Education Funded With Appreciated Asset
The goal of a unitrust is to provide for the college education of a child, nephew, niece or grandchild. The education trust typically will pay a fairly high unitrust amount for a term of four or five years.
The trust is most advantageously funded with appreciated stock or real estate. The donor receives an income tax deduction equal to the present value of the remainder interest and benefits from bypassing capital gain when the trust sells the stock or land.
Kiddie Tax Applies to Education Unitrusts
The Kiddie Tax rates apply to dependent children up to age 19 (24 for full-time students). The Kiddie Tax generally applies to the unearned income of a child over a basic threshold. This may have an adverse impact on education unitrusts and annuity trusts. With increased tax rates on passive income, a major benefit of education remainder trusts has declined significantly. A charitable deduction will be available for a parent or grandparent who funds one of these plans, but the lower student income tax rate no longer exists.
The student will 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 child or grandchild 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? There are two basic choices for the term of years trusts. These are the "Give it Now" option and use this year's exclusion choice or the "Keep a String" option and use future years' annual exclusions.
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 annual exclusion for each person. If two donors are funding the trusts, then the potential exclusion amount would be four exclusions – two for the donors times the two students.
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 income 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, further reduced by annual exclusions and the remainder would be a taxable transfer. If sufficient exemption were available, the taxable transfer would merely reduce the remaining available gift exemption. In rare cases with large estates and donors who have made substantial prior gifts, the donor could pay gift tax on the value of the gift over the available lifetime gift exemption.
The "Keep a String" Option
Method number two is the "Keep a String" or "Use Annual Exclusions" concept. In PLR 8949061, the taxpayer created a term of years trust with income payable to seven students. This donor also retained a testamentary 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. 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 up to 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 will 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.
Example 3.11.1A Education Unitrust for One Student
Assume that Mary Jones desires to assist her granddaughter Susie in her college education. Susie has a college savings fund, she works during the summer and her parents will provide some assistance. However, Grandmother Mary would like to provide an additional amount to assist in Susie's education. In addition, Mary has supported several charities and she would like both to help Susie receive a college education and to benefit her favorite charities.
Mary owns stock that she purchased for $10,000. It has increased in value to $50,000 and has been held for more than one year. She transfers the stock into an 8% charitable remainder unitrust. The unitrust can sell tax-free and then diversify into a portfolio of stocks and bonds. This is a standard unitrust that pays out 8% for four years.
Mary Jones saves $12,688 from the income tax deduction and bypasses $8,000 in capital gains tax. In addition to $20,000 in direct tax savings, she assists Susie with four years of college education. At the end of that time, the trust is distributed to charity.
Since none of the distributions will be more than the annual gift tax-exemption amount in a given year, Mary decides to retain a testamentary power of revocation over the trust. This "string" allows her to avoid a current taxable gift to Susie and to use her annual exclusions for the transfer each year. Since the payments are present interest gifts each year and are less than the annual exclusion amount, there is no gift tax consequence for Mary Jones.
Example 3.11.1B Education Trust For Seven Grandchildren
John and Mary Smith have seven grandchildren. They desire a very flexible plan that will also encourage their grandchildren to be diligent in pursuing their college education.
John and Mary hold a fairly substantial block of appreciated stock. They would like to make transfers of stock each year for four years and then use the charitable deduction from the gift plan to reduce their other income. They plan to transfer stock valued at $200,000 in year one, $180,000 in year two, $160,000 in year three and $140,000 in year four. They also note that the grandchildren are currently age four to eleven and will not need payouts for a period of eight years. At that time, two students will be in college. However, by trust years twelve or thirteen, there may be three or more at one time in college. In addition, they want the trustee to have the discretion to make distributions to the students who are making satisfactory progress in college.
This advanced education unitrust achieves all of their objectives. It is permissible to make additions to the unitrust in years two, three and four. Since the unitrust is a net income plus makeup trust, the trustee may invest for growth for a period of seven years. By selecting an independent trustee, as defined under Sec. 674, they are permitted to allow the trustee to have discretion to make distribution to the various students. In addition, they choose to retain a testamentary power of revocation and use annual exclusions to cover distributions to students. The annual exclusions will be sufficient to cover distributions to any student in a given year, particularly since they are creating the trust with joint property and thus have two exclusions each year per student.
The bypass of capital gain and income tax savings are very substantial. In addition, over $1.1 million after tax is available for the students. All seven students will be able to attend very fine colleges and even graduate and professional schools with this level of funding. Finally, after the term of twenty years is completed, over $1 million will be distributed to a charity.
The trustee will invest for growth for a period of seven or eight years. After perhaps investing for the next three years in a balanced portfolio, the trustee will then invest to maximize the payout. The combination of the power to select investments and the power to choose the income recipient makes this a very effective educational program. Given the flexibility of the plan and the requirement for an independent trustee, it is preferable that a charity not serve as trustee of this trust, but rather that a financial advisor for the donor serve as trustee. If a private trustee is selected, then it is important to use one of the several trust administration companies to file the Form 5227 tax returns.