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529 Plans Versus Crummey Trusts for Single Beneficiaries

There are advantages and disadvantages with Crummey trusts.

Susan T. Bart, 09/25/2009

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 July column, I compared 529 savings accounts with Uniform Transfers to Minors Act accounts and, in my August column, I compared 529 savings accounts with gifts to 2503(c) trusts. This month I will compare 529 savings accounts with another alternative way of making gifts to minors: gifts to Crummey trusts that are each established for a single beneficiary.

Background: 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 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 a 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. Such gifts will also qualify for the GST annual exclusion provided that the beneficiary is the sole beneficiary of the trust during such beneficiary's life and the trust will be included in the beneficiary's estate upon the beneficiary's death. Usually when a trust is established for a grandchild or other skip person, the beneficiary is given a power to appoint the trust assets at death to anyone, including the beneficiary's estate or creditors, to ensure that the trust will be included in the beneficiary's estate and that contributions to the trust will therefore qualify for the GST annual exclusion.

When a Crummey trust is established for a single beneficiary, typically the rights to withdraw contributions to the trust lapses after a particular period of time, such as 60 or 90 days. If the beneficiary does not have a power of appointment over the trust assets that would prevent a gift from being completed, then when the beneficiary's right to withdraw a contribution lapses, the beneficiary would be 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. To avoid any gift from the beneficiary to the contingent remainder beneficiaries of the trust when the right of withdrawal lapses, typically the beneficiary is given a power to appoint the trust assets upon his or her death, which causes the lapse of the right of withdrawal to be only an incomplete gift and therefore not subject to gift tax.

The trust may permit discretionary income and principal distributions to the beneficiary. Alternatively, the trust may require certain mandatory distributions to the beneficiary, such as the distribution of net trust income after a certain age or the distribution of a certain percentage of the value of the trust assets to the beneficiary each year. The trust may provide for a particular age or ages at which the trust will distribute to the beneficiary or, alternatively, at which the beneficiary will have the right to withdraw the trust assets.

Beneficiary: A Crummey trust for a single beneficiary may have only one beneficiary by definition. The beneficiary may be of any age. The beneficiary of a Crummey trust for a single beneficiary may not be changed. In contrast, the beneficiary of a 529 savings account may be changed to a member of the family of the old beneficiary.

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 beneficiary.

Time for Final Distribution: Unlike a 2503(c) trust, the beneficiary does 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 beneficiary's life subject to the Trustee's discretion, or other trust directions, about when distributions should be made to the beneficiary. 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 beneficiary to follow the terms of the trust, invest the assets prudently and to act in the best interests of the beneficiary. 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, the 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 beneficiary of the right 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 the 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 beneficiary's right of withdrawal for the period of time set forth in the trust instrument. 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 the beneficiary's estate if the beneficiary has a power to appoint the assets to the beneficiary's estate or the beneficiary's creditors. As noted above, such a general power of appointment is required in order to obtain the GST annual exclusion.

Generation-Skipping Transfer Tax: Contributions to a Crummey trust for a single individual will qualify for the GST annual exclusion if the trust will be included in the beneficiary's estate. As noted above, commonly the beneficiary is given a general power of appointment in order to ensure that the trust will be included in the beneficiary's estate and that contributions to the trust will therefore qualify for the GST annual exclusion. If the beneficiary is a grandchild (or other skip person) and contributions to the trust exceed the annual exclusion, a donor may allocate GST exemption to gifts exceeding the annual exclusion amount to avoid GST tax. Allocation of GST exemption to excess contributions that exceed the annual exclusion amount is not necessary if the donee is not a skip person (e.g., a grandchild) if the trust assets will be included in the estate of the beneficiary, who will then be treated as the transferor for GST purposes.

Income Tax: There is some uncertainty about the correct income taxation of a Crummey trust for a single beneficiary. However, the IRS's position is that if all contributions to the trust were subject to the beneficiary's right of withdrawal, the trust should be treated as a grantor trust with respect to the beneficiary. Thus all of the trust income, whether or not distributed to the beneficiary, would be taxable to the beneficiary. The Kiddie Tax may apply, causing the income to be taxed at the beneficiary's parents' income tax rate. 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.

If it is preferable to have the trust income taxed to the grantor, certain provisions can be inserted in the trust, such as granting 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 beneficiary.

Financial Aid: For financial aid purposes, the beneficiary generally must report the present value of the trust as an asset, even if the beneficiary's access to the trust is restricted. In contrast, a 529 savings account is treated as an asset of the parent if the student is a dependent.

Creditor Protection: Because the 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 a Crummey Trust Over 529 Savings Accounts: Distributions may be made from a Crummey trust to the beneficiary for any purpose permitted by the trust instrument without adverse 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 another beneficiary or to the Trustee.

Disadvantages of a Crummey Trust Over 529 Savings Accounts: 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. Further, if the trust is taxed as a grantor trust with respect to the beneficiary, the trust income may be taxed at the beneficiary's parents' tax rate under the Kiddie Tax rules.

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

With a Crummey trust for a single beneficiary there is no ability to change the beneficiary even if the funds are not needed by the trust beneficiary for higher education expenses or other purposes. The donor cannot retain a right to get the funds back. In contrast, the beneficiary of a 529 savings account may be changed to a member of the family of the old beneficiary, and the account owner has a right to distribute the 529 account funds to himself or herself.

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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