December brings out the generosity of most. Holiday gifts are bestowed upon loved ones and charitable donations are completed. While most givers are motivated purely by a benevolent spirit, others also consider tax planning objectives when writing year-end checks to loved ones. Because young recipients are unable to handle large sums of money responsibly, it is common for gifts to be made in trust - sometimes to a custodial account. The remainder of this blog post outlines rules applicable in the UTMA/UGMA arena.*
Forty-eight states and the District of Columbia have in place a version of the Uniform Transfer to Minors Act (UTMA). Both South Carolina and Vermont operate under an older model of the law - Uniform Gift to Minors Act (UGMA).
Both statutes allow “custodial accounts” to be established on behalf of those who are under age 18 or 21, the year of legal majority being jurisdictionally determined. Minors’ accounts provide an inexpensive and uncomplicated way to make gifts to minors - who, not having the right to contract, are restricted from owning investments such as stocks, bonds and annuities.
When establishing a UTMA or UGMA, the donor designates a custodian (often himself) and a beneficiary (one per account). The account is titled: "(Custodian's Name) as custodian for (Minor's Name) under the (State of Residence of Minor) Uniform Transfer to Minors Act". (When setting up a UGMA account, substitute the word “Gift” for the word “Transfer”.)
The custodian handles funds on the minor’s behalf until the beneficiary reaches majority whereupon he or she is entitled to full control of the investments held in the account, presuming that capacity is not an issue.
A financial institution normally handles the mechanics of establishing the account. While the bank or brokerage house employee opening up the account may advise you of the basics, he or she may not be equipped to render advice with respect to more complicated issues. Consequently, parents often establish these accounts as a college savings vehicle without full awareness of the following rules that apply in most states:
- IRREVOCABLE GIFT - The gift to the custodial account is irrevocable which means that the donor cannot take it back - ever. While the contribution to the account may be a characterized as a taxable gift, it is unlikely that any tax will be owed in light of the generous annual exclusion and lifetime exemption discussed in Part Four. If the custodian dies during the term of the account, the value will be included in her estate if she has a legal obligation to support the beneficiary.
- ACCOUNTINGS - Once the minor reaches age 14, the custodian is required to provide accountings upon demand.
- LIMITED INCOME TAX BENEFIT - Current law taxes unearned income (such as dividends, interest and capital) of children under age 18 as well as children age 18 and full time students age 19 through 23 whose earned income is not more than one-half of their support as follows:
- The first $1000 is tax-free as it is offset by the standard deduction.
- The next $1000 is taxed at the child's tax rate.
- Amounts greater than $2000 is taxed at the parent's rate
Note that prior to January 1, 2006, the “Kiddie tax” was applicable only to unearned income of children under the age of 14.
4. BENEFICIARY’S RIGHT TO DISTRIBUTION - The beneficiary has an unfettered right (presuming no issues of capacity) to distribution of the funds upon reaching the age of majority. If the value of the account is relatively small, this may not matter. However, if a large sum of money is involved, retaining counsel to draft a trust directing age and terms of distribution may be a worthwhile investment.
Example: Harold and Melinda established UTMA accounts for their two young children and contributed annually until Harold passed away at the age of 35. Melinda did not make additional contributions; however, after many years of modest appreciation, the account balances were sufficient to fund college educations, which was the purpose intended by both Harold and Melinda. When their son, Jerry, graduated from high school and refused to attend college, Melinda continued to hold the funds even though Jerry had reached 18, the age of majority. Neither child was aware of the existence of the funds until Jerry found brokerage statements in the course of a search of his mother’s file cabinet. He demanded that she turn over the money. When she refused, he hired an attorney who filed suit against Melinda, demanding release of the funds, and alleging her breach of duty as a custodian for her failure to provide accountings as required under state law. Ultimately, she was required to distribute the money to Jerry who spent the entire amount on a Porsche.
UTMAs are often established when a beneficiary is young - which means that nobody really knows where on the spectrum of financial responsibility the child will lie upon reaching majority. That being said, most of the situations do not turn out like the above true story. By and large, the child is thrilled to have money available for college and the funds are used for their intended purpose.
* This blog post is reproduced from my upcoming book The Lawyers’ Guide to Attaining Financial Security to be published by the ABA Solo, Small Firm and General Practice Division in late spring of 2014.