Notably, there is no limit on the number of annual exclusion gifts that can be made, nor is there any requirement that a gift be made to a family member. Annual exclusion gifts can be made to in-laws, friends, or even complete strangers.
Using the same assumptions as above, if the married couple were to make gifts to the spouse of each child and grandchild—adding another 6 donees—this simple technique would transfer between $8.5 and $10 million in only 15 years, depending on whether 4% or 6% is earned, saving between $3.4 and $4 million in estate taxes, respectively. The estate tax savings would be even greater if family wealth was subject to a state level estate tax.
B. “Annual” Gifting
The annual exclusion is annual. The gift must be completed every calendar year, if not the opportunity to make that year’s gift is lost. To minimize that risk, many families make annual exclusion gifts in January of each year. In such cases it is important to remind clients that if a full annual exclusion gift is made, clients cannot also give a birthday present or a holiday gift without using some of their lifetime gift tax exemption ($13.61 million in 2024), and such gifts would also have to be reported on a gift tax return.
In practice, clients generally do not inform their advisors of modest non-monetary gifts. In other words, if you make a full annual exclusion gift to a grandchild in January and you give the same grandchild a new bike for their birthday, it is unlikely the gift of the bike will be reported. That said, there is no statutory or regulatory exception for non-monetary gifts. In the foregoing example the fair market value of the bike should be reported as a gift in excess of the annual exclusion amount and a portion of the $13.61 million lifetime exemption should be used to shelter that gift from a 40% tax, along with a portion of the client’s generation skipping tax exemption as discussed below.
A good reason for making January gifts is that December gifts may not be completed before the end of the calendar year. A physical check must clear before the gift is complete. Until that time, the writer of the check can direct his or her bank to stop payment on that check, meaning it has not left the dominion and control of the writer until it clears.
C. Qualifying for the Annual Exclusion
Qualifying for the annual exclusion from gift tax is not a given. The annual exclusion from gift taxes is authorized by section 2503 of the Code: subsection (a) of section 2503 sets out a definition of “taxable gifts,” then subsection (b) carves out from that the annual exclusion from taxable gifts, instructing that:
[I]n the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of such gifts to such person shall not, for purposes of subsection (a), be included in the total amount of gifts made during such year.
As emphasized by the parenthetical in subsection (b), the annual exclusion from gift taxes generally applies only to a gift of a present interest.
1. Present vs. Future Interest
The present interest requirement of section 2503(b)(1) has long been difficult to pin down. In 1945, when the U.S. Supreme Court faced the question of what constitutes a “present interest,” Justice Rutledge mused, “The question is of time, not when title vests, but when enjoyment begins.” The regulations take a more practical approach, emphasizing that “the entire value of any gifts of a future interest in property must be included in the total amount of gifts for the calendar period in which the gift is made,” and elaborating upon the definition of “future interest”:
“Future interest” is a legal term, and includes reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time. The term has no reference to such contractual rights as exist in a bond, note (though bearing no interest until maturity), or in a policy of life insurance, the obligations of which are to be discharged by payments in the future.
A “present interest,” on the other hand, is “[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain).” The question, accordingly, is whether what the donee received meets this present interest definition, and the question is not resolved simply by asking whether “the donors [gave] up all of their legal rights.”
2. Transfers in Trust
In the estate planning context, the distinction between present and future interests most often arises when a gift is made to a trust, but it can also be relevant when a partial interest in an entity is gifted, even if that gift is made directly to an individual. When using vehicles like trusts, LLCs, and other entities, if annual exclusion treatment is desirable, the vehicles should be specifically constructed with the annual exclusion in mind.
The general rule is that gifts in trust do not qualify as annual exclusion gifts because they are gifts of future interests. An important exception to that rule has existed since 1968 thanks to Crummey v. Commissioner. Since Crummey, it is possible for a transfer to a trust to qualify as a present interest, and therefore as an annual exclusion gift, if the trust is drafted to give beneficiaries a present interest through a withdrawal right, triggered each time the trust receives a gift, also known as a “Crummey” right.
If the present interest relies on a withdrawal right, the donee must have reasonable notice of, and opportunity to exercise, the power. Revenue Ruling 81-7 addresses this issue with the example of a trust created and funded on December 29 under which the right to withdraw lapsed on December 31. There, the withdrawal right was determined to be illusory because the beneficiary was not made aware of the right until after it had lapsed.
To qualify as a present interest, it is not necessary that a beneficiary be notified of the withdrawal right in the same tax year as the gift. Revenue Ruling 83-108 confirms a withdrawal right was not illusory when the beneficiary received notice in early January of a late December gift and had 45 days after receipt of notice to exercise the withdrawal right. The key factor was whether the beneficiary had a reasonable opportunity to exercise the withdrawal right.
Importantly, there cannot exist an agreement or understanding between the donor and the powerholders not to exercise their power. In Estate of Cristofani, the Tax Court upheld application of the annual exclusion to gifts in trust to the donor’s minor grandchildren who were contingent remainderman to the donor’s children, citing the lack of express or implied agreement and the legal right of the grandchildren to demand the amount subject to the withdrawal right. Estate of Cristofani reinforced Crummey in stating that “the likelihood that the beneficiary will actually receive present enjoyment of the property is not the test for determining whether a present interest was received.” It did not matter that the grandchildren, who did not exercise their withdrawal rights, would only receive a later distribution from the trust if they survived their parent and their parent predeceased their grandparent.
3. Transfers of Entity Interests
Gifting an interest in an entity is an attractive option for several reasons. First, if a client gifts a non-controlling interest in an entity, applicable valuation discounts from the pro-rata net asset value will generally allow the client to transfer more wealth to future generations. Second, gifting interests in an entity provides a convenient structure for the members of the senior generation to manage assets if they are named as the manager of the LLC, or equivalent. In addition, gifting interests in an entity instead of cash or marketable securities limits the ability of the younger generation to spend the gift, and that limitation is attractive for many families. Unfortunately, that limit has led the Service to argue that these are gifts of future interests and therefore they are not eligible for annual exclusion.
With respect to a gift of an interest in a closely held entity, such as an LLC, the central question to ask in determining whether the gift will be treated as a present interest is whether the donee of that interest has a “substantial economic benefit.” More specifically, the question is whether the donee has “an unrestricted and a noncontingent right to the immediate use, possession or enjoyment (1) of property or (2) of income from property, both of which alternatives in turn demand that such immediate use, possession or enjoyment be of a nature that substantial economic benefit is derived therefrom.”
Proving that the donee had a substantial economic benefit requires an analysis of the rights and restrictions contained in the operating agreement, or equivalent, of the relevant entity. This analysis would include looking at factors like the right to withdraw capital, the right to distributions, the right to sell the property, and the right to borrow against the property. With regard to income, a substantial economic benefit is shown when (1) the entity will receive income, (2) some portion of that income will flow steadily to the donee, and (3) the portion of income flowing to the donee is ascertainable. Based on case law, gifts of minority interests in most family-owned entities will not qualify for annual exclusion treatment unless the operating provisions of the entities provide either (1) a way to monetize entity interest, or (2) an adequate income stream from the entity interest.
4. Exception to the Present Interest Requirement
Section 2503(c) of the Code sets out a limited exception to the present interest requirement for certain gifts of future interests to minors. To meet the 2503(c) exception, the gift must be (1) to an individual under the age of 21, (2) expendable by or for that individual before turning 21, and (3) if not expended by the time the individual turns 21, the remainder of the gift must either pass to the individual at age 21, or if the individual dies before that age, to the individual’s estate or as the individual directs under a general power of appointment. A trust structured to allow for annual exclusion gifts to be made to a minor under section 2503(c) is often referred to as a “2503(c) Minor’s Trust.”
5. 2503(e) Exclusion
Section 2503(e) sets out a different exclusion from treatment as a taxable gift, often referred to as the “med/ed exclusion(s).” Under this section, “qualified transfers” are not treated as gifts—they are amounts “paid on behalf of an individual . . . as tuition to an educational organization . . . or . . . to any person who provides medical care.” Unlike the annual exclusion, there is no ceiling on the amount of transfers eligible for this exclusion, but like the annual exclusion, there are various requirements that must be met. The amounts must be paid by the transferor directly to the educational organization or medical provider, each of which must meet the requirements of corresponding sections of the Code, section 170(b)(1)(A)(ii) and section 213(d), respectively. For example, a grandparent looking to take advantage of this exclusion to benefit a grandchild by helping cover educational expenses must make tuition payments directly to the institution, rather than to the grandchild with the expectation the transfer will be used for that purpose or to reimburse the grandchild for an expense already incurred. It is also worth noting this exclusion applies only to tuition, and not other related expenses like room and board.
D. Criteria to Qualify for the Annual Exclusion for GST Tax
Grandparents contemplating gift planning for grandchildren must also consider the impact of the generation skipping transfer (GST) tax. Predictably, the annual exclusion from gift tax and the annual exclusion from GST tax are addressed under different sections of the Code, and although the criteria to qualify for each generally do overlap, they differ. This is particularly relevant with respect to gifts in trust.
The annual exclusion from GST tax arises from section 2642(c) of the Code, which begins by applying a GST inclusion ratio of zero to all “nontaxable gifts.” The section operates by defining “nontaxable gifts” with reference to section 2503, specifically the annual exclusion gifts under section 2503(b) and med/ed exclusion gifts under section 2503(e), in effect extending these exclusions from the gift tax to the GST tax. However, section 2642(c)(2) makes a key modification: transfers to a trust are excluded from this beneficial treatment, unless (1) the transfer is to a trust for the sole benefit of one individual during that individual’s life, and (2) if the trust does not terminate before the individual’s death, its corpus will be includable in the individual’s estate. A key distinction here is that section 2642(c)(2) broadly excepts transfers to trust from the benefits of the section 2642(c)(1) exemption unless the trust meets these very specific requirements. Merely qualifying as a present interest gift is not enough to meet the criteria for exclusion from the GST tax.
E. Maximizing the Annual Exclusion
As estate planners, we are focused on ways to maximize estate tax exemptions and exclusions, and the annual exclusion is an important tool. One annual exclusion gift year-over-year adds up, but the strategy is exponentially more powerful when multiplied.
1. Gift Splitting
The most common way to multiply the annual exclusion is by gift splitting with a spouse. Section 2513 permits a gift made by one spouse to any person, other than a spouse, to be considered as made one-half by each spouse, provided both spouses signify their consent to gift-splitting and each spouse is a citizen or resident of the United States.
Gift-splitting has its limitations. For example, a gift-splitting election applies to all gifts made during the calendar year while the couple is married, other than gifts in which the other spouse has an unascertainable interest. Once an election is made, the election is irrevocable, and it can only be made on the first gift tax return filed for the relevant tax year, whether or not the return is filed timely.
Gift-splitting is a convenience for married couples, such as when only one spouse owns the asset being gifted, or if the couple wants to have a single trust and single donor for double the gifts. Gift-splitting does not increase the amount of the annual exclusion available from a couple who could individually undertake annual exclusion planning.
2. Increasing the Number of Beneficiaries
Multiple beneficiaries means multiple exclusions. In the case of gifts in trust with withdrawal rights, a large beneficiary class can allow for significant transfers without utilizing the donor’s lifetime gift tax exemption amount. Once a withdrawal right lapses, the funds become available for distribution by the trustee subject to the standard set forth in the trust agreement, potentially only benefitting a subset of the large class. This flexibility is an attractive reason to use trusts.
There is potential to abuse this concept by making annual exclusion gifts to individuals as part of a reciprocal arrangement. The Service has been successful in clawing back annual exclusions in cases of reciprocal giving. In Schultz v. United States, the Fourth Circuit upheld the Service’s application of the reciprocal doctrine to exclude gifts made by two brothers of closely held stock on the same date to their respective nieces and nephews, three each, after making like gifts to their own children on the finding that each brother’s primary purpose was for larger amounts to pass to his own children. More recent cases have been consistent on this issue.
The concept of reciprocal giving has also been applied in other contexts to disallow the annual exclusion. For example, Revenue Ruling 85-24 extended the concept of reciprocal withdrawal rights to the case of two or more grantors, each of whom created a trust for the primary benefit of that grantor’s child, and granting the other grantors a right to withdraw in the trust. There, the Service refused to allow the annual exclusion for the gifts subject to the withdrawal power by the other grantors.
Another way of adding beneficiaries is to create so called “naked” Crummey powerholders. Those are beneficiaries whose only interest in the trust is their Crummey power. If such beneficiaries do not exercise the power, there is no way for them to benefit from a future trust distribution. While using naked Crummey powers is not recommended, the mere fact that a beneficiary’s interest in a trust is contingent on a future event should not be enough to prevent their Crummey power from qualifying a gift to the trust as an annual exclusion gift.
A large beneficiary class is not by itself an issue. A Tax Court case decided in 2015 involved a trust in which sixty beneficiaries had withdrawal rights. The case did not address the number of beneficiaries; rather, the question, decided favorably for the taxpayer, was whether certain trust provisions, including a no contest clause and provision for disputes to be settled in arbitration, meant the withdrawal right was not legally enforceable, a factor that has been considered critical in the present interest analysis.
II. Common Methods for Making AnnualExclusion Gifts
As planners, we know that it is essential to really understand our clients’ goals and objectives before we can effectively propose and structure a plan for them. A client may wish to help a grandchild with a discrete need, such a buying a first home, or may wish to set aside assets for the benefit of a class of their grandchildren so that they may have flexibility to choose a career path that is gratifying but not highly compen-sated. Another client may feel that the best way to leave a legacy is to ensure that the education of future generations is paid for. A client may only be making annual exclusion gifts during their lifetimes, or they may have engaged in more advanced planning using some or all of their exemption amounts and are augmenting their wealth transfer plans with a program of lifetime exclusion gifting.
As noted above, an annual exclusion gift in trust must generally satisfy the present interest requirement. Below are some of the most frequently used methods for making annual exclusion gifts, from the most simple to more complex, and what, in the experience of the authors, are effective uses for each depending upon a client’s assets, beneficiaries, and object-ives.
Once the plan has been established, we encourage clients, when appropriate, to let their children and/or grandchildren know what they have set in place for their benefit, and the reasons why. Lifetime gifting can be very gratifying not only to the recipients but also to the donors as it allows the donors to experience the effects of their generosity—whether in the relief their children feel knowing that education is covered for their children, for example, or in seeing a child or grandchild choose a career that is morally or intellectually rewarding, if not financially rewarding.
A. Outright Gifts
At first blush, an outright gift sounds straightforward and certainly qualifies as a present interest. In practice, the circumstances under which this makes sense are limited. First, generally speaking, outright transfers cannot be made directly to a minor. To qualify for the annual exclusion, the gift to the minor would have to be made to a custodial account or to a trust for the minor that is drafted so that the transfer qualifies for the annual exclusion.
If the recipient is not a minor, an outright gift of $18,000 or $36,000, or potentially double or triple that amount if parents and grandparents are all making gifts, could be helpful for specific or one-time needs or as a regular supplement for support. Such gifts are not really practical if the plan is to engage in a sustained program of annual exclusion gifting, with the hope the funds will be preserved and grow for a long period of time. Therefore, for long-term goals, planners will generally recommend other methods for annual exclusion gifting.
1. UTMAs
Accounts created under the Uniform Transfers to Minor Act or the Uniform Gifts to Minors Act are investment accounts established to receive gifts for the benefit of a minor, while an adult custodian holds title to and has control of the account for the benefit of the minor. Usually, a parent or grandparent will make gifts to the account for the benefit of a child or grandchild, and the parent or grandparent will either act as custo-dian or name a spouse or the child’s parent as custodian. Gifts to these accounts qualify for the annual exclusion.
Until the beneficiary attains majority, usually eighteen or twenty-one years old, the custodian has investment control over the assets as well as control over the distributions to be made for the child. However, the account must fully transfer to the child once she or he is no longer a minor. It is easy to see how this can make UTMA accounts undesirable.
Example 2: Assume grandparents established an UTMA for their first grandson on his first birthday and consistently made annual exclusion gifts into the account. The money was wisely invested and because his parents were able to provide for all of his needs, barely any distributions were made out of the account. Assume there is now over $600,000 in the account. Unfortunately, the grandson fell into some bad habits in his late teens. There is very little the parents or grandparents can do if the grandson wants to take control of this money when he is no longer a minor.
Despite the administrative convenience of an UTMA, this example is usually enough to prompt clients to choose another vehicle for their annual exclusion gifts. Another important estate planning tip for UTMA accounts is that if the donor or a parent is the custodian on the account and dies before the beneficiary attains majority, the account’s assets can be includ-ible in the estate of the custodian under section 2038 or section 2036 of the Code, another potential drawback to these types of accounts.
2. 2503(c) Minor’s Trusts
A 2503(c) Minor’s Trust refers to a trust established under the exception to the present interest rule under section 2503(c) of the Code, for annual exclusion gifts to minors. Similar to the UTMA, the trustee has investment control over the assets and discretion to make distributions for the benefit of the minor, but because the assets are in trust, the trustee is held to a higher fiduciary standard than the custodian of the UTMA. In addition, although the assets are distributable to the beneficiary once he reaches twenty-one, these trusts can be drafted to give the beneficiary the right to extend the term of the trust upon reaching age twenty-one, typically structured as a continuing right to withdraw the assets or with a right that lapses after a period of time, for example sixty days. If that right to withdraw is not exercised, the trust continues until the beneficiary reaches some other age. The advantage of a lapsing withdrawal right is the beneficiary only has a limited window to exercise the power. A drawback to that right is it creates an income tax complication because, if the right is not exercised, the beneficiary in effect released a general power of appointment and would be treated as having made a gratuitous transfer back to the trust under section 2514. As a result, the beneficiary becomes a grantor under section 671, triggering the beneficiary to be responsible for the income tax on the trust’s earnings.
Depending upon the child, and what phase of life the child is in at age twenty-one, it may be easier or more compelling for the child to forego the right of withdrawal. However, there are no guarantees that the child will not exercise the power of withdrawal. In this respect, 2503(c) Minor’s Trusts have a similar disadvantage as UTMA accounts and often result in conversations with clients looking for options to extend control and management of the assets. The vehicles discussed below include options that can provide greater control.
3. 2503(b) Crummey Trusts
A 2503(b) Crummey Trust refers to a trust that is drafted to include a withdrawal right over contributions structured to qualify the gifts for the annual exclusion as a present interest. The beneficiary must have notice of the contribution and the right to withdraw, usually given by the trustee in the form of an annual Crummey notice that the beneficiary is asked to countersign to acknowledge receipt. The notices must be sent and the signed copies should be retained with the trust records, imposing an added administrative burden specific to these trusts.
As alluded to above, the lapse of a withdrawal right can be treated as the release of a general power of appointment under section 2514 and result in a gift by the beneficiary for gift tax purposes. To avoid this result, a 2503(b) Crummey Trust will provide that the withdrawal right lapses annually up to the greater of (i) $5,000 or (ii) 5% of the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied; this is the maximum amount that a general power of appointment can lapse without it being treated as a release of a general power of appointment under section 2514(e). In other words, an annual exclusion gift of $18,000 would only lapse up to $5,000 in the first year. The remaining $13,000 is what is known as a “hanging Crummey” that continues to be subject to the beneficiary’s withdrawal right until enough years pass or the trust becomes large enough that 5% of the aggregate value of the assets from which the exercise could be satisfied produces a larger threshold. For example, a trust with $360,000 of assets available to satisfy the withdrawal would be large enough to cause the right to fully lapse. Where simplicity is desired, or in the event of a concern about accumulating hanging Crummey amounts with each annual gift, a 2503(b) Crummey Trust may limit contributions that qualify for the annual exclusion to only the amount that can lapse in the same year.
2503(b) Crummey Trusts can provide a lot of flexibility and are typically used for a large class of beneficiaries, often in multiple genera-tions, in ways that the other methods covered thus far cannot. In addition, there is no set termination for a 2503(b) Crummey Trust. Unlike the age twenty-one distribution requirement for 2503(c) Minor’s Trusts, if the grantor would like to provide for lifetime trusts or otherwise limit distribution discretion, they may do so without jeopardizing qualification for the annual exclusion.
For insurance trusts that require annual funding to cover the premium on the insurance policy and or polices, the Crummey withdrawal right offers an opportunity to utilize the annual exclusion to gift the premium dollars into the trust without using any gift tax exemption. For this reason, most life insurance trusts are structured as 2503(b) Crummey Trusts.
A typical 2503(b) Crummey Trust with multiple beneficiaries would not qualify for the annual exclusion from GST tax. If it is not tax efficient to apply the donor’s GST tax exemption to the trust, then as a non-GST exempt trust, its optimal use will be primarily for distribution among the donor’s children or for grandchildren if the distributions qualify for the med/ed exclusion under section 2503(e) described above. If such a trust only has grandchildren as beneficiaries, gifts to the trust would generally trigger GST tax at the time of funding as a direct skip for GST purposes, unless the donor has GST exemption that can be allocated to avoid such tax.
4. 2642(c) GST Trust
If GST tax exemption is or will be utilized in other trust planning and the client’s primary goal is to benefit grandchildren, a 2642(c) GST Trust is an alternative to the 2503(c) Minor’s Trust. As noted above, a 2642(c) GST Trust can only have one beneficiary, and any trust property remaining at the beneficiary’s death must be included in the beneficiary’s gross estate. While a 2503(c) Minor’s Trust by its structure would inherently meet the requirements for the annual exclusion from GST tax, the requirements for the annual exclusion from GST tax are not as limiting as those in section 2503(c) of the Code, which includes the additional requirement that the beneficiary have access to the trust property by age twenty-one. By contrast, a trust structured to meet the requirements of section 2642(c) of the Code could give the beneficiary a Crummey withdrawal right for gifts to the trust, to qualify for the annual exclusion from gift tax, and have the flexibility to continue the trust for the life of the beneficiary. For this reason, a 2642(c) GST Trust can avoid the concern described above of a young adult having access to a potentially large sum of money at a young age, which is a drawback to both the UTMA custodial account and 2503(c) Minor’s Trust options.
5. 529 Plans
Authorized under Code section 529, a 529 Plan is a qualified program that is established and maintained by a State or eligible educational institution to fund qualified education expenses. The primary advantage of this plan is that the money grows free of federal income tax, and funds will not be subject to tax upon distribution so long as the distribution is for a qualified educational expense. Some states also have tax credits for contributing to their 529 Plans. Qualified education expenses include tuition, fees, books, supplies, equipment, and room and board at a college or university; tuition for K-12s, whether public, private, or religious school, up to $10,000; expenses for fees, books, supplies, and equipment for qualified apprenticeship programs; and payments of principal or interest on a qualified education loan of the beneficiary of the plan, or their sibling, up to $10,000.
If the money is used for any purpose other than qualified expenses, tax plus a 10% penalty on the withdrawal is due, but the ability to use the assets for nonqualified expenses does not prevent the original contribu-tions from qualifying as annual exclusion gifts. For clients whose primary goal is to provide for the education of their children, grand-children, and potentially even great grandchildren, 529 Plans are one of the more compelling uses for annual exclusion gifts, especially if estab-lished when the beneficiaries are young. Gifts to 529 Plans qualify for the annual exclusion while the flexibility provided has some advantages not available in other methods covered in this Article.
Donors have the ability to accelerate five years of annual exclusion gifts, and gift splitting is allowed. The gift would be prorated over five years, and a gift tax return would have to be filed to elect proration. This is unique to 529 Plans.
Example 3: Assume your clients have six grandchildren. Gift splitting, they can fund each of their grandchildren’s 529 Plans with $180,000, thereby reducing their taxable estate by $1,080,000 with no gift tax consequence, subject to a clawback if they die before the fifth year. Considering assets can grow tax free, this is a very compelling strategy.
Another feature of 529 Plans is that the account owner may change the beneficiary, and if the new beneficiary is considered to be a family member of the current beneficiary, it is not a distribution for income tax purposes. Also, if the new beneficiary is assigned to the same genera-tion, or higher, than the old beneficiary, gift and GST tax will not apply to the transfer. Therefore, if there is money left over in the account, the assets can continue to rollover and do not have to be distributed outright to a beneficiary. In addition, although the account owners have signif-icant control over distributions and beneficiary changes, the assets are not includible in their estates.
With the latest round of retirement-related changes in SECURE 2.0 Act of 2022, up to $35,000 of otherwise unused 529 Plan funds can be rolled over into a ROTH account for the beneficiary, provided the ROTH account has been open for at least fifteen years and the funds were contributed at least five years prior. These rollovers are subject to the ROTH IRA annual contribution limits. This furthers the income tax advantage of 529 Plans for a non-education related use.
Finally, trusts can also hold 529 Plans, so it is possible to enjoy the benefits of 529 Plans that are limited to educational expenses, combined and supplemented by a trust whose terms are more flexible regarding distributions.
A 529 Plan can even be beneficial for families who are in a position to pay tuition directly based on the section 2503(e) exclusion for qualified education expenses and to make annual exclusion gifts in some other form. Recall that the section 2503(e) education exclusion only covers tuition costs, whereas a 529 Plan covers all related expenses as well, such as room and board.
6. 529A ABLE Account
In 2014, the Achieving a Better Life Experience (ABLE) Act was enacted under section 529A of the Code. Whereas a 529 Plan allows a beneficiary to save for educational expenses free from federal income tax, a 529A Plan similarly allows an “eligible individual” who is the designated beneficiary to save for “qualified disability expenses” free from federal income tax and, to a degree, without impacting eligibility for means-tested benefits. A transfer to a 529A Plan is a completed gift to its designated beneficiary and qualifies for annual exclusion treatment. Like 529 Plans, ABLE accounts are established by the state, and some permit out-of-state beneficiaries to open accounts under their program.
In order to be “eligible,” the designated beneficiary of a 529A Plan must be disabled, which is determined under section 529A(e)(1) in one of two ways: either the individual qualifies for benefits for blindness or disability under titles II or XVI of the Social Security Act, or a “disability certification” was filed in the applicable year certifying as to the individ-ual’s “medically determinable physical or mental impairment.” In both cases, for the individual to be “eligible” the “blindness or disability” must have occurred before the individual reached the age of twenty-six, limiting the use of 529A Plans to beneficiaries who are disabled from childhood or young adulthood. Under 529A(e)(5), the “qualified disability expenses” towards which funds in an ABLE account may be used income tax-free include education, housing, transportation, employment training, and assistive technology for the designated beneficiary, as well as funeral and burial expenses.
Under 529A(b), aggregate annual gifts into an ABLE account are generally limited to cash in the amount of the annual exclusion in effect in that year under section 2503(b), and there may be only one 529A account for an individual at a time. There is also a cap on the total amount that may be held in a 529A Plan. Although the absolute cap for a 529A Plan is commensurate with the maximum for a 529 Plan, only the first $100,000 in a 529A Plan will be disregarded in determining the designated beneficiary’s eligibility for social security benefits. Under section 529A(f), 529A Plans have a payback requirement on the death of the beneficiary.
Section 529A Plans can be very meaningful with respect to disability planning, including by offering a degree of autonomy and flexibility to a designated beneficiary without impacting accessibility of state benefits. However, because there are significant limitations on how much may be contributed into a 529A Plan, 529A Plans are of limited use in estate planning and may not be relevant to families with the resources to care for loved ones without means-tested benefits. If neither eligibility for benefits nor near-term creditor access is a concern, families wishing to provide for a disabled individual among other beneficiaries through annual exclusion gifts may wish to consider using a 2503(b) Crummey Trust in which distributions are in the trustee’s absolute discretion as such trusts can generally be administered to preserve eligibility for needs-based benefits without being subject to state clawback at the beneficiary’s death.
B. Forgiveness of Intra-Family Debt
Lending money to a child, grandchild, or other descendant, or selling property in exchange for a note, can be a very effective planning tech-nique, and it is often used as a way to let younger generations benefit from the financial accumulations of older generations. At one point, it was common for these loans to bear no interest, but in 1984 the Supreme Court in Dickman v. Commissioner ruled a loan with a below market interest rate is a gift to the extent of the foregone interest. On the heels of Dickman Congress enacted section 7872, under which a loan bearing interest at the “applicable federal rate” does not have a gift element. Each month the Treasury publishes applicable federal rates for short term loans (under three years in duration), mid-term loans (more than three years but less than nine), and long-term loans (nine years or more). So long as a loan between family members bears interest at the applicable federal rate (AFR), it is not a gift.
While a loan may be documented as required by section 7872, for various reasons a family member may want to forgive any annual payments required by those notes. The Service and the Tax Court do not agree on what happens if a family member forgives part or all of the payments under a note.
Example 4: Mary loans $200,000 to her son and daughter-in-law to help with the purchase of a house. She takes back a 15-year secured mortgage with interest at 5%. The mortgage calls for the annual payment of interest, with a balloon payment of principal due at the end of the term. The interest due at the end of the first year is $10,000, but instead of demanding payment Mary forgives the $10,000 of interest and another $26,000 of principal. Mary reports this as an annual exclusion gift of $18,000 to her son and $18,000 to her daughter-in-law. At the end of year two, Mary again forgives all of the interest due and principal to bring her total gift for year two to $36,000.
The Tax Court, on several occasions, has ruled that even if the taxpayer intended to forgive a debt it will still be valid consideration—and therefore reduce the amount of the original gift—so long as the debt was an enforceable obligation at the time of the “gift.” In short, it is the long standing position of the Tax Court that if notes are enforceable they are valid consideration for any property received, even if the obligee of that debt intended to forgive the notes as they came due. This is a reasonable position given that “intent” is irrelevant in determining whether or not a gift is being made and the obligee is free to change her mind at any time and insist a note be repaid, assuming it was a legally binding obligation when made.
The Service, on the other hand, specifically rejected this position in Rev. Rul. 77-299. If there is a prearranged plan to forgive the notes, the position of the Service is that the notes are not valuable consideration and should not offset the value of the initial gift, a position restated by the service four years later in Rev. Rul. 81-264. A client who wishes to make annual exclusion gifts in association with outstanding intra-family debt could instead make a cash gift to the borrowers, and the borrowers can choose to use the cash to repay the loan in accordance with its terms.
III. Considerations when Advising Clients on the Structure of Annual Exclusion Gifts
As described above, there are a number of vehicles to utilize the annual exclusion. Deciding which vehicle or vehicles is optimal in a given situation will depend on a particular client’s goals. Key considerations in selecting a gifting vehicle include the following: (1) whether there will be one or multiple donors, (2) whether the family wants one vehicle to receive all gifts, or if they prefer a different gifting vehicle for each beneficiary, (3) income taxation of the gifting vehicle, (4) protecting assets from creditors, (5) how the donors envision the gifted assets will be used, (6) the types of investments the family wants to make, (7) the impact on financial aid, (8) the overall administrative burden the family finds acceptable, along with other factors unique to each family.
A. Number and Identity of Beneficiaries
The number of intended beneficiaries and their relationship to the donor are important variables when selecting an annual gifting vehicle. If the target beneficiary is one person, any of the options discussed could work. If, on the other hand, the donor or donors would like to benefit a broader class of people, such as all of their descendants, over an extended period of time, then 2503(b) Crummey Trusts become a common option because they allow annual exclusion gifts for all living descendants to be pooled, and ultimately distributed more broadly, including among descendants who were unborn at the time the gifts were initially made.
Another closely related threshold question relates to the relationship between the donor and the individual the donor primarily wishes to benefit. Donors who want to benefit one or more grandchildren will be limited to using one of the methods that qualifies for the GST annual exclusion unless the donors have GST tax exemption available for this purpose. A disadvantage of having to qualify for the GST annual exclusion is that none of the options, except the 529 Plan in the case of same-generation rollover, permit accumulations that can benefit the donor’s unborn grandchildren. Donors who have GST exemption to use often decide to make gifts to 2503(b) Crummey Trusts for a broader group of beneficiaries.
Because of the mismatch between the annual exclusion from gift tax and the annual exclusion from GST tax with respect to 2503(b) Crummey Trusts, GST tax should be a central consideration in approaching planning with a 2503(b) Crummey Trust. If trust beneficiaries include a non-skip person—say, one or more children of the donor—the gift to the trust itself may not automatically trigger a GST tax or unavoidably use up exemption from GST tax, as the case may be. However, if the transfer to trust qualifies as an “indirect skip” within the meaning of section 2632(c) of the Code, GST exemption will be automatically allocated to the transfer unless the donor elects out from automatic allocation on a timely-filed gift tax return as outlined under section 2642(c)(5). Donors funding 2503(b) Crummey Trusts should decide whether they want that trust to be GST exempt. If so, donors should then ensure their gift tax returns are prepared accordingly and the exemption, if allocated, is properly tallied, including in years where annual exclusion gifts are made but a return is not otherwise required to be filed.
1. Number of Donors
Another factor that could change the analysis is the desire to have a single vehicle for gifts from multiple donors, other than spouses. This comes up commonly in two situations. Most often, parents and grandparents want to make gifts to the same vehicle. Less common, but prevalent, is when the donors want a free-for-all designed for anyone to contribute.
Because of the more limited application of the annual exclusion from GST tax, grandparents have fewer options for the vehicles to which they can gift if they do not have excess GST tax exemption to apply to the transfer. For grandparents who do not have GST tax exemption to spare, the most flexible option is the 2642(c) GST Trust. If the parents are in a position to make full use of their annual exclusion, the most flexible option with creditor protection is the 2503(b) Crummey Trust. In other words, a single vehicle may not optimize the planning for both grand-parents and parents and it may be appropriate to advise creating separate vehicles for their respective gifting.
In cases where gifts by either the parents or the grandparents are expected to be modest, in lieu of sharing a gifting vehicle, the clients could consider a trust created by the wealthier donor, and the more modest donor could contribute to a 529 Plan or UTMA account.
If a shared vehicle is nonetheless desired, whether for parents and grandparents or to capture gifts from a broad group, the 2642(c) GST Trust offers the most flexible trust option that qualifies for the annual exclusion from GST tax. A multi-donor trust should be structured as a non-grantor, complex trust for income tax purposes, or as a section 678(a) grantor trust as to the beneficiary. Having a trust with multiple donors that is taxed as a grantor trust to the grantor is administratively unworkable, as detailed below.
A workable exception to administer a multi-donor grantor trust is a trust funded by married donors who file their income tax returns jointly. In this case, it is advisable to fund the trusts in equal shares with the same asset so that when one grantor dies, the trust can be immediately divided into two trusts to continue one-half the trust as a grantor trust to the surviving spouse and one-half of the trust as a non-grantor trust. This is still more complicated from an income tax perspective than a trust funded by one spouse to which the other spouse consents to split the gift under section 2513; however, it may be more practical in light of other client-specific factors.
2. Who Will Pay the Tax
In determining which gifting approach is best for a particular family, it is important to consider who will pay the income tax associated with the gifted assets. Excluding 529 Plans, which are tax exempt so long as the assets are used for qualified educational expenses, there are four possibilities: (1) the beneficiary could pay, (2) the parents could pay because of the “kiddie tax,” (3) the donor(s) could pay because of the grantor trust rules, or (4) the trust could pay based on the non-grantor trust rules.
B. Kiddie Tax
With regard to outright gifts to children or gifts to UTMA accounts, the child will pay the tax unless a parent is allowed to and does in fact elect to pay the tax on their behalf. The “kiddie tax,” however, could impact the amount of tax a child must pay even if the parent does not elect to pay the tax on behalf of the child.
Historically there was a benefit in gifting income-producing assets to children, assuming each child would pay tax at a lower marginal rate than a parent. In 2023, single individuals pay a 10% tax on the first $11,000 of income and only a 12% tax on income up to $44,725, ignoring credits and deductions. The top marginal rate is 37% so it is easy to see how moving taxable income from a parent to a child would provide tax savings.
To minimize this practice, section 1(g) imposes the so called “kiddie tax.” Section 1(g) applies if a child has unearned income above a threshold and either (1) the child has not reached age eighteen before the close of the tax year or (2) the child’s earned income does not exceed one-half of his or her support and the child is age eighteen or a full-time student from ages nineteen to twenty-three.
If the kiddie tax applies, unearned income above the threshold is taxed at the parents’ tax rates. In other words, the child still files his or her own tax return, but unearned income is taxed at the higher tax rate of the parents. Earned income, wages, is not impacted by the kiddie tax. The kiddie tax is computed and reported on Form 8615, which is attached to the child’s Form 1040.
In the alternative, parents may elect to include the child’s income on their own return, thereby avoiding the need for the child to file a separate return. That election is made on Form 8814 and can only be made if (1) the child’s gross income is exclusively from interest and dividends; (2) that gross income is between $1,250 and $12,500; and (3) the child has not made any estimated tax payments, including an overpayment from the prior year applied to the current year, or had any federal income tax withheld.
C. Grantor Trusts
2503(b) Crummey Trusts, 2503(c) Minor’s Trusts, and 2642(c) GST Trusts are frequently structured as grantor trusts, resulting in the trust donors paying tax on any income earned by those trust assets.
Section 671, et seq. defines a grantor trust and explains how such a trust is taxed. Stated simply, under section 671 the grantor of a grantor trust is treated, for income tax purposes, as owning the trust assets. As a result, it is the grantor who must report and pay tax on any income earned by the trust, and it is the grantor who will report and benefit from any deductions or credits against tax associated with the trust assets.
This is generally advantageous because it allows the trust to grow income tax free since the grantor, often a wealthy family member who will eventually be subject to estate tax, is legally obligated to pay that tax. The payment of those income taxes is not treated like an additional gift to the trust.
D. 678 Grantor Trusts
Another reason that 2503(b) Crummey Trusts are almost always structured as grantor trusts is because the associated withdrawal right makes it possible that the trust beneficiary will be treated as the owner of a share of the trust under the grantor trust rules rather than the person who actually transferred assets to the trust.
Under section 678(a), a person is treated as the trust owner for grantor trust purposes if (1) that person has a power exercisable solely by himself to vest corpus in himself or (2) that person previously partially released or otherwise modified such a power and retains a power that would treat such a person as the owner of a trust under sections 671-677. Under section 678(b), if the grantor of the trust, the person who actually contributed funds, is treated as the owner of the trust under the grantor trust rules, that will trump section 678(a) and the grantor who funded the trust, not the trust beneficiary, will be taxed as the owner of trust assets.
In other words, the existence of the Crummey withdrawal power will generally cause the powerholder to be treated as the owner of a trust under the grantor trust rules, both while the power is exercisable and after it has lapsed, unless the actual grantor is so treated. A 2503(b) Crummey Trust with its multiple beneficiaries can make the application of section 678(a) an accounting nightmare because each beneficiary would be treated as the owner of a portion of the trust attributable to that beneficiary’s lapsed and continuing withdrawal rights. Helpfully, the Service issued a ruling in 1993 that a trust that was a grantor trust to the grantor under section 678(b) did not become a grantor trust to the beneficiary under section 678(a) when the trust ceased to be a grantor trust to the grantor with respect to previously lapsed withdrawal rights. Practitioners generally rely upon this ruling to thereafter treat a 2503(b) Crummey Trust as a non-grantor, complex trust.
By contrast, a 2642(c) GST Trust, with its one beneficiary, can more easily be administered if subject to tax under section 678(a). This is an important factor, as discussed above, regarding the functionality of this trust where there are multiple donors.
E. Non-grantor Trusts
A trust can usually be designed so it is a non-grantor trust. In that case the general rules of Subchapter J, section 641 of the Code will apply. Specifically, the trust will be subject to tax on all income and capital gains earned unless a distribution is made. If a distribution is made, the trust will receive a deduction and the trust beneficiary who receives the distribution will report the associated income on the tax return of the beneficiary.
It should be noted that under section 1(e), non-grantor trusts pay tax at the top rates after only $14,450 of income. As a result there is no federal tax advantage to non-grantor trust treatment unless distributions are made to trust beneficiaries who are subject to tax at a lower rate than the grantor.
Careful attention must also be given to the state income taxation of non-grantor trusts. It may be possible to use a non-grantor trust to eliminate state income tax, providing a significant income tax benefit. On the other hand, if the trust makes distributions to beneficiaries in high tax jurisdictions, a non-grantor trust could actually create more income tax than a grantor trust.
Example 5: Florida client creates a non-grantor trust for the benefit of grandchildren living in Florida, New York, and California. All trustees live in Florida and the trust owns only marketable securities generating interest, dividends, and long-term capital gains. If the trust does not make any distributions, it will pay Federal income tax on all of the passive income earned by trust assets. If the trust makes a distribution of $1,000 to each grandchild, that income will be reported on the grandchild’s federal and state income tax returns, meaning it will be subject to California and New York income tax for the grandchildren living in those locations.
Because states tax trusts based on different criteria, it is also possible a non-grantor trust could owe state-level income tax in multiple states. For example, if a non-grantor trust is created by a New York resident and administered by two trustees, one in California and one in Oregon, it is possible the trust will be subject to income tax in all three states.
As alluded to above, with respect to trusts funded with annual exclusion dollars, it is relatively easy for a 2503(c) Minor’s Trust to be structured from the outset as a non-grantor trust. Other types of trusts will generally be grantor trusts to avoid taxation pursuant to section 678(a) resulting from the Crummey withdrawal rights where the trust is not otherwise treated as a grantor trust to the grantor under section 678(b).
F. Administrative Factors
1. Creditor Protection
Trusts provide significant protection against the creditors of a beneficiary, including a divorcing spouse. This important benefit makes lifetime trusts a better option than trusts that pay out at certain ages, UTMA accounts, and outright gifts. An important caveat relates to the Crummey withdrawal right, which as a presently exercisable general power of appointment may be subject to the powerholder’s creditors depending on the state. For this reason, it is generally not advisable to give a withdrawal right to a beneficiary who has creditors with enforcement actions or to advise a hanging Crummey to a beneficiary with potential creditors on the horizon. Similarly, a withdrawal right should not be given to a beneficiary who is receiving needs-based benefits because it could cause the beneficiary to no longer qualify or for the funds to be taken by the state.
2. Flexibility
Even if a client is clear on their goals and objectives, unforeseen circumstances can change those objectives, including the birth of additional beneficiaries, changes in the tax laws, and changes to the circumstances of the beneficiary who may later experience disability, divorce, business failure, tort liability, or struggle with substance abuse or addiction. Beyond the restrictions that must be put in place in certain trusts in order to qualify for the annual exclusion, trusts can be drafted with as much flexibility as possible. Some vehicles, like 529 Plans, have minimal ability for their purpose to pivot over time as needs change. Other vehicles, like UTMA accounts and 2503(c) Minor’s Trusts, terminate when a beneficiary is aged twenty-one or younger, without the flexibility to adapt if the distribution is not in the beneficiary’s best interest. The reality of an increasingly litigious society, the high divorce rate, and the prevalence of substance abuse, coupled with the opportunity for tax benefits that can be derived from keeping assets in trust longer, has resulted in a trend away from mandatory distribution of assets at certain ages and towards lifetime trusts. The flexibility that can be achieved with assets in trust is one of the most important features clients consider when developing their planning.
3. Investment options
With trusts, there is no restriction on the type of property that can be held, although the trustee does have fiduciary duties with regard to the investment and management of trust assets.
UTMA accounts may be invested by the custodian, so once the property is gifted, a grandparent who is not the custodian cannot control the investment of those assets. In addition, financial service firms some-times place their own limits on the types of property an UTMA account can invest in.
529 Plans have limited investment options, generally a selection of mutual funds, that vary state by state. There are limits to additions once the account reaches a certain size, typically what each state will assume to be the cost of college for four years.
In thinking about the type of assets intended for the gift, if the assets for gifting are entity interests that are unlikely to qualify as transfers of a present interest, a 2503(c) Minor’s Trust is likely the optimal vehicle for a minor beneficiary because it is the only one that is not subject to the present interest requirement of section 2503(b).
4. Impact on Financial Aid Eligibility
With soaring costs of education, even wealthy families should consider the impact of gifting on financial aid. When creating a plan, it is helpful to think through who to name as account owner. For example, 529 Plans owned by a parent are considered for financial aid as an asset of the parent, not the student; plans owned by grandparents or other relatives are generally not considered. UTMAs, because they are an asset of the minor beneficiary, have a more negative impact on the beneficiary’s eligibility for financial aid. Trusts, like UTMAs, can also be considered as assets of the student.
IV. Legislative Proposals Impacting the Annual Exclusion
Some policymakers view annual exclusion planning with trusts as an abusive strategy that should be reduced or eliminated. Therefore, estate planners should be aware of proposals that could impact this planning, the latest of which is reflected in the Biden Administration’s Revenue Proposals for 2024 (commonly known as the Green Book). That proposal would limit the availability of the annual exclusion for any transfer to a trust—except 2642(c)(2) GST Trusts including 2503(c) Trusts—and transfers of an interest in a passthrough entity, a partial interest in property, and “other transfers of property that, without regard to withdrawal, put, or other such rights in the donee, cannot immediately be liquidated by the donee.” If the proposal were to become law, the maximum amount of these types of transfers that could be annually transferred gift tax free would be $50,000.
With the current divided Congress, it is not expected that many of the Biden Administration’s revenue proposals will become law at this time.
V. Conclusion
Annual exclusion gifts are a powerful planning tool, and the wide range of options for annual exclusion gifts create the opportunity to identify the best solution for each client. For some, simplicity, the ability to aggregate gifts from multiple donors, and a focus on education will make a 529 Plan the best choice; for others the administrative burden of a 2503(b) Crummey Trust will be offset by the convenience of aggregating gifts to children and grandchildren in a single account. Ultimately, the fact that each of these tools has advantages and disadvantages makes annual exclusion gifts one of the places where our experience and thoughtfulness can provide the maximum benefits for clients.
