to accumulate the income because they are certain they could meet all of their daughters reasonable needs from their own resources.
You inform them, however, that the trust will not qualify for the annual exclusion unless the trustee is given discretion to spend the income or principal of the trust for the benefit of their daughter.
Observation: As a practical matter, the trustee is unlikely to spend any of the income or principal of the trust if the minor’s needs may be met from other sources. However, the trust agreement may not limit the trustee’s discretion to situations where the minor’s needs cannot be met from other sources.
Observation: A mandatory accumulation to a date before the minor reaches 21 also should be avoided even if the trustee has discretion to spend income or principal for the minor’s benefit during part of the period that the trust is in existence.
This is so even though such a provision seems to meet the literal wording of IRC § 2503(c)(1) that principal or income may be expended by or for the benefit of the minor "before his attaining the age of 21 years."
The purpose of IRC § 2503(c) seems to require that the principal and income be available for the minor’s benefit throughout the entire period between the date of the gift to the trust and the minor’s 21st birthday, even if no part is ever spent for his benefit.
Example (2): Your client wants to establish a trust for the benefit of her 10-year-old grandson. The trust is to continue until her grandson reaches 21. At that time, all the accumulated income and principal of the trust will be distributed to the grandson. She would like the trustee to be required to accumulate all income until her grandson reaches 18. After he is 18, the trustee will have discretion to distribute income or principal to or for the benefit of her grandson.
If this provision is adopted, any gift to the trust probably will not qualify for the annual gift tax exclusion as the trustee will not have discretion to distribute income and principal during that the entire period the trust is in existence.
Requirement that principal and income be distributed to the minor’s estate, or pursuant to the exercise of a general power of appointment if the minor dies before reaching 21
The estate of a minor means the minor’s intestate estate if she does not make a valid will under state law, or the probate estate if she makes a valid will. Thus, if the minor doesn’t make a valid will, the principal and accumulated income of the trust would be distributed to those who would inherit the minor’s property under state law where there is no will.
If the minor has a valid will, though, the trust property would go to the minor’s beneficiaries under the will. A provision in the trust agreement that provides that the property will go to the minor’s heirs at law, or issue, or direct descendants does not meet the requirement that the property must be distributed to the minor’s estate if the minor dies before 21.
A general power of appointment means a power (exercisable by deed or will) as defined in the gift tax law, i.e., a power that allows the minor to appoint the property to himself , his estate, his creditors or the creditors of the estate.
The minor’s power of appointment over the unexpended part of a trust’s principal and income required under IRC § 2503(c) may be exercisable by his will only, or during his lifetime only. It does not have to be exercisable both by will and during the minor’s lifetime.
The exercise may be subject to limitations, but only if these limitations are of a formal nature only and do not affect the substance of the power. For example, a lifetime power may have to be exercised in a particular form, or with reasonable advance notice, or, in the case of successive partial exercises, only at reasonable intervals or the exercise of a testamentary power may have to be made by specific reference to the power.
Suppose a minor is given a lifetime power or a testamentary power of appointment under a trust but cannot exercise it because under the applicable local law he is under a disability to exercise such a power, e.g., because the minor is under a specified age. This legal obstacle will not prevent gifts to the trust from being eligible for the gift tax annual exclusion.
This is so even if the terms of the trust contain a disposition of the unexpended part of the trust in favor of persons other than the minor’s estate if the minor fails to exercise the power of appointment. However, a gift to a trust will not be eligible for the exclusion if the trust itself provides that the general power of appointment may not be exercised before the minor reaches a certain age.
Example (3): Your client wants to make a gift of property to a trust for the benefit of his daughter who is now 13. The trustee will have discretion to spend the principal or income of the trust for his daughter’s benefit, but your client expects that no such expenditure will ever have to be made.
The trust will terminate on his daughter 21st birthday and all of the trust principal and accumulated income will be distributed to her daughter at that time.
Your client also wishes to give his/her daughter a general power of appointment exercisable only in a will made by her on or after her 20th birthday. Under local law, an individual is eligible to make a will at age 18. If this provision is included in the trust, the gift will not qualify for the annual exclusion unless all the trust property will go to the daughter’s estate if the power is not exercised.
Thus, if there is a gift to the daughter’s siblings if the power is not exercised, the gift will not qualify. However, if the limitation is not included so that your client’s daughter can exercise the power in a will that is made on or after her 18th birthday, the gift will qualify.
In my next column, I will discuss other issues involving an IRC § 2503(c) trust, including whether a gift can qualify for the exclusion if the trust is to continue beyond age 21 but all accumulated income has to be distributed when the minor reaches 21; whether a gift in trust for an unborn child qualifies for the annual gift tax exclusion; and when the gift will qualify for the exclusion if the trust in fact continues after the minor is 21 if the minor has the power to terminate the trust when she reaches 21.
