Alternatives for Financing Education: Section 2503(c) Trusts and Crummey Trusts
In our previous edition of alternatives for financing education, we discussed outright gifts as well as Section 2503(e) gifts. In this edition, we'll talk about Section 2503(c) Trusts and Crummey Trusts.
Section 2503(c) Trusts
For parents who wish to establish a trust account for a child’s education in a way that will not generate any gift tax consequences, there are two alternatives. The first is a so-called “2503(c) trust.” Section 2503(c) of the Internal Revenue Code specifically allows a trust to be established for a child under age 21 which will qualify for annual exclusion treatment.
The parent can retain complete control of the trust property, at least until the child reaches age 21. There is no need for “Crummey” withdrawal notices (discussed below) and, to the extent the trust is maintained for college costs only, virtually all the trust assets may be gone by the time the beneficiary attains age 21.
The biggest drawback is that upon the child reaching age 21, the trust must terminate and the remaining assets must be distributed outright to the beneficiary. So, if the trust is intended to hold more than college funds, this technique may be less attractive since the beneficiary will have complete control upon attaining age 21. A common technique for extending the term after the beneficiary attains age 21 is to give the beneficiary a short period of time after reaching age 21 (perhaps 60 days) during which she has the unrestricted right to withdraw the remaining trust funds. If the funds are not withdrawn, the assets can be continued in trust. The other big disadvantage is income tax – the earnings on the trust assets are taxed at trust income tax rates (with highly compressed tax brackets) to the extent that the earnings are not distributed to the beneficiary.
One of the most famous names in estate planning is Crummey, from the 1968 case in the U.S. Court of Appeals (Crummey v. Commissioner, 397 F.2nd 82 (Ninth Circuit 1968)), which established a technique for transferring assets to a trust while receiving annual exclusion treatment. Essentially, a gift is made to a trust on behalf of a beneficiary. Immediately following the gift, notice of the gift is given to the beneficiary (or the non-donor parent of a minor beneficiary) and the beneficiary is given a period of time during which the gift may be withdrawn from the trust. When the withdrawal period ends, the gifted amount irrevocably becomes the property of the trust. Crummey confirmed that the withdrawal period creates a present interest in the gifted amount so that the gift qualifies for the annual exclusion.
There are few restrictions on the design of a Crummey trust. Once the contribution and withdrawal language is set, the trust can be designed in a multitude of ways. There is no mandatory right to trust income, nor is there a mandatory distribution of trust principal at age 21 as required by the 2503(c) trust or UTMA. Although income distributions are not required to be made, the income of the trust can be taxed to the beneficiary. The lapse of the withdrawal right is generally believed to cause the beneficiary to become a grantor of the trust and accordingly, the income will be taxed to him or her. This is a desirable result after the child attains age 19 and presumably, is in a low income tax bracket.
The administrative burdens of documenting gifts and withdrawal notices can be significant and confusing. You inevitably face the dilemma of dealing with a beneficiary who inquires about distribution of the amount over which he or she holds a withdrawal power each year when the Crummey notice is given.
We'll wrap up this series in the next edition as we cover State-Sponsored College-Savings Plans (or 529 Plans).