It's so basic that I'm almost embarrassed to write about it. Plus, after over 10 years of Professional Insights columns, I profess that, for the very first time, I must repeat a topic because I get so frustrated when I meet prospective clients, and strangers at my favorite local saloons. (Note to my younger readers: No, I do not get my hair styled at a saloon. I don't have enough hair to need much styling.)
The problem is a very common mistake in using the most basic form of estate planning the $11,000 gift tax annual exclusion. It is not a technical tax issue. Rather, people use shortsighted approaches that they come to regret for personal reasons years later.
I remember when my parents decided to start making annual gifts to my kids. I thanked them for their generosity and asked how they planned to do it. Easy, Dad said. We'll set up custody accounts in our grandkids names and make you the custodian. You'll control it until they become adults.
My oldest was about 11 at the time. With lightening speed, I calculated that if Mom and Dad gave $20,000 annually for the next 10 years, each kid would have $200,000 if I put the money under the mattress. Later, with a calculator, I figured they'd have about $350,000 if I invested in the stock market and earned 10% annually.
Uhmmm, Dad, I'm not comfortable with my kids getting that kind of dough when they turn 21 and have the right to their custody accounts. Just think of the potential partying and fancy cars they could buy!
Minor s Disaster
Several years back, I got a call from a panicked father who had used the second most common approach for his annual exclusion gifts. It is a so-called minor's trust, which meets the requirements of tax law Section 2503(c). One such requirement is that the trust either must distribute to the child at age 21 or give her the right to withdraw everything for a period of time after reaching that age. If the child chooses not to withdraw, the assets can stay in trust, usually until age 30.
Well, it seems that the caller, who was an investment banker, had managed (legally, I assumed at the time) to parlay the annual gifts into about $3 million. You ve got to help me! he said breathlessly. My son turns 21 next month and I m scared to death that he will ignore my demands that he leave the money in the trust. He's planning to quit college and lord knows what he's going to do, but I m sure it won t be pretty.
There is yet another problem with using custody accounts and minors trusts. What happens if a new baby comes along late in the game after you ve built up significant amounts of family business stock or other assets for the lucky older kids?
Grandparents frequently face this problem. They love the grandkids equally and want each to have the same amount. However, a combination of years of annual gifts and good growth could leave the new little darling way behind his older peers. You cannot legally take stock or other assets from the older kids custody accounts or minors trusts to equalize the younger ones.
There is a way to avoid these problems. It requires a trust that incorporates a Crummey power, which is named after the court case that authorizes it. It's rather simple. The power gives the beneficiaries a right to withdraw a pro-rata portion of each gift. There is only one problem. You must notify the beneficiaries of their withdrawal right.
Yeowsers! you exclaim. You mean my 15-year old maniac can take the $22,000 gift and buy a Ferrari? No, not even a Yugo. As all parents know, minors have no rights (only demands). A minor can't exercise the withdrawal right. So, you give the notice to his legal guardian (who might be you), not your precocious teenager, who may remain blissfully ignorant (or, at least, asleep until three in the afternoon).
I've never seen it happen, but there is gossip in the estate planning community that an over-18-year-old beneficiary somewhere once actually exercised his withdrawal right. I think that' s folklore and, in any event, once is the operative word. Why? There is great power in a subtle threat (delivered verbally, not in writing) accompanying the notice that you will make no future gifts and you'll rewrite your will if he exercises his withdrawal right.
The cool thing (my younger readers will not appreciate my hipness or this concept) is that the withdrawal right lapses 30 days after each gift. They cannot withdraw the rest of the trust. My experience is that, while $22K sounds like a lot to 18-year olds, they are adult enough to understand the bigger picture. Hold the fort 30 days and the property is locked in the trust and cannot be withdrawn.
There is no required termination date, so you can tie the assets up until you think the kids will be mature enough to handle the responsibility. Unlike a minor's trust, the kid does not have the right to withdraw the entire trust at age 21. The distribution terms can be as tight or as liberal as you choose, or you can give the trustee discretion over distributions.
All current and future kids and grandkids can be beneficiaries of a single trust and can share equally in the entire trust, including additions made before they were born. However, if grandkids are potential beneficiaries, your gifts might consume a portion of your generation skipping exemption. For most people, there is likely to be plenty of that exemption available since it rises to $1.5 million ($3 million for married donors) next year.
Admittedly, setting up and operating a trust is a little more burdensome than a custodial account. And, since it will last longer, it requires more thought than a simple minor s trust. But, trust me. It can save considerable grief in the future. And, it will keep me from having to write a third column to express my frustration about encountering this problem again and again.