Outright Gifts of Cash

Perhaps the easiest gift to make is cash. You simply write a check to your child or other donee. The recipient receives the money and does with it as he or she pleases. The disadvantage is that your child may spend the money unwisely. We have seen many cases where children become dependent on annual gifts from their parents. Another disadvantage is that the money you give could become subject to either a divorce proceeding or a creditor's claim.

Outright Gifts of Appreciating Property

The value of giving away property that is expected to appreciate rapidly is that you are also giving away the future growth. Suppose you give your child $14,000 worth of stock in a start-up company that you expect to appreciate significantly. As it turns out, you were correct, and the stock appreciates on average 15 percent per year over the next 25 years. By making a gift of $14,000 in the present, you have removed an asset that would have grown (compounding appreciation) to $460,865 in the future.

Outright Gifts of Appreciated Property

Some people choose to give away assets that have already appreciated substantially. If you expect the asset to continue to appreciate rapidly in the future, then you will receive some of the same benefits mentioned previously. Gifting appreciated property can have its disadvantages. Some of your gifts of appreciated property are subject to divorce proceedings and creditor claims. Also, if you hold appreciated property until you die, your heirs receive a stepped-up basis. Your heirs could then sell the property and not incur income tax liability from the sale.

Roth IRAs

It may seem strange to discuss Roth individual retirement accounts (IRAs) in the section on giving assets to your children, but one of the true power plays is to give your children the money to make a Roth IRA contribution. Assume that your 19-year-old daughter works summers to earn extra spending money. Her total earnings are $6,500. You give her $5,500 so she can make a contribution to a Roth IRA. Her contribution to the Roth IRA is not deductible, but because of her low tax bracket this is unimportant. The true value of the Roth IRA is tax-free growth. The earnings will never be taxed if she adheres to the following rules:

A qualified distribution is one made:

• After the five-year period beginning with the first taxable year for which a taxable contribution was made to a Roth IRA in your name; and
• After she turns age 59¹/₂; or
• Because she is disabled; or
• She used the money for a qualified purpose. A qualified purpose includes withdrawals of up to $10,000 in acquisition costs for her first home. Another qualified purpose is withdrawals for tuition payments of qualified higher education expenses for herself, her spouse, or her children.

Distributions of the amount she has invested (called basis) in her Roth IRA are never subject to taxes or penalties.

Although a $5,500 contribution may not seem significant, the results can be quite dramatic. Let's assume that your daughter invests in a stock mutual fund that earns on average 10.5 percent, and she does not touch it until she is age 75. Your small one-time gift of $5,500 has turned into $1,474,519! This is the type of gift you will want to make each year. As an added bonus, because it is a retirement account, she is less likely to squander the money.

Custodial Accounts

Most often, assets are transferred to minors under either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), depending on which act your state has adopted. The forerunner of these was the UGMA, which allowed an adult (the custodian) to act on the behalf of a minor concerning the minor's property. Under this act, the custodian can invest the child's money in bank accounts, securities, annuities, and life insurance. The UTMA expanded the types of investments to include real estate and tangible personal property.

2503(b) Trust

The primary advantage of this trust is that the trustee is never required to distribute principal to your child. The trustee must, however, distribute all the income on at least an annual basis. Gifts to the trust do qualify for the annual gift tax exclusion, but only as related to the present value of the future income stream. For example, you contribute $10,000 to a trust for your five-year-old daughter to last for 30 years. If the Internal Revenue Service interest rate assumption is 2.3 percent, considering these facts, the value of your gift was $5,091, which qualifies for the $14,000 annual gift tax exclusion. Therefore, $4,909 is considered a gift of a future interest, and you must either pay gift taxes on this amount or use part of your lifetime applicable exclusion amount. This trust can also be structured to allow the trustee to distribute principal under certain conditions. This type of trust requires the filing of an annual gift tax return in any year that a gift is made. The trustee must also apply for and receive a tax identification number. A separate trust must be set up for each beneficiary.

2503(c) Trust

We have found that because of greater flexibility and control, clients are more willing to consider the 2503(c) trust arrangement. This type of trust allows the trustee to either distribute or accumulate trust income. The trust document can also allow the trustee to make distributions of trust corpus for predetermined reasons or at the trustee's discretion. Any income not distributed will be taxed to the trust. Income distributed to your child will be taxed at your child's tax bracket if your child is age 19 or older. The kiddie tax rules apply for children under the age 18 or younger and dependent students under the age of 24.

The primary disadvantage of the 2503(c) trust is that your child has a legal right to all trust assets when he or she turns 21. To avoid this result, the best solution is to incorporate a “window” in your trust document. When your child reaches age 21, he or she has the right to terminate the trust and receive all assets. If he or she fails to exercise his or her right within a certain time period (usually 60 days), the child's right to take possession of the trust assets expires. The trust then continues to be managed for your child's benefit for life or until your child reaches a certain age that you choose. As with the custodial accounts and the 2503(b) trust, this trust is irrevocable. Once you have made the gifts, you cannot get your assets back. Gifts to the trust do qualify for the annual gift tax exclusion. By including a special provision in the trust, you as the grantor may be responsible to report and pay all income taxes (ordinary and capital gains). This can greatly benefit the child but is not considered a taxable gift. The provision may even be changed if paying the income taxes becomes a financial burden.

529 Plans

The average costs to pay for one year at a private college exceeds $40,000; for a public college the average annual costs exceeds $18,000. From our perspective, there is no greater gift that you can give a person than the best education that they can qualify for and allow that person to avoid crippling student loans. The single best strategy for funding college is the 529 Plan.

Advantages

• The primary advantage of a GRAT is that it allows you to give away a large asset while paying little or no gift taxes.
• The gift, although a gift of a future interest, represents the immediate transfer of an asset. As a result, any appreciation of that asset accrues to the benefit of your beneficiaries and is not included in your estate.
• As grantor, you retain the income from the trust during the term of the trust.
• You can act as the trustee of your GRAT if the trust is properly drafted.

Disadvantages

• One of the primary disadvantages of the GRAT is that if you die during the term of the trust the assets revert back to your estate for estate tax purposes. For planning purposes, you will want to choose a trust term that you are likely to survive.
• The GRAT is an irrevocable trust, and, therefore, you have permanently given up the right to your principal.
• The GRAT is a grantor trust, and as such, all income is taxed to the grantor (you) whether or not it is paid to the grantor.
• Your beneficiaries' interest in the trust is a future interest and therefore does not qualify for the annual gift tax exclusion. Your only alternatives are to pay the gift taxes associated with the gift or use a portion of your lifetime applicable exclusion amount. Typically, the GRAT is structured in a way that the amount of the gift is either zero or very small.
• The income that you receive is a fixed income and therefore may not adequately offset the future ravages of inflation.

How to Set Up a Qualified Personal Residence Trust

Under a QPRT, an individual known as a grantor irrevocably transfers his or her primary or secondary residence to a trust for a fixed period of time such as 10 to 15 years. During the term of the trust, the grantor retains the right to use and occupy the personal residence on an unrestricted basis. At the end of the term, the residence then passes to the designated beneficiaries known as remaindermen (usually the grantor's children). At the end of the term, the grantor then leases the residence back from the remaindermen. These lease payments do not interfere with his or her ability to make annual gifts each year.

Tax Treatment

Because the remaindermen will not receive the gift for 10 to 15 years, the grantor is allowed a discount based on the present value of the future gift. The amount of the discount is determined by Internal Revenue Service tables. This allows the grantor to significantly discount the value of the gift.

Death during the Term of the Trust

As the grantor, you can receive a larger discount by creating a contingent reversionary interest. With a contingent reversionary interest, you state in the trust agreement that if you die before the trust term expires, your last will and testament will determine who receives the trust property.

If the grantor dies during the term of the trust, the property is included in the grantor's estate and, at that time, receives a stepped-up cost basis based on the fair market value at the date of death. Also, any applicable exclusion amount that was used to transfer the property to the trust will be revived to the benefit of the grantor. In other words, it is as if this transaction had never taken place.

Installment Sales to Family Members

Installment sales between family members are set up like any other installment sale. You determine a fair market price and then arrange repayment terms based on a market interest rate. If the sale was to include a below-market price or below-market interest rate, the Internal Revenue Service considers that you have made a gift for gift tax purposes. Advantages and disadvantages of asset sales to family members are presented in the following sections.

The Private Annuity

A private annuity is the sale of property by one family member (the annuitant) to another family member (the obligor) in exchange for an unsecured promise by the obligor to make payments to the annuitant for the rest of the annuitant's life.

How Long Does a Legacy Trust Last?

The short answer is that you get to decide how long it will last. In most cases the legacy trust is designed to last for at least the lifetime of each child. The reason is that this is the best way to get the full benefit of the asset protection attributes of the legacy trust. If you said that the trust would end when the child is age 60, then those assets would forever in the future be subject to litigation risks. In fact, in the typical case, we recommend leaving the assets in trust for as long as the law allows. How long the law allows is determined by each state. Some states allow the trust to last virtually forever—what we call a  Rockefeller trust, named after industrialist and oil magnate John D. Rockefeller, who became one of the wealthiest men in the world in the late nineteenth and early twentieth centuries and went on to create a perpetual trust that continues to benefit his heirs to this day. Other states have a “law against perpetuities,” which essentially says that the trust can last for as long as the “lives in being plus twenty-one years.” Sound confusing? In our case study about the Nelsons, this means that the trust, once established at the death of the last parent, would last as long as any of the then-living potential beneficiaries, including any children, grandchildren, or great grandchildren who are alive, plus 21 years for beneficiaries who were not alive at the time the legacy trust first came into being. We like to refer to this as a 75-year trust, because it will often last 75 years or more, but not indefinitely. A number of states that had a law against perpetuities have statutorily set longer time frames, such as 300 years.

The Nelsons decided that while they wanted a legacy trust for their children's lifetime, they wanted the children to decide where their share of the trust would go at their death. We suggested that we give the children a testamentary general power of appointment. This would allow each child, through his or her own will, to terminate the trust in favor of his or her chosen heirs. We further suggested that if the child failed to exercise the general power of appointment that the money would remain in the legacy trust for that child's children and grandchildren. This general power of appointment creates great flexibility, but it causes the trust assets to be included in the child's estate for estate tax purposes (see the discussion on generation-skipping transfers later in this section). This can be avoided by granting the child a limited power of appointment, which limits the potential appointees of the assets to someone or something other than the child's estate or creditors of the child's estate.

How Do the Children Get Money from a Legacy Trust?

You get to decide how the trust benefits your heirs. Typically, we provide that, under normal circumstances, the trust will either distribute all of the income (interest and dividends) or we'll use a set withdrawal rate such as 3 or 4 percent based on the principal balance as of January 1 of each year. In addition, we will often make allowances for distributions of principal under certain circumstances. The variations here are limitless and bound only by the imagination of the clients or their advisers. We often say to the client, “If you can figure out what you want, we can figure out how to provide for it in the trust agreement.” We'll discuss some of the more esoteric ideas later in this section.

Who Would Be the Trustee?

Again, the trustee of your legacy trust can be whomever you wish. In some cases, the child will be a cotrustee of their legacy trust, which gives the child a sense of having some “ownership” of the money and of the trust's operation. If you want to preserve the asset protection attributes of the trust, the law in some states will not allow a child to be the “sole” trustee of his or her own trust and still receive the benefits of asset protection. This is because the trust document will give the trustee a wide range of powers that allow the trustee to decide “when and if” to make distributions. If the child were his or her own and sole trustee and there were a legal judgment against the child personally, the courts could compel the child, as the sole trustee, to make distributions to himself or herself, therefore making those funds available to the creditor, soon-to-be ex-spouse, or plaintiff in a lawsuit. This will not be the case when there is a separate trustee. So in the cases where the child will serve as a trustee, you may need a cotrustee depending on the law in your state. This can be an individual or an institution such as a trust company or a bank, which has trust services or another professional such as an attorney, accountant, or financial adviser. What is most important to remember is that the legacy trust will likely last a very long time, and therefore most of the “people-trustees” will not outlive the trust, so you'll want to take care in choosing a succession of people-trustees as well as an “institutional” trustee as your backup. Having an institutional trustee in place ensures that you don't run out of trustees, which would then require the retention of an attorney to go to court and have a trustee appointed, a proposition that could be expensive and produce less-than-optimal results.

In some states, the law governing trusts will permit the child or other beneficiary to be the sole trustee and protect the assets from potential creditors, as long as the distributions are subject to an ascertainable standard. Thus, creditors cannot compel a distribution by the trustee-beneficiary if the trust document limits the circumstances in which a distribution may be made—for instance, for health, education, maintenance, and support.

What if the Children Don't Like the Trustee?

When you begin discussing an institutional trustee or any trustee other than the child, there's invariably the question, “What happens if the child and the trustee don't get along?” One trust provision we recommend is giving someone, typically the trust beneficiary (or majority of beneficiaries) the power to replace the institutional or professional trustee with another institutional or professional trustee. What's important here is to make certain that the new trustee is also an institutional or professional trustee. A real case example will illustrate the reason why: One trust beneficiary became unhappy with the trustee because the trustee would not release funds when she wanted. The trust agreement allowed her to remove the trustee in favor of another trustee but was silent as to the required qualifications of the new trustee. She thought she could solve her problem of getting money out of the trust more quickly by appointing her good friend as the trustee. As the situation began to unfold, and more and more trust withdrawals were requested, we informed the new trustee of her fiduciary responsibility regarding the trust. If she failed to follow the instructions and guidelines outlined in the trust, she could become personally liable for her actions. For example, if the trust were depleted, she could actually be sued by her good friend, the beneficiary! This is something that all institutional and professional trustees understand. Having the trust agreement require successor institutional or professional trustees will often solve the problem of beneficiaries changing trustees with the expectation of having unreasonable demands met by the new trustee.

What About Having a Sibling as the Trustee?

Another idea clients will have is to make the siblings “cross-trustees.” This means, for example, designating the brother the trustee of his sister's trust and the sister the trustee of her brother's trust, thereby creating very “friendly” trustees. The problem with this strategy is what attorneys call substance over form. This means that the courts could view this as each sibling having, in effect, full power over their own trust, and they could lose the asset protection attributes intended for the trust. We also run into a lot of cases where one child is highly responsible and another highly irresponsible. The client may suggest having the responsible child act as trustee over the irresponsible child's trust. In our experience, this sets up a form of sibling resentment that most often leads to conflict and a deterioration of relationships.

What About the Different Needs of the Children?

In our case study, the Nelsons pointed out that each of the children would likely have very different needs. The child who intended to become a college professor would likely need income from the trust to supplement her salary, while the physician child would likely want his trust invested predominantly for growth since he'd have no immediate income needs from the trust. The business owner child might need loans for business expansion. How would the legacy trust meet the diverse needs of these very different financial situations? Typically, this is addressed by splitting the estate assets into separate trusts for each of the children. Trust language is drawn so that it is broad enough to meet a wide range of needs, or it can be tailored specifically for each child's trust.

The Umbrella Trust

We recently ran into an exception to the separate trusts strategy. In this case, the client has three children, all of whom are adults. Two of the children have good jobs and stable marriages, while the third child has a history of health problems that have prevented him from maintaining steady employment. His health could change in his favor and he could have steady employment, or his current situation could persist. The client's estate totaled about $2 million. If they divided the estate equally, we were concerned that $700,000 may not be sufficient to fully take care of the potentially disabled child. The solution was to create an umbrella trust. Instead of creating three separate trusts, we held all of the funds in one trust with language that suggested that the trustee treat all of the children equally unless there was a compelling reason (health, for example) to treat them unequally. This gave the trustee the flexibility to focus on the individual needs of each child and allowed, if necessary, the trustee to use the full power of the trust to take care of the disabled child should that become necessary. We understand that some people may view this as unfair, and our response is what's “fair” may not always be what's “appropriate.”

Can the Legacy Trust Be Used to Fund the Education of Our Grandchildren?

Our clients, the Nelsons, placed a very high value on a good education. It was their advanced education that allowed them to accumulate their own estate and they could see how being educated benefited their children. They loved the possibility of using part of their estate to fund the education of their grandchildren. Would that be possible? This is a very typical request from grandparents, and the answer is, “Yes.” We often insert language in the trust document that provides for the use of trust funds for the educational expenses of grandchildren. We agree that one of the greatest gifts you can give anyone is the gift of the best education for which they can qualify. Another possibility within this planning point is to provide specific language allowing the trustee to transfer funds into a 529 plan, Coverdell education savings plan, or other similar plan. This would allow those funds to grow tax deferred and then make tax-free distributions for qualified education expenses.

What Are the Disadvantages of a Legacy Trust?

As opposed to leaving your heirs their inheritance outright, one obvious downside is the costs involved in setting up and maintaining a legacy trust, or any type of trust for that matter. Depending on the complexity of the trust design, attorney's fees can run into the thousands or tens of thousands of dollars. Once the trust becomes effective (in the case of the legacy trust, this would typically be at the death of the last remaining parent), there will often be trust management fees, investment management fees, and fees associated with the filing of the trust tax return. In addition to the costs associated with the trusts, we find that children are not always fond of the idea of having their inheritance placed in a trust over which they have limited control. It's human nature to want to be in control and this is especially true when it comes to what children view as “their” money. If you decide to use a legacy trust, we highly recommend that you have a formal conversation with each of your children to explain the reasons you made this decision. If you're going to have a mutiny on your hands, it's usually better to find out while you're alive and can do something about it. Our experience is that a well-planned conversation tends to be received well by mature adult children. The children who react negatively often do so out of immaturity, which serves to emphasize just why the legacy trust is appropriate.

The Family Council

We have developed a concept called The Family Council, where we will meet with the parents and children to discuss money responsibility in light of potential future inheritance. This is the perfect setting to discuss all of the benefits of the legacy trust. The Family Council is discussed in more detail in the epilogue.

Think about it logically. If a child were to receive his inheritance outright, he only has two basic choices: he can spend it (or give it away) or he can invest it. If he spends it, there are only two results: he can spend it in a way that would meet your approval or in a way that would not. If he invests it, there are only two results: he can invest it well or he can invest it poorly. In most cases, our clients are not opposed to the child's spending some of the money on certain types of things like the down payment on a home or a child's education, and the trust allows for this. If the child chooses to invest the money, does it really matter that the investments are being done through a trust, and one that protects the child from creditors? We would argue that the legacy trust can provide a lifetime financial safety net for your children without unduly burdening them. If fact, it can free them up to focus on things that have more meaning to them like raising their children or pursuing their careers.

Can a Legacy Trust Spoil the Children?

This is a valid concern. In too many cases, we see trust fund babies never having the hunger or drive to work hard and create their own success. Think about it. When most kids graduate from college, the entry-level job opportunities might offer a starting salary of $30,000 to $50,000 per year. If that person is currently receiving $150,000 per year from their $3 million trust, what's the incentive to work? In many cases, the answer is “none.” If this is a concern for you, you might consider including an incentive provision in your legacy trust. There are many variations of this idea, but most go something like this: for every dollar of earned income, the trustee will give the beneficiary a “matching dollar.” Under this provision, if our college graduate gets that entry-level job earning $35,000, he'll also receive $35,000 from his trust. And he has every incentive to work hard and move up in the organization because future raises will also be matched!

Are There Provisions that Must Be Included in the Legacy Trust?

If one of your goals is for the trust to serve as an asset protection trust, you'll need to include language giving the trustee the discretion to both make and withhold distributions of income and principal. The typical trust agreement provides that all of the income must be paid out to the beneficiary at least quarterly. Typical trust agreements also often mandate distributions of principal at certain ages. Here's a typical example in layman's terms: “The trustee is instructed to distribute all of the trust income at least quarterly. Distributions of principal will occur as follows: one-third at age 25; one-half at age 30; the balance at age 35.” This arrangement provides little, if any, asset protection for the beneficiary. For example, in the event of a divorce or other legal judgment, the trust income could effectively be “garnished.” Large-dollar judgments could be “settled” on the future event of the mandatory distribution of principal. Giving the independent trustee the discretion of withholding income or principal allows trust assets to be shielded from would-be legal predators.

Generation-Skipping Transfers

While you're creating your legacy trust, you should consider including a provision allocating the maximum allowable transfer to a GST trust. Currently, this is $5,340,000 total for you and, if you are married, $5,340,000 for your spouse as well. Money transferred into a GST trust will not be included in your heir's estates upon their death. Let's look at an example of how this might work: John and May Moneybags die in 2014 leaving a total estate of $20 million to their two children. Assume that John and May each owned $10 million of assets. Their will directs that the maximum amount go to a GST legacy trust for each child. As a result, each child receives $5,340,000 in their GST legacy trust, with the balance, after paying estate taxes, going to a traditional legacy trust; which means each child has two trusts. At any child's subsequent death, any money in the GST legacy trust will not be includable in that child's estate and therefore will not be subject to estate taxes. The assets in the traditional (non-GST) legacy trust are includable in the child's estate and may be subject to estate taxes. If the GST planning is desired, the power of appointment options must be carefully examined.

In this section, we've discussed the concept of the legacy trust and the importance of using this strategy to protect your assets from possible legal attacks against your children after your death. We should note that no trust is perfectly “bulletproof.” It will be important to include language giving the trustee instructions to do everything legally possible to protect trust assets from legal challenges.

Just as gifts to family members can be a powerful tool for tax-efficient transfers of wealth, gifts to charities can provide tax benefits as well as satisfy your desire to help the broader community. Gifts to charities are covered in our next chapter.