Answering reader questions on combining 529s and gift trusts, grandparents' 529 contributions, and person-to-person loans for college.
1. My client has about an $8,000,000 estate and wants to fund education for his two very small daughters. He and I discussed a gifting trust because excess funds can be used for other purposes later in the children's lives. The financial advisor who referred the client to me prefers 529 accounts for this purpose. The client is looking to eventually leave a fair amount to his daughters and wants divorce protection, etc., for the rest of their lives. Should I just advise him to do the 529 accounts for educational gifts and gift to a trust for other purposes? To get something set up by year end, would it be possible to simply advise the client to establish a 529 account for each of his children and then later transfer the account to a Crummey trust?
Your year-end solution--to establish a 529 account for the beneficiary and then, after there is time to draft and sign a Crummey Trust for the beneficiary, to change the account owner from the client to the Crummey Trust--is clever, but it would have had some risk. (For a description of Crummey Trusts, see my September 2009 column.)
The designated beneficiary of the 529 account would remain the same; only the account owner would change. Internal Revenue Code section 529 does not impose gift tax on a change of account owner and the Advance Notice of Proposed Rulemaking does not contain any such proposal. Nonetheless, some 529 plans may prohibit changes of account owners except under limited circumstances or may report a change of account owner as a nonqualified distribution, leaving it to the taxpayer to explain to the IRS why the transaction should not be taxable. Therefore, it is advisable to consult the plan manager on its policies before changing the account owner.
The Advance Notice, however, proposes that in determining the amount of earnings subject to income tax and penalty on a nonqualified distribution, only contributions made by the account owner should be treated as capital contributions or basis. If this rule went into effect, any contributions made by the client prior to changing the account owner to the trust would be ignored, thus causing them to be subject to income tax and the penalty tax if a nonqualified distribution were later made. This proposed rule would not impact qualified distributions.
Further, the Advance Notice proposes that trusts not be allowed to be account owners. If this rule went into effect, it would be prospective only, and it is unclear how 529 accounts that already had trusts as account owners would be treated.
With respect to your more general question of whether to use 529 accounts or Crummey Trusts for annual exclusion gifts to minors, I would limit gifts to 529 accounts only to the amount that the client is fairly certain will be used for higher education, taking into account that the client (or a grandparent) may wish to directly pay tuition under 2503(e) as a tax-free gift to reduce his or her estate for estate tax purposes. The remainder of the annual exclusion gifts could go into Crummey Trusts.
Gifts to Crummey Trusts qualify for the gift tax annual exclusion, but the trusts do not need to distribute to the beneficiary at any particular age. Thus the assets could remain in trust for the beneficiary's entire life, subject to the Trustee's power to make discretionary distributions to the beneficiary. In most states this would protect the trust assets from being distributed to the other spouse in a divorce, although a divorce court might take into account the trust assets in dividing marital property (in a state in which the court has discretion in dividing marital property) and in setting maintenance or child support payments.
The degree of protection from creditors of the beneficiary will depend upon the applicable state law. In some states the trust assets will be protected from the beneficiary's creditors, especially if the trust contains a "spendthrift provision." Other states may not protect the trust assets from the beneficiary's creditors on the theory that a Crummey Trust is akin to a self-settled trust because the beneficiary had a right to withdraw the trust assets when contributed. Traditionally, trusts created by a settlor for the settlor's own benefit (a "self-settled trust") are not protected from the settlor's creditors.