Some grandparents send stuffed animals or a brand-new copy of The Cat in the Hat when a new member joins the family. For wealthier, more financially savvy families, however, the ultimate new baby gift is financial security – a trust that will cover college costs, unexpected medical expenses or down payment on a first house.
One of the couples that Cindy Peterson, a senior advisor at Greenville, Delaware-based Lau Associates, works with began setting up trusts when their first grandchild arrived.
They established an irrevocable trust with the child as a beneficiary, then began funding it with their $14,000 annual gift tax exclusion ($28,000 for a married couple).
A second child arrived a few years later and the couple established another trust. Then the couple’s two younger children got married and began starting their families.
“The grandparents realized that the cost of setting up and administrating individual trusts for all the potential grandchildren is going to be enormous,” says Peterson.
“They decided to set up a single trust that allows separate shares for all the grandchildren. So we had a single trust, requiring only a single 1041 to be filed. But each of the grandchildren has a separate investment account within that trust.”
If the grandparents use their maximum gift tax exclusion every year for 18 years, they will be able to reduce their taxable estate by more than $500,000, even before accounting for any potential asset appreciation that has been shifted to the grandchildren.
But more important, they will be able to make sure that all of their descendants have a good start on college costs. Their oldest grandson is now a teenager whose college expenses may be expected to top $250,000 by graduation. His younger siblings and cousins will face even higher costs.
Peterson says that it is fairly typical for grandparents, rather than parents, to fund trusts for newborns.
That’s partly because they are more likely to be financial secure, but also because they recognize that they may not be around when the child reaches young adulthood and needs money for college.
Jennifer Junker, JD, Trust Officer at GenSpring Family Offices in Jupiter, Florida, explains:
“It is true that unlimited tax free gifts which do not impact the client’s annual exclusion or his or her lifetime gift or GST tax exemption can be made for the benefit of a beneficiary directly to an educational institution. Putting aside certain aggressive planning techniques, however, it is also true, that you must be alive to make such a gift. Funding a trust immediately upon the birth of a child and then each year thereafter permits clients to build up sizable educational funds for children or grandchildren without concern as to whether they will be around when the funds are actually needed.”
Trust structures for newborns
In order to place assets in trusts – even for a child too old to sit up unaided – requires some ceding of control.
“In order for a gift to qualify for the gift tax annual exclusion, it must be a gift of a present interest, meaning that the trust beneficiary must have the opportunity to actually put his or her hands on the gift despite it being made to a trust,” Junker explains.
As a result, she says that most of the trusts she creates have Crummey powers or withdrawal rights that require that beneficiaries get the opportunity to request that any gift to the trust be transferred outright to him or her.
“In the case of a minor beneficiary, these powers are usually exercisable by the natural guardian of the beneficiary," she says. "Often, these powers are not exercised and ‘lapse,’ leaving the gift in the trust to be administered for the benefit of the beneficiary."
Peterson says that many of her clients use defective grantor trust, an irrevocable trust in which the grantor continues to pay the income taxes, rather than paying them out of the trust itself.
People are somewhat reluctant, though, to set up 2503(c) trusts, which require distribution out or an opportunity to distribute out at age 21.
Giving young adults all the money they will ever receive at once, Peterson says, is inherently risky.
“We spend a lot of time with clients talking about ages that the children can have access to the money," she explains.
"Frequently, we’ll use the three-step. A third at one age, a third at another age and then access to the balance at another age. That’s one of our recommendations because it gives the young adult a limited amount of money at the beginning."
Of course, she admits, "They’re probably going to make some mistakes with it. Everybody makes mistakes. But at least you haven’t given them the maximum to make mistakes with everything. And you know that there’s that safety net there for them.”
Other trusts allow discretionary distributions for specific situation – medical expenses, a first home purchase, a wedding.
However, Peterson says that many of her clients are wary about allowing their children and grandchildren to invest trust assets in new businesses.
“What parents and grandparents generally say is that if the child is starting a business in which they are going to be the active member or are going to be very active, then we will allow a certain amount to go towards creating that business,” she says. “But we will not give the trustee discretion to distribute principal if it’s just to invest in somebody else’s new business.”
Peterson says that the education element of trusts for newborns is essentially the same as for any minor beneficiary, since most families don’t even tell their children about the assets in trust for them until the early teenage years.
She sees no difference in work ethic or ability to handle wealth between beneficiaries who have had trusts from birth and those who received them later.
Some additional trust structuring and planning issues do come into play when there is a special needs child the family, though.
“We do have several plans for special needs children, and they have all set up trusts in advance even if they’re not funded yet, the vehicle is there and the proper vehicle is being referenced in everybody’s estate documents,” Peterson explains.
Cost and complication
Both Junker and Peterson caution that trusts are not necessary or even appropriate in all cases.
“Children generally cannot own assets directly and gifts in excess of certain dollars must be facilitated through a trust structure, UTMA (Uniform Transfers to Minors) account, 529 plan, guardian of the property or some other legal structure,” says Junker.
“While these other structures work, trusts provide for much greater flexibility and many other benefits such as creditor protection, the ability to postpone inheritances for young beneficiaries, and potential tax savings. However, the benefits provided by a trust must be weighed against costs incurred in creation and administration of the trust, income tax considerations, and administrative complexity. Additionally, there are certain types of assets, such as retirement benefits, that just do not work well with a trust structure. In these cases, the benefits and detriments of the trust structure should be compared with other ways of transferring assets to a minor child.”
Moreover with the lifetime gift and estate exemption now established at $10 million, many wealthy parents and grandparents are feeling less pressure to remove assets from their estates.
“We have clients who are saying, my estate is not going to be subject to gift and estate tax. Rather than transfer funds, I’ll just create an account and earmark it for the grandchild. We saw a lot more trusts when there was uncertainty around whether the estate tax exemption was going to be $5 million or $3 million.”
Jennifer Kelly, Contributor, The Trust Advisor
