One of the least-complicated longterm methods of funding education for children is a gifting plan under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). Generally, UGMA or UTMA funds can be used to pay a child’s college education expenses, provided such costs are not part of the parental obligation of support of either parent (under state law or other agreement (e.g., divorce decree)). Due to difficulties associated with guardianships, the UGMA was developed in 1956 and was adopted in some form in all 50 states to allow parents, grandparents, or others to transfer assets to a custodian for the benefit of a minor child.
Unlike a trust, a custodianship is not a separate legal entity or taxpayer. The custodial property is fully vested in the minor, so any income is taxed to the minor, regardless of whether it is distributed. Unlike a guardian, the custodian is not accountable to a court and has broad powers over investments. Commonly, the custodian (who may be a parent) simply establishes a UGMA account at a financial institution and transfers funds to it. The income is reported under the child’s Social Security number on his or her tax return. No separate legal forms or trust documents are required. The custodian takes title and holds property for the minor’s benefit and must distribute the assets to the minor upon his or her reaching the age of majority (18–21, as determined under state law). Many potential donors consider this requirement the biggest drawback to UGMA gifts.
The UGMA, as originally enacted, did not allow a custodial account to hold real estate and various other investments. A revised act, the UTMA, has been adopted in many states to allow a custodial account to hold real estate, personal property, limited partnership units, and other investments. In addition, UTMA accounts generally terminate at age 21 (as opposed to age 18 in the case of many UGMA gifts), although some states allow UTMA custodianships to extend until age 25. This longer duration is an attractive feature of UTMA gifts when compared with the more limited duration of UGMA gifts. To ensure that clients get the benefit of the longer duration, practitioners should advise them not to commingle current UTMA gifts into existing UGMA accounts that terminate at age 18. A gift under the UGMA/UTMA is diagrammed in the exhibit.
For income tax purposes, income earned on UGMA/UTMA assets generally is taxable to the child. However, the kiddie tax rules apply to income earned on UGMA/UTMA gifts if the beneficiary is under age 18 or if the child is age 18 or a full-time student aged 19–23 whose earned income does not exceed 50% of his or her support. This is important when determining how much to gift to a child or how to invest the funds. Once a child reaches age 24, the kiddie tax rules do not apply, so more income is taxed at the child’s lower tax rates.
Under Rev. Rul. 56-484, if a legal obligation to support a minor child is satisfied by the income from the UGMA/UTMA account, the person with the legal obligation to support the child must recognize the income (regardless of the custodian), as would be the case for the grantor of a grantor trust if such an obligation was satisfied from trust income (Sec. 677(b)). In the context of education planning, this has important ramifications in those states where a college education is considered an item of support. In most states, however, a college education is not considered an obligation of parental support.
Provisions of the Internal Revenue Code relating to gift tax are favorable for gifts to a UGMA/UTMA. Sec. 2503 excludes from the gift tax annual gifts up to $13,000 (for 2011) per donee. By taking advantage of the gift-splitting provisions, a married couple can give each donee up to $26,000 per year without incurring any gift tax liability. For the exclusion to apply, the gift must be of a present, rather than future, interest in the property. The IRS has ruled that a gift to a UGMA/UTMA is a gift of a present interest, qualifying for the annual gift tax exclusion (Rev. Rul. 59-357). Gifts of community property are considered made half by each spouse. Thus, for these gifts, a gift-splitting election is not necessary to accomplish the same result.
The annual gift tax exclusion is available for transfers to UGMA/UTMA accounts, even though the child’s enjoyment of the property is delayed. However, UGMA/UTMA transfers will be included in the donor’s gross estate for estate tax purposes if the donor dies while serving as custodian. The custodial powers constitute a retained power to “alter, amend, or revoke” the transfer under Sec. 2038, causing the property to be included in the donor’s gross estate (Rev. Rul. 59-357). The donor can avoid this risk by not naming himself or herself custodian of the UGMA/UTMA property. However, many parents are willing to accept this risk, which in most cases is small, because they wish to maintain control of the funds and determine how they are invested. As an alternative, the donor can name the nondonor spouse as custodian without triggering Sec. 2038. Even when gift splitting is elected to treat a gift as made half by each spouse, half of the property will not be included in the consenting spouse’s estate if that spouse dies while acting as custodian (Rev. Rul. 74-556).
UGMA/UTMA accounts have advantages and disadvantages. The main advantages are:
- Low cost; and
- Ease of administration.
The possible disadvantages include:
- Loss of parental control over assets;
- Inflexible distribution requirements at age of majority;
- Questions about education and other expenditures as “support” items;
- Kiddie tax rules that can negate the opportunity for tax savings;
- The prospect of the child receiving more money than he or she is capable of managing (or willing to use for the intended purposes); and
- The negative impact of the accounts on the child’s eligibility for college financial aid.
Based on several of these disadvantages, the authors believe the UGMA/UTMA is best used as a small to moderately sized fund. When there is a desire to shift larger amounts of assets to a child, a trust should be considered, or, if the funds are designated for future college expenses, a qualified tuition program.
This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 11th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Ft. Worth, TX, 2010 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.