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July 1997 Hot Topics

July 1997 - Tax Consequences of Gifts to Minors Using
Custodial Accounts

 

Introduction

The easiest way to give a child property, while retaining a measure of control over the gift, is under the Uniform Gifts to Minor's Act. These "custodial: arrangement are accounts in the name of a custodian who holds property for the benefit of a minor subject to state custodianship statutes. A custodianship may also have favorable tax consequences. Every state has enacted custodial statutes based on various model acts. California uses the Uniform Transfers to Minors Act (Act), Prob. Code 3900-3925.


Requirements

If you have property that you would like to gift to your minor child, you can designate yourself (with some exceptions), another adult, or a trust company to serve as custodian for the property. Prob. Code 3909(a)(1)-(6). The custodian manages and invests the property, and has broad discretion to use the property and income for the child's benefit, without court approval. Prob. Code 3912(b). When the child reaches age 21, the principal and all accumulated income must be paid to the child, or the child's estate if the child dies before age 21.

When applying his or her discretion to pay out custodial property for the minor's benefit, the custodian need not consider the ability or duty of any person to support the minor, or other income of the minor [Prob. Code 3914(a)], and the custodian's rights and duties do not affect any obligation of a person to support the minor. Prob. Code 3914(c).

A custodianship can consist of only one custodian and one minor. Prob. Code 3910. With some exceptions, you can generally make additional transfers from different sources at different times without creating additional custodianships. Law Revision Commission Comment to Prob. Code 3910.


Gift Tax Issues

When you give your minor child money, clothing, a car, or other types of personal property, the transfers to the child are ordinarily considered a satisfaction of your legal obligation to support the child. If the transfer goes beyond your legal obligation to support your child, such as the transfer of investment property or a large amount of money, the transfer will be deemed a gift.

If the gift exceeds the $10,000 annual federal gift tax exclusion, or if that exclusion does not apply, you will be required to file a federal gift tax return. If you are married, you and your spouse can treat half of the gift as made by you and the other half as made by your spouse by filing form 709-A. You can each use your $10,000 annual exclusion to reduce the size of the gift by $20,000 for gift tax purposes. Therefore, you can avoid gift tax liability by limiting the transfers to your child to $20,000 per year. Note: You also have a Unified and Estate Tax Credit worth $600,000 which may be applied to gifts over the annual gift tax exclusion.

The $10,000 annual federal gift tax exclusion of Internal Revenue Code (IRC) 2503(b) only applies if the transfer to the donee is a present interest (i.e. not a future interest) in the property. Gifts in trust, where the beneficiary is not entitled to the property until a future date, violated this present interest rule and, thus, the annual gift tax exclusion cannot be applied to them.

In a custodial arrangement, however, even though the child does not receive the property outright, the transfer is still considered a present interest gift under IRC 2503(c) if:

(1) the property may be expended for the benefit of the donee before the age of 21 years, and

(2) the property and income not spent for the minor's benefit will pass to the minor when he reaches age 21, or, if the minor dies before age 21, be payable to his estate or as he may appoint under a general power of appointment. See Rev. Rul. 59-357, 1959-2 C.B. 212.

In California, custodial property is transferred to the child at age 18, unless the donor specifies in the transfer instrument a delay in the custodianship termination period up to the age of 21 for property transferred by irrevocable gift. Prob. Code 3920.5(e) and (g). The IRS has ruled that states may reduce the statutory age at which property passes to the donee from 21 to 18, to be consistent with the state's age of legal emancipation, without violating IRC 2503(c). Rev. Rul. 73-287, 1973-2 CB 321. Thus, gifts under the Act will qualify for the annual exclusion.


Income Tax Consequences

Because a custodial transfer is considered a completed gift, income generated by custodial property is generally taxable to the minor. However, the income will be taxed to you to the extent that the custodian uses the income to satisfy your legal support obligations. See Rev. Rul. 59-357, 1959-2 CB 212. Unearned income over $1,300 is taxed to the child (the first $650 is not taxed and the next $650 is taxed at 15%), under the "kiddie tax" provisions, at the parent's tax brackets as long as the child is under age 14. Thereafter, the income is taxed directly to the child.

For example, a gift transfer to a child under age 14 of $10,000 which earns 6.5% annually will not be taxed. A transfer of $20,000 earning 6.5% annually ($1,300 in income) will produce just a $97.65 tax (15% of $650) to the child. If the same income were taxed to a parent in the 31% tax bracket, the tax would be $403.


Estate Tax Issues

Custodial property will be included in your estate if you are serving as the custodian. Rev. Rul. 57-366, 1957-2 C.B. 618. Under the California Act, if you want to serve as custodian, but avoid inclusion of the property in your gross estate, you must waive the right as custodian to make support payments, (you may make support payments under a court order). Prob. Code 3914 (d). Generally, this is not an issue if your estate is under $600,000 since there will not an estate tax.

A parent's right to petition the court to order a custodian to use custodial property for the support of the parent's minor child will not cause the custodial property to be included in the parent's gross estate, because the right does not constitute a general power of appointment over the custodial property. Rev. Rul. 77-460,1977-2 CB 323.


Designating a Custodian

You can designate yourself, another adult, or a trust company to serve as custodian. Prob. Code 3909(a)(1)-(6). You may designate successor custodians in the original transfer document, or in a separate writing executed and dated at the same time as the original transfer document. Prob. Code 3918(b). The custodian is required to manage and invest custodial property, subject to the "prudent person" standard, keep records of custodial transactions, and must identify and keep custodial property separate from other property. Prob. Code 3812 (a),(d) and (e). A custodian may annually charge reasonable compensation for services performed, unless the custodian is also the transferor of the property. Prob. Code 3915. The custodian is also entitled to reimbursement for reasonable expenses incurred for services performed. Prob. Code 3915(a).

If you name yourself as custodian, you save the expense of paying someone to manage the custodial property; however, your actions may be more closely scrutinized to ensure that the arrangement is a legitimate custodianship. Be careful not to deal with custodial property in a manner inconsistent with your custodial duties, such as commingling custodial property with your own funds, or exercising dominion over the gifts; otherwise, the custodianship may be disregarded as a sham and you will be treated as owner of the property.

You cannot serve as custodian if you transfer personal property such as a coin collection or unregistered securities, since these assets do not have title (ownership) documents. If you serve as custodian, the methods of transferring title are more limited than the methods for changing title when another party serves as custodian. Prob. Code 3909(a)(1)-(7).

If you name a friend or relative as custodian, you can fix the custodian's compensation in advance. By separate agreement, you can provide that the custodian will receive a fixed annual fee, or an annual fee that is a specified percentage of the value of the custodial property. The disadvantage of naming a friend or relative is the potential for conflicts and sensitivities involved with having a friend or relative "hold the purse strings." If any custodian fails to make payments to or for the benefit of the minor, the minor (if 14 years of age or older) or an interested person (including the parent) may petition the court to order the custodian to make such payments as the court considers advisable. Prob. Code 3914(b).

Trust companies generally have their own rate scales for computing compensation, based on the value of the custodial property, and generally use their own forms. The advantages of naming a trust company as custodian are professional management and impartial distribution of the custodial assets.


Transferring Assets to a Custodian

Deliver the money to a broker or financial institution for credit to an account in the name of your brother, followed by the words "as custodian for (your child's name) under the California Uniform Transfers to Minors Act." Prob. Code 3909(a)(2).

To transfer the real property, deliver a gift deed in to you brother in his name, followed by the words "as custodian for (your child's name) under the California Uniform Transfers to Minors Act." Prob. Code 3909(a)(6).

Register the securities in your brother's name, followed by the words "as custodian for (your child's name) under the California Uniform Transfers to Minors Act." Prob. Code 3909(a)(1).

Note: If the securities are certificated but unregistered, or uncertificated, you should use a special form prescribed by Prob. Code 3909(a)(1)(B). The same form should be used to transfer uncertificated tangible personal property that is not registered with a governmental agency, such as the watch collection. Prob. Code 3909 (a)(7),(b).


Custodial Gifts that Take Effect in the Future.

You can make a revocable nomination of a custodian to receive property for a minor upon your death (or upon the occurrence of another future event) by will, trust, or certain other methods. Prob. Code 3903(a); Prob. Code 6341-6349 (testamentary dispositions). You may extend the custodianship period to age 25 for transfers:

(1) on the occurrence of a future event,

(2) by the exercise of a power of appointment, or

(3) from a personal representative or trustee when there is no will or trust authorizing a transfer under the Act. Prob. Code 3920.5(c),(d), and (f).

However, a revocable nomination is not a completed gift and will probably be included in your estate for estate tax purposes. The property is not custodial property until the transfer becomes irrevocable, upon the occurrence of the specified event. Prob. Code 3903(c).


Custodianship vs. Trusts?

Although certain trusts can serve similar purposes, a custodianship is the easier to implement and administer. Gifts to children are also made to minor's trusts which comply with IRC 2503(c), and irrevocable trusts (which usually use sophisticated "Crummey" withdrawal powers to comply with the annual gift tax exclusion). Consult an estate planning or tax attorney, for more detailed descriptions of these alternatives. Also, review the following article contained on my Website: Use of Revocable and Irrevocable Trusts.




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