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529 Plans Versus Shared Crummey Trust for Grandchildren

Generation-skipping transfer tax consequences need to be taken into account.

Susan T. Bart, 11/20/2009

College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to advisorquest@morningstar.com.

In my August column, I compared 529 savings accounts with an alternative way of making gifts to minors, gifts to 2503(c) trusts. In my September column, I compared 529 savings accounts with gifts to Crummey trusts that are each established for a single beneficiary. Thus both my August and September columns discussed trusts that would only have a single beneficiary. A major limitation of these types of trusts is the inability to spray trust distributions among the group of beneficiaries. Thus if a 529 savings account is owned by one of these types of trusts and not all of the funds are needed for qualified higher education expenses of the beneficiary, a nonqualified distribution must be made either to the beneficiary directly or to the trust for future distribution to the beneficiary. Because of the restrictions in the trust, the beneficiary of the 529 savings account cannot be changed to another family member.

In my October column, I discussed another alternative way of making gifts to minors, gifts to a Crummey trust established for multiple beneficiaries, all of whom are children of the donor. A significant advantage of a shared Crummey trust for children is that if the trust owns a 529 savings account for one beneficiary, the beneficiary of the account later can be changed to another child.

This column will discuss shared Crummey trusts for grandchildren or more remote descendants. For a shared trust for grandchildren, generation-skipping transfer tax consequences need to be taken into account.

Gift Tax Annual Exclusion
Usually gifts to a trust do not qualify for the gift tax annual exclusion because the trust beneficiary does not have the "present interest" required to qualify for the gift tax annual exclusion. Typically, a trust beneficiary only has a future interest in the trust property. However, the case of Crummey v. Commissioner, 397 F.2d 82 (9th Circuit 1968) established that a present interest is created if the beneficiary of a trust has the right to withdraw contributions to the trust when made. Thus annual exclusion gifts to a Crummey trust will qualify for the gift tax annual exclusion.

A Crummey trust may have multiple beneficiaries, each of whom has a right to withdraw a portion of contributions made to the trust. For example, if Mother establishes a shared Crummey trust for her children, Alice, Atticus and Alex, the trust could provide that each child would have a right to withdraw a pro rata share of each contribution to the trust. Thus if Mother contributed $39,000 to the trust in 2009 (and made no other gifts to the children during the year), each child would have a right to withdraw $13,000 of the contribution and the entire contribution to the trust would qualify for the gift tax annual exclusion.

Tax complications arise, however, when the beneficiaries' rights of withdrawal lapse. When a beneficiary's right to withdraw a contribution lapses, the beneficiary is deemed to have made a gift to the trust to the extent the lapse in any year exceeds the greater of $5,000 or 5% of the trust assets. Thus in the prior example, if the trust was worth $100,000 or less, and assuming that the rights of withdrawal lapsed 90 days after the contribution to the trust was made, upon the date the rights of withdrawal lapsed, each beneficiary would be deemed to have made a gift to the trust of $8,000 ($13,000 less $5,000). As discussed in the September column, with a Crummey trust for a single beneficiary, gift tax consequences can be avoided by giving the beneficiary a power to appoint the trust assets upon his or her death. This solution, however, is generally not available with respect to a shared Crummey trust.

My October column discussed a number of possible strategies to avoid a taxable gift from each beneficiary to the trust upon the lapse of the beneficiary's rights of withdrawal. The most common solution to avoid a gift to the trust when a beneficiary's right of withdrawal lapses is to use "hanging powers." A "hanging power" is a provision in the trust that provides for the beneficiary's right of withdrawal to expire only at a rate that will not exceed the greater of $5,000 or 5% of the value of the trust in any given year. The hanging power thus can extend the time period during which a trust beneficiary can exercise a power of withdrawal. If, in a given year, a withdrawal beneficiary's share of contributions to the trust exceeds the $5,000 or 5% threshold, the amount in excess of such threshold will remain subject to withdrawal. In succeeding years, contributions to the trust may again exceed the $5,000 or 5% threshold, and the amount remaining subject to withdrawal will accumulate. As a result, the beneficiary may possess a power to withdraw assets from the trust for quite a long time, and the power may eventually involve a sizable amount of property. In time, however, due to growth in value of the trust or other factors, the annual contributions to the trust may be less than the $5,000 or 5% threshold. As a result, the accumulated excess amounts remaining subject to withdrawal will begin to decline and may eventually be reduced to zero.

GST Annual Exclusion
Thus contributions to a shared Crummey trust for grandchildren can qualify for the gift tax annual exclusion. However, contributions to such a trust will not qualify for the GST annual exclusion. The requirements for obtaining the GST annual exclusion for a gift to a trust are:

1) The gift qualifies for the gift tax annual exclusion;
2) The trust is only for a single beneficiary during the beneficiary's life;
3) The trust is included in the beneficiary's estate.

Thus a gift to a trust for multiple beneficiaries cannot qualify for the GST annual exclusion. Consequently, a GST tax will be imposed either (1) when assets are contributed to the trust (if all trust beneficiaries are "skip persons," i.e., grandchildren or more remote descendants), (2) if not all of the trust beneficiaries are initially skip persons (e.g., a child is also an initial discretionary beneficiary of the trust) when circumstances leave the trust only with skip persons as beneficiaries, or (3) if not all of the trust beneficiaries are initially skip persons, when a distribution is made to a skip person (e.g., a grandchild). Paying a 45% GST tax when the trust is created or at a later time is generally not a palatable option.

There is a way to avoid GST tax on a gift to a shared Crummey trust for grandchildren. Each individual has a GST exemption (currently, $3,500,000) that he or she can assign to transfers to avoid GST tax. For example, if Grandparent established a shared Crummey trust for his five grandchildren and in 2009 contributed $65,000 to the trust, (1) the gift would qualify for the gift tax annual exclusion ($13,000 per grandchild) assuming the trust was properly drafted and administered and Grandparent made no other gifts to the grandchildren during the year, and (2) no GST tax would be imposed if Grandparent assigned $65,000 of her GST exemption to the gift on a timely filed gift tax return. Each time the Grandparent makes additional gifts to the trust the Grandparent would need to assign additional GST exemption.

Depending upon the exact terms of the trust, the GST tax rules might automatically assign GST exemption to the gifts to the trust (unless the donor "opts out" of automatic allocation on a timely filed gift tax return). However, legal advice should be sought on whether gifts to the particular trust qualify for the automatic allocation. Even if they do, it still may be advisable to file a gift tax return to provide a record of how much of the donor's GST exemption has been allocated to lifetime gifts.

Beneficiaries
Because a shared Crummey trust permits all of the donor's grandchildren to share the trust, the trust may permit the Trustee to make unequal distributions among the beneficiaries. Similarly, 529 savings accounts provide the flexibility to share the benefits of the accounts among the donor's grandchildren because the beneficiary of a 529 account may be changed to a member of the family of the old beneficiary. All of a donor's grandchildren are "members of the family" of each other because they are either siblings or cousins.

Trust Investments
Unless the trust restricts the Trustee's powers, generally the trust property may be invested in any manner, including in stocks, bonds, mutual funds, cash accounts, partnership or LLC interests, etc. The prudent investor rule of the appropriate state applies to trust investments. In contrast, 529 savings accounts may only be invested in the investment choices offered by the particular state plan.

Distributions
The Trustee, like the account owner with respect to a section 529 savings account, controls distributions subject to the terms of the trust. The trust structure, however, gives the grantor of the trust greater flexibility to specify the circumstances under which the grantor would or would not want the Trustee to make distributions to the beneficiaries. Typically, the shared Crummey trust would provide for a particular time at which the trust would be divided and either distributed to the beneficiaries or held in further trust with each beneficiary having his or her own trust. For example, if the trust was established to pay for the education of the donor's grandchildren, the Trustee could be directed to make distributions to each beneficiary to pay for his or her education, without regard to whether one beneficiary's education was more costly than another beneficiary's education. If funds remained in the trust after all of the beneficiaries had completed their education, the trust could either direct that the remaining funds be distributed equally among the grandchildren, or alternatively could direct that the funds be distributed in a manner that "equalized" for the differences in the cost of the beneficiaries' educations.

Time for Final Distribution
Unlike a 2503(c) trust, the beneficiaries do not have to have a right to withdraw the assets of a Crummey trust at age 21. The trust can provide for a later age for distribution or no age at all. The trust assets can even remain in the trust for the beneficiaries' lives subject to the Trustee's discretion, or other trust directions, about when distributions should be made to the beneficiaries. Similarly, a 529 savings account does not give the beneficiary the right to demand distributions of the assets at any point in time (unless the account is a custodial 529 account subject to the Uniform Transfers to Minors Act).

Fiduciary Duties
The Trustee has fiduciary duties to the beneficiaries to follow the terms of the trust, invest the assets prudently and to act in the best interests of the beneficiaries. In contrast, as has been discussed in past columns, the account owner of a 529 savings account has no fiduciary duties to the beneficiary and regardless of the circumstances, may distribute the funds to the account owner or change the beneficiary.

Gift Tax
Transfers to a Crummey trust will be treated as completed gifts for gift tax purposes and, provided that the trust contains properly drafted rights of withdrawal, will qualify for the gift tax annual exclusion. However, each beneficiary, or in the case of a minor beneficiary some adult on behalf of the beneficiary, must receive prompt notice of the right of withdrawal. Thus the Trustee has a duty each time a contribution is made to the trust to notify the beneficiaries of their rights of withdrawal. Consequently, there is some administrative work required with a Crummey trust in order to ensure that contributions to the trust qualify for the gift tax annual exclusion. In addition, there is always the possibility that a beneficiary, or an adult on behalf of a minor beneficiary, could exercise the withdrawal right and demand immediate distribution of the assets that were just given to the Crummey trust.

Thus gifts to both Crummey trusts and 529 savings accounts qualify for the gift tax annual exclusion. However, gifts to a Crummey trust are subject to the beneficiaries' right of withdrawal. In contrast, gifts to a 529 savings account may not be unilaterally withdrawn by the beneficiary.

Estate Tax
If the donor does not retain any interest in or power over the trust, the Crummey trust assets will not be included in the donor's estate. Thus the donor to a Crummey trust should not act as the Trustee. By comparison, the donor to a 529 savings account may act as the account owner without causing estate tax inclusion in the donor's estate.

The assets of a Crummey trust will be included in a beneficiary's estate if a beneficiary has a power to appoint a portion of the trust assets to the beneficiary's estate or the beneficiary's creditors. With a shared Crummey trust, typically this would not be the case, at least not until after the trust has divided into separate trusts for the grandchildren.

Generation-Skipping Transfer Tax
As noted above, gifts to a shared Crummey trust for grandchildren do not qualify for the GST annual exclusion, and therefore a portion of the donor's GST exemption must be allocated to each gift to the trust to avoid GST tax. In contrast, gifts to a 529 savings account for a grandchild qualify for the GST annual exclusion.

What if the trust established a 529 savings account for a grandchild and the donor made a contribution directly to the 529 account owned by the trust (rather than making a contribution to the trust and then having the trust make the addition to the 529 account)? This could be done only in states that permit a non-account owner to make a contribution to an account; some programs only permit contributions from the account owner. It would appear that Internal Revenue Code section 529 would qualify the direct contribution for the GST annual exclusion, although I know of no authority addressing this issue.

Income Tax
The IRS is most likely to take a position that the portion of the trust that was subject to a beneficiary's right of withdrawal should be treated as a grantor trust with respect to such beneficiary. Because a shared Crummey trust by definition has more than one beneficiary, the income tax consequences would be spread among all of the beneficiaries. This would result in complicated tax reporting. Thus it might be preferable to design the trust so that all of its income is taxed to the grantor. This can be accomplished by inserting certain provisions in the trust, such as giving the grantor a power to substitute trust assets with assets of an equivalent value, that would cause the trust to be treated as a grantor trust with respect to the grantor instead of with respect to the beneficiaries.

By comparison, no income taxes are imposed on a 529 savings account while the assets are held in the account or if distributions are made for qualified higher education expenses.

Financial Aid
For financial aid purposes, a beneficiary of a trust generally must report the present value of the trust as an asset. Presumably, the fact that the trust is established for multiple beneficiaries would be taken into account. In contrast, a 529 savings account owned by a grandparent may be ignored for financial aid purposes.

Creditor Protection
To the extent a beneficiary of a Crummey trust had a right to withdraw the trust assets initially, the beneficiary may be viewed for property law purposes as having funded a trust for himself or herself. Therefore, such a trust may not provide complete protection from the beneficiary's creditors even if the trust contains a "spendthrift provision." State law may vary on this point. However, with respect to the donor's creditors, once a gift is made to the Crummey trust, the donor's creditors should not be able to reach the assets of the Crummey trust unless the gift was a fraudulent conveyance. The protection of a 529 savings account from the account owner's creditors is more limited and, except with respect to the limited federal protection in a bankruptcy proceeding, depends upon state law.

Advantages of Crummey Trust Over 529 Savings Account
Distributions may be made from a Crummey trust to the beneficiary for any purpose permitted by the trust instrument without adverse income tax consequences. In contrast, distributions from a 529 savings account that are not for qualified higher education expenses will generally be subject to adverse income taxation and a penalty tax. Further, because the Trustee is subject to fiduciary duties, the Trustee cannot divert the trust assets to non-beneficiaries or to the Trustee.

Disadvantages of Crummey Trust Over 529 Savings Account
On the other hand, earnings on investments held in a Crummey trust are subject to income taxes even if used for qualified higher education expenses.

The requirement that the beneficiaries be given notice of each contribution to the trust and of the beneficiaries' right of withdrawal over such contribution imposes some administrative responsibilities on the Trustee. Further, the beneficiaries may exercise the right of withdrawal, which may not be the result for which the donor hoped.

Finally, a Crummey trust should be prepared by an attorney, while 529 savings accounts are often created without the assistance of an attorney.

To comply with certain Treasury regulations, we state that (i) this article is written to support the promotion and marketing of the transactions or matters addressed herein, (ii) this article is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (iii) each taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

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