Overview: Crummey Trust

A Crummey trust is a vehicle that allows parents to take advantage of tax planning through the use of the annual exclusion gift while also not handing over large amounts of money to their minor children. The annual exclusion gift currently allows a person to make gifts of $13,000 each year to as many people as he or she would like. No tax is due on this amount and a gift tax return does not have to be filed, although if a married couple wants to gift-split, they will have to file a gift tax return to elect gift-splitting. A requirement for obtaining the annual exclusion status is that the gift must be a present interest, which means the recipient of the gift must have the unrestricted right to the immediate use, possession, or enjoyment of the property or the income from the property. The present interest requirement presents the problem of wanting to take advantage of the annual exclusion gift to one’s children each year, but not wanting to hand over up to $13,000 annually to a minor. The Crummey trust solves the problem by satisfying the present interest requirement for the annual exclusion gift. It satisfies the present interest requirement by creating a right to demand payment in the beneficiary. The demand right satisfies the present interest requirement because the beneficiary has the immediate right to the contributions, and it is up to the beneficiary as to whether he or she wants to demand payment.

In order to receive the desired tax effects of a Crummey trust, several requirements must be met. First, the beneficiary of the trust must receive actual notice of contributions to the trust and the right to withdraw contributions. This requirement is satisfied by having the trustee send out a letter to the beneficiary giving him or her notice of the contribution and the right to withdraw each time a contribution is made to the trust. Second, the beneficiary must have a reasonable period of time to exercise the withdrawal right. Thirty days is considered a reasonable period of time. Third, the trust must have sufficient liquid assets to satisfy any demand made pursuant to the beneficiary’s right to demand. This means the trust should not be funded with assets that are illiquid or assets that the donor does not want to be sold to satisfy a demand. Lastly, the donor cannot enter into an agreement with the beneficiary that he or she will not exercise the demand right.

This is just a brief overview of the need that the Crummey trust fills and the requirements that need to be satisfied to get the desired tax effects. Many other considerations need to be discussed before a Crummey trust is set up, such as who will be the trustee, whether a guardian should be appointed for the minor child to receive the notice from the trustee, and whether the donor trusts the beneficiary to not exercise the demand right. A Crummey trust is not for everyone, but parents or grandparents may want to consider it if they have some of these factors: 1) they want to gift large amounts of money to their children or grandchildren, 2) they have a large estate and want to reduce their estate tax, 3) they have maxed out their other college savings options and want to save more, 4) they do not trust their children or grandchildren to manage the money as young adults, and 5) they would like their children’s or grandchildren’s college fund to own alternative investments.

Overview: Transfer of Family Home to Children

The economy is currently in a recession with the real estate market seeing some of the biggest declines. Due to this decline people’s family homes probably have not appreciated much in value. One important benefit of leaving the family home to children in a will is that the children would get a step-up in basis. This means that the children would not have to pay tax on the appreciation in the property that occurred before it was transferred to them. Thus, the current economic and real estate climate takes away the big advantage of leaving the property to children in a will.

The current tax climate also makes it advantageous to transfer the family home to one’s children now. Currently, the lifetime gift tax exemption is $5.12 million and the gift tax rate is 35%. The lifetime gift tax exemption amount has generally been set at $1 million and the gift tax rate has generally been higher. So with this high exemption amount a parent could transfer the family home to his or her children with no gift tax due, assuming he or she has not made lifetime gifts before this that would use up the $5 million exemption. I will outline three options for transferring the family home now below.

Tenants-In-Common

The first option is transferring the property to one’s children as tenants-in-common. This means they will each own an undivided interest in the property. Some of the benefits of this approach are that the value of the property and any future appreciation will be out of the donor’s estate. Also, since the children will have undivided interests, certain discounts will apply in calculating the gift, such as minority interests, so the amount of the gift will actually be less than the total value of the property.

This option also comes with some costs. The costs to effectuate this transfer include having to file new deeds showing the children as the owners. The gift tax costs will be zero if the donor still has enough exemption left to cover the gift, but if not then the donor will be able to use discounts to lower the value of the gift. There will be no costs to the donor to administer the property or for on-going use once it is transferred, because the donor will no longer own it. If the donor wants to continue to use the property, the donor will have to pay his or her children a fair rental value. But if the donor does not pay rent, the children will be treated as giving the donor a gift.

Qualified Personal Residence Trust (QPRT)

The next option is transferring the property into a qualified personal residence trust (QPRT). A QPRT allows the parent to make a gift of the property to a trust for the benefit of the children. Also, the parent can reserve the right to use the property for a specified number of years rent-free and upon expiration of the trust term, the property would be distributed to the children.

One benefit of the QPRT approach is that the donor is able to still use the property rent-free for the trust term. Another benefit is that as long as the donor outlives the trust term, the property and any appreciation during the trust term will not be in his or her estate. Also, gift tax is only paid on the value of the remainder interest that will pass to the children, instead of the whole property value. So the longer the trust term the lower the value of the remainder and the gift.

The QPRT approach does not come without costs though. The costs to effectuate this transfer include drafting the trust agreement and possible payment to a trustee. The gift tax costs will once against be zero if the donor still has enough exemption left to cover the gift, but if not gift tax will only be paid on the value of the remainder. Since the donor will still have the right to use the property for the term of the trust, he or she will have to pay the costs to administer the property and to use it during the trust term. Also, if the donor wants to continue to use the property after the trust term, he or she will need to pay a fair rental value to the children.

LLC

The third option is to transfer the property into a LLC and then gift units in the LLC to the children. The transaction must be structured in that order to get the benefit of it. One benefit of this option is that discounts, such as minority discounts and lack of marketability discounts, are applied to the gifts making the gift value less than the full value of the property. Another benefit is that a LLC can protect the underlying assets, and the members of the LLC from liability. Also, restrictions can be placed in the LLC agreement, such as transferability restrictions.

This option comes with costs and many more obligations than the other two options. The costs to effectuate this transfer include setting up the LLC, transferring the property to the LLC and changing the deed, getting an appraisal of the property, and getting an appraisal of the fractional interests to calculate the gifts. The gift tax costs will once against be zero if the donor still has enough exemption left to cover the gift, but if not then the gifts will be reduced by the discounts. Since the LLC now owns the property, it will be responsible for any costs to administer the property and any costs for its ongoing use. If the donor wants to continue to use the property, he or she will need to pay fair rental value to the LLC.

This option has many other obligations that must be adhered to. The LLC must be managed and run like a business. This means that the LLC must have meetings, take minutes, pay the costs associated with the property, and in general just follow LLC formalities. The donor will also want to make sure he or she does not retain management control over the LLC, because then the property could be pulled back into the donor’s estate. Another issue with this option is that LLC agreements can be amended much easier than a trust so it does not provide as much certainty.

Conclusion

The three different options all come with benefits and costs that must be weighed. The LLC option has much higher costs than the other two and requires much more on the part of the donor and the children to make sure all the requirements are met to receive all of the benefits. The tenants-in-common option is not as desirable because the donor is basically giving up all control. Also, there are no documents with the tenants-in-common option, such as a trust agreement or LLC agreement, that allow the donor to make restrictions or specify what he or she wants to happen. The QPRT allows the donor to keep using the property rent-free while also getting the property out of the donor’s estate, as long as the donor outlives the trust term. An issue with using a QPRT is that it is best to use them when the interest rates are high and right now the interest rates are very low. These are just three of many options to utilize in transferring the family home, and as displayed above, many factors need to be weighed before choosing a particular option.

Overview: 529 Plans

Introduction

A 529 plan, also known as a qualified tuition plan, is an education savings plan that is operated by either a state or an eligible educational institution. The purpose of 529 plans is to help families pay for future college costs. Every state now has at least one 529 plan. There are two types of 529 plans, savings plans and prepaid plans. Savings plans essentially operate like an investment account in that you contribute money to the plan with the idea that it will grow through investing so that there will be more money for the beneficiary when he or she goes to college. On the other hand, a prepaid plan allows you to purchase tuition certificates that lock in today’s tuition rates for the beneficiary to use when he or she attends college. As a general rule, savings plans are better when the beneficiary is young so the investment will have time to grow, while prepaid plans are better when the beneficiary is close to college age, because you can lock in lower tuition rates, and you have a better idea of where the beneficiary will attend college.

Benefits

529 plans provide numerous benefits. First, the person setting up the account is able to provide for the beneficiary’s higher education expenses, which could occur a long time in the future. Second, the investment in the account grows while not being taxed, making it tax-deferred. Also, the distributions come out federally tax-free as long as the distributions are to pay for the beneficiary’s qualified higher education expenses. Third, under most plans qualified education expenses cover tuition, fees, cost of books, supplies, equipment, expenses for special services for a special-needs beneficiary, and reasonable room and board (cost of attendance under federal financial aid programs). Therefore, a 529 plan can pay for nearly all the costs the beneficiary will have while attending college. Fourth, the donor retains control of the account, which means that the donor decides when withdrawals are taken and for what purpose, whether or not to change beneficiaries, and most plans allow the donor to reclaim the funds. Although the donor retains control over the account, the contributions to the account still qualify for the annual exclusion for gifts and the funds in the account are not brought back into the donor’s gross estate. 529 plans also provide another benefit with the annual exclusion in that the donor can use five years worth of annual exclusion gifts in one year without paying gift tax. Thus, one donor could contribute $65,000 ($13,000 x 5) and a married couple could gift-split and contribute $130,000 ($26,000 x 5) without gift tax consequences in one year, which in some instances could fully fund the beneficiary’s higher education expenses. Lastly, 529 plans are very flexible. The account owner is able to change investment options once a year and can also rollover the plan into another state’s plan as long as it has not occurred in the last twelve months. Also, a 529 plan in one state can be used for education expenses in another state, and if the beneficiary ends up not going to college or needing all the funds, then the account owner can roll the funds over to another beneficiary.

Risks

As you can see 529 plans provide many benefits, but they also have some risks. First, with the savings plans investment risk is involved. The investment could lose value and potentially not provide as much money as you wanted for the higher education expenses of the beneficiary. Second, there is always the risk that the beneficiary will not go to college. This does not mean you will not be able to get the money out of the account, but withdrawals not used for qualified higher educations expenses receive a 10% penalty tax on top of being subject to income tax, and most plans cap the earnings at a low amount under such a situation. Some states also recapture any state tax deductions or credits used previously when the withdrawals are unqualified. Third, the investment options are limited by the state or educational institution administering the program, and therefore not all investment vehicles are available to invest in. Lastly, the investment option can only be changed once per year so you cannot change the investment strategy frequently as the market moves.

Private College 529 Plan

The Private College 529 Plan (PC Plan) is quite different from most plans, which is why I will discuss it specifically. This plan is a prepaid plan, and as the name suggests, this plan applies to participating private colleges, which is currently at 270-plus private colleges. The strength of this plan is the low-level of investment risk. The contributions are used to lock in tuition rates, and thus are not subject to the risk of the market as in savings plans. Prepaid plans have been especially beneficial in the recent economy because savings plans move with the stock markets, which have struggled in the recent economy, while prepaid plans continue to provide benefits as the colleges continue to increase tuition rates. Another strength of the PC Plan is that there are no fees involved. Since the contributions are used to buy tuition certificates rather than invested in a fund, there are no management-type fees involved.

The PC Plan also comes with some weaknesses. First, a tuition certificate cannot be redeemed until a minimum of 36 months has elapsed since its purchase and must be used within 30 years of its purchase. The consequence of these time restrictions is that you cannot fund the PC Plan right before the beneficiary enters college and expect to use the tuition certificates right away. Also, if the beneficiary does not end up going to college until later in life, the tuition certificates cannot be used if 30 years have passed. Second, the PC Plan involves not only the risk that the beneficiary will not go to college, which is a risk of all 529 plans, but also the risk that the child either will not want to go to one of the private colleges or will not be admitted. None of these 529 plans provide the beneficiary with an advantage when applying to colleges. If the beneficiary does not end up attending one of the private colleges participating in this plan, the money is refunded, but with only a 2% annualized return. Lastly, the PC Plan can only be used for tuition and mandatory fees. The PC Plan does not provide the benefit that other 529 plans offer of being able to use the funds for room and board.

Conclusion

529 plans can provide many benefits to all parties involved, but one must do his or her homework to mitigate the risks and assure that the proper plan is chosen. Many factors must be considered when choosing a 529 plan, such as the age of the beneficiary, where the beneficiary might go to college, the state tax deductions offered, the fees associated with the different investment options, how the investment options have performed, whether there are disincentives to switching plans, who can contribute to the plan, and what expenses can the funds from the plan be used for. After pinpointing the important factors, a donor can use savingforcollege.com to compare 529 plans and find the best 529 plan for his or her needs.