Tax and Financial Benefits of Gifts to Children and Grandchildren

As the end of the school year draws near, you may be thinking about gifts to children and grandchildren.* Aside from the personal satisfaction you receive from making these gifts, there are also valuable tax and financial benefits. First, gifts to children and grandchildren reduce the size of your estate for estate-tax purposes — and, yes, the estate tax is still with us until 2010 — when it disappears for only one year, unless Congress acts to make the repeal permanent. In addition, you may save income taxes, because some or all of the income on the transferred property may be shifted to the child or grandchild. The way a gift is structured can make a big difference in both the tax consequences and the amount of control a child or grandchild has over the property and its income. Let’s look at some alternatives.

Outright Gifts
The simplest way to make a gift is to transfer stock, mutual fund shares, cash, or other property outright. But, here’s the rub — if your child or grandchild is a minor, he or she won’t be able to transact any financial business with the gift (such as selling and buying stock or other property) without a court-appointed guardian. Chances are, there will also be restrictions on what the guardian can do with the property on the minor’s behalf. For example, the guardian may not even be able to use the property to pay for college if the parents have adequate resources. When the child or grandchild reaches the age of majority (18 to 25, depending on the state), the guardianship lapses and the child has complete control over the property. That raises another concern. Many parents and grandparents are reluctant to grant their young adult offspring the ability to spend large sums of money without restriction. Think about it — how ready for such responsibility were you at age 20? One benefit of an outright gift is that it clearly qualifies for the annual gifttax exclusion ($11,000 in 2005, $22,000 if your spouse also gives). If the child or grandchild is under age 14, income on the gift is subject to the “kiddie” tax: the first $800 in unearned investment income is not taxed. The next $800 is subject to the child’s tax rate, but any investment income above $1,600 is taxed at the parents’ rate. For minors 14 or older, investment income is taxed at their marginal rate, which is usually lower than the parents’ rate.

Custodial Accounts
One way to transfer property to a minor and avoid the hassle of a guardianship is to establish a custodial account under the Uniform Transfers to Minors Act (UTMA).With this type of transfer, you set up an account for the benefit of a minor and name a custodian. The custodian can be a parent, adult, sibling or other person. The custodian must invest the funds and use them solely for the education, medical care, support and benefit of the minor. A major advantage of a custodial account is simplicity.With a custodial account, there is no trust to prepare, and no separate tax return. In addition, the gift qualifies for the annual gift-tax exclusion. Again with the kiddie tax, investment income in excess of $1,600 is taxed at the parents’ rate, if the minor is under 14. For minors age 14 and older, income is reported on the child’s income-tax return — no separate return for the custodianship is required. One disadvantage of a custodial account is that when the minor who owns custodial assets reaches the age of majority, the parent or grandparent no longer has any control over how the money is spent. That control passes to the child or grandchild. Another disadvantage involves a potential tax trap. If you name yourself as the custodian and die before the child reaches the age of majority, the assets are included in your estate for estate-tax purposes.

Minor’s Trust
Another approach to making gifts to minors is to use a trust. The law authorizes two types of trusts for those who intend to make substantial gifts to minors. If the trust meets the requirements of a “minor’s trust” under Section 2503(c) of the Internal Revenue Code, transfers qualify for the annual gift-tax exclusion. Under this trust, the trustee is required to use trust income and principal solely for the minor’s benefit and distribute the assets to the beneficiary when he or she attains age 21. The Section 2503(b) trust should be considered by a donor who does not want the trust assets distributed by age 21. Under this trust, the trustee can distribute trust principal to the beneficiary at whatever dates or times are established by the donor. However, such a trust must provide for a distribution of income to the beneficiary, at least annually. Because establishment of both types of trusts can be expensive and timeconsuming, many donors may find it more convenient to make gifts under UTMA.

There are a variety of ways to make gifts to children and grandchildren. Choosing the best approach for you is not easy. Seek the advice of a qualified professional to help you decide.

* Gifts to grandchildren may be subject to the generation-skipping transfer tax (GST), which is repealed in 2010 (for one year only). If you are considering a trust for the benefit of a grandchild, you should discuss with your tax advisor steps to qualify for the annual GST exclusion in addition to the annual gift-tax exclusion.

Our firm does not render legal, accounting or tax advice. Please consult your CPA or attorney on such matters.

The accuracy and completeness of this material are not guaranteed. The opinions expressed are those of Fraser M Horn and are not necessarily those of Berthel Fisher or its affiliates. The material is distributed solely for information purposes and is not a solicitation of an offer to buy any security or instrument or to participate in any trading strategy. Provided by courtesy of Fraser M Horn, a Investment Advisor representative with Berthel Fisher in Edwards, CO. For more information, please call Fraser M Horn at (970)926-2500.

Registered Representative of and securities offered through Berthel Fisher & Company Financial Services, Inc. (BFCFS). Member NASD/SIPC, 1st & Main Investment Advisors is independent of BFCFS.