Education AT Funded with Appreciated Asset
An excellent application for an annuity trust is to provide for the college education of a child, nephew, niece, grandchild or other person. The education trust typically will pay a fairly high annuity amount for a term of four or five years.
The trust is most advantageously funded with appreciated stock. The donor receives an income tax deduction equal to the present value of the remainder interest and also benefits from bypassing capital gain when the trust sells and diversifies the portfolio.
Kiddie Tax Applies to Education Annuity Trusts
The Kiddie Tax rates apply to children age 19 or younger (24 for students). This increase will have major adverse impact on education annuity trusts. With increased tax rates on passive income, a major benefit of education remainder trusts has declined significantly. There still will be a charitable deduction for parent or grandparent who funds one of these plans, but the lower student income tax rate no longer exists for most recipients.
The student will still benefit from his or her exemption and pay tax at the lowest bracket on an amount equal to that exemption. However, students under age 24 with over 50% passive income will be taxed on excess amounts at their parent's tax rate. Sec. 1(g)(2)(a)(ii)(II) states that the "Kiddie" tax will apply unless the student has earned income equal to one half of his or her support. This is a standard that college students will find very difficult to meet.
Gift Tax Options
The Sec. 2503 annual exclusion applies only if the transfer is a "present interest." This means that the recipient must be able to spend the money. However, with respect to a trust, "an unrestricted right to the... income from property is a present interest." See Reg. 25.2503-3(b). This means that it is possible to qualify an income stream for the gift exclusion so long as the income stream right commences immediately after the trust is created.
What impact do these gift tax rules have on education unitrusts or annuity trusts? There are two basic choices for the term of years trusts. These are the "Give it Now" and use this year's exclusion choice or the "Keep a String" and use future years' annual exclusions option.
The "Give it Now" Option
The "Give it Now" choice was selected by the donor in PLR 8637084. This donor funded unitrusts with income paid for four years to students S and T. Afterward, income was then paid for three more years to U, V and W. Since the income to S and T was vested and commenced as soon as the trust was created, these income interests qualified for the gift exclusion. The exclusion amount would be the lesser of the present value of the income interest or the amount of the annual exclusion for each person.
Since the income to U, V and W is in the future, there is no present exclusion for the value transferred to them. This "no exclusion" rule also applies if a trustee has the power to allocate among the various beneficiaries. See Reg. 25.2503-3(c), Example 3.
On April 15 of the year following the creation of this trust, the CPA for the donor will file both a Form 1040 Income Tax Return and a Form 709 Gift Tax Return. The same gift deduction will be reported on both returns. The Gift Tax Return will show the total amount transferred less the charitable gift tax deduction and less the exclusions, if any. For example, with a $100,000 trust, there could be a $30,000 charitable gift deduction, a deduction in the amount of the annual exclusions if available, and the remainder is a taxable transfer. If sufficient exemption were available, taxable transfer would merely reduce the remaining available lifetime gift exemption. In rare cases, the donor could even pay gift tax on the value of the gift over the gift exemption equivalent.
The "Annual Exclusions" Option
Method number two is the "Use Annual Exclusions" option. In PLR 8949061, the taxpayer created a term of years trust with income payable to seven students. This donor also retained a right to revoke income interests. Under Reg. 25.2511-2(f), the retention of the testamentary right of revocation (permitted under Sec. 664 for unitrusts and annuity trusts) was a "string" that precluded a present gift. In effect, the transfer of funds each year to a student would then be a completed gift for that year, thus enabling the use of annual exclusions in future years.
This conversion to annual exclusions is permitted only for a term of years trust. In Reg. 1.664-3(a)(5), Treasury notes that "If an individual receives an amount for life, it must be solely for his life." Since the donor is not an income beneficiary, under this regulation the income could not be payable to a student or students for life, but rather the duration of the trust may be only a term of 1-20 years.
With the "Use Annual Exclusions" method, the donor with several beneficiaries and sufficient exclusions will not suffer any adverse transfer tax consequences during life. However, under Sec. 2036(a)(2), the donor should know that if he or she dies prior to the expiration of the term of years, there would be an inclusion in his or her estate. Essentially, the present value of the remaining income stream would be a taxable transfer in the estate.
Notwithstanding this rule, if the donor will probably live most or all of the projected term of years and there are sufficient available gift exclusions, it seems probable that the "Use Annual Exclusions" method will be preferable. Since donors may be familiar with the concept of the annual exclusion amount or less annual gift, this method is likely to be more easily understood by donors.
Which method should be used - the "Give It Now" option or the "Use Annual Exclusions" method? If there are sufficient exclusions to cover the reported gift now, it may be preferable to file the Form 709 and have a completed transaction. However, if the donor is reasonably young, there are several students or the donor has selected an independent trustee and that independent trustee has the ability to allocate among the students, then it may be preferable to use the annual exclusions option.
