There are several ways to transfer assets to your children. However, some are either not tax advantageous or not a smart way to give a child access to money.
When I was 18, I was stupid, as I think we all were. Imagine what would have happened if 18-year-old you had full access to $1 million in assets. I, like most 18 year olds, would have blown through that money in no time.
Recently, I had a big blowout with a financial advisor who recommended a Uniform Transfers to Minors Act (UTMA) account to a client of mine. With these, a parent contributes up to the gift tax limit per year. The money is usually invested and creates a “kiddie tax” situation for the parents. In addition, at age 18, the money and/or assets in the account belong, unrestrictedly, to the child. After explaining this to my client, he agreed with me and closed the account before it was funded.
A better way to give a minor money would be through an IRC §529 account. With this type, the parents own the assets. The amount that can be contributed each year is the gift tax limit. For 2019, an individual can gift $15,000 per person, per year. However if married spouses elect to split their gifts, they can give $30,000 per person per year.
Traditionally, a 529 account was meant for higher education. However, with the TCJA, up to $10,000 per year can be used for private K-12 education. The parents own the assets in the account, with the child as the beneficiary. Importantly, the child doesn’t have free reign over the money at age 18. Further, the money grows tax free, and it isn't taxable when it's withdrawn, provided it is used for qualified educational expenses.
Another way to give assets to your children and control the manner in which they receive the money is to set up an irrevocable trust, or a trust that cannot be changed. This is a legal document involving three parties: the grantor or trustmaker (the person creating the trust), the trustee (the person or entity that controls and distributes the assets in accordance with the trust document, but not the grantor) and the beneficiary(ies) (the people or entity that inherits the assets). It is important to point out that an irrevocable trust provides legal protection from the grantor, as contributions are considered completed gifts.
The assets contributed to the trust are called the corpus. Beneficiaries don’t pay income tax on this; however, they would pay tax on any income the corpus generated (albeit at a lower rate). You can contribute cash or assets within the gift tax limit. For example, if I am married, and my spouse and I elect to split our gifts, we can contribute $30,000 in cash or assets that have a basis to us of $30,000.
Further, if I am in an estate tax situation, my contribution to the trust is no longer part of my taxable estate. Further, in the trust document, I can dictate the terms by which my child receives the money. For example, if my child is 21, in college and maintains a 3.0 GPA, I might allow him to receive 10 percent. When they are age 30, they can receive another percentage, and so on. Frequently, people add clauses denying the distribution in the event of a drug or alcohol problem.
If your child will be taking over the family business as opposed to simply receiving dividends, you can still retain control over the finances and mitigate both estate and income taxes.
Most family businesses are set up as pass-thru entities, such as S corporations, or disregarded multi-member LLCs. However, the strategies I am going to discuss would also work for a C corporation.
A Grantor Retained Annuity Trust (GRAT) accomplishes two things. First of all, as the business owner, I would keep all of the voting shares of stock, which would represent 1 percent, and transfer the non-voting shares to the GRAT. Note, voting and non-voting shares would not create two separate classes of stock, so this strategy is okay for S corporations.
I would then transfer 99 percent of the non-voting shares to the GRAT for the FMV; let's say the latter is $3 million. This type of account has a time limit; in this example, my GRAT will last for 15 years. For estate tax purposes, I have “frozen” the value of the asset at $3 million. The GRAT becomes the majority shareholder and pays me an annuity for its lifetime. The annuity would be paid at $200,000 a year, and it would come from the profits of the business.
The theory here is that the business will grow in value and make more income. After the GRAT is done, all of the shares revert to the beneficiary, and I retire. However, there is a catch: If I die before the GRAT ends, the FMV of the stock reverts back to my taxable estate.
A better way to handle the sale would be through an Intentionally Defective Grantor Trust (IDGT). The use of an intentionally defective irrevocable trust (IDIT) is a technique that may allow you to transfer the future appreciation of an asset to your beneficiaries while keeping its current value plus a fixed annual interest payment.
Typically, there are two basic types of IDIT transactions: gifts and sales. For the former, any gifts would be treated as completed (i.e., “true” gifts) for estate and gift tax purposes but not for income tax purposes. Alternatively, a sale transaction can be used to reduce the gift tax that might otherwise be due on a simple gift transaction.
After setting up an IDIT, you would sell an asset to the trust in exchange for the promissory note (although the IDIT should be properly “seeded” before the sale, which means it should have some amount of equity that would substantiate its ability to make payments on the loan). The terms of the promissory note would require the trust to pay you an amount equal to the fair market value of the property at the time you sold the asset, plus a fixed rate of interest.
The interest rate would be based on the prevailing one (as published by the IRS) for the month the sale occurs and would depend on the length of the note and the frequency with which interest payments must be made (e.g., annually, semiannually, quarterly). Similar to GRATs, IDITs work best when interest rates are low because appreciation passes to the beneficiaries.
If the trust assets produce a rate of return that exceeds the specified interest rate, the IDIT’s beneficiaries will receive the excess either in trust or outright, at little or no gift tax cost. Unlike GRATs, IDITs can also be used effectively as a tax-planning tool in connection with the GST tax.
Like a GRAT, an IDIT works best with assets that are likely to appreciate rapidly. The higher the rate of return, the greater the amount that will pass to the beneficiaries free of gift tax. Typical assets placed in this type of trust include closely held businesses, publicly traded stock and others that are expected to grow quickly.
Although the IDIT will be the legal owner of the asset, you will remain liable for the tax on the income earned within it—hence, the trust is “defective.” As with GRATs, there have been proposals to change the tax results of IDITs, so if you’re considering setting one up, it may be a good idea to do so sooner rather than later.
As you can see, there are much better ways to pass along your assets than an UTMA account.
About Craig W. Smalley, EA
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.