The many flavors of Gifting

There is more than one way to give a gift.  It is true that in most circumstances, a gift should be complete and final immediately, but there are situations where it may not be well advised to give the donee total, absolute control over a gift which has significant value.  An easy example is a gift of a large amount of cash (say, $100,000) to a spend­thrift child.  Here, clearly, the risk is that the child will fritter the money away in a short time and end up just as before with nothing to show for it, other than maybe a hangover (or several).  Thus, it is useful to have handy an array of gifting options which, in one way or another, delay or regulate the distribution of the gift to the donee.  The purpose of this paper is to highlight these options and some of the situations to which they might be applied.

First, however, it is important to review, for the sake of clarity, the accounting fund­amentals relating to “income” and “principal.”  “Principal” in accounting terms is the original corpus (or body) of the gift; for instance: a check for $100,000; a stock certificate for 100 shares of IBM common stock; or a parcel of land an acre in size with a house on it.  “In­come,” on the other hand, are the “fruits” of that principal: the interest paid yearly on a bond or on a CD or savings account; the dividends paid quarterly by IBM; or the rent paid by the tenant who lives in the house on the acre of land.  In the branch of an accounting that deals with principal and income in trusts and estates, income is recorded and accounted for entirely separate from principal.  Similarly, from a tax point of view, the gift of “principal” may generate a one-time gift tax, but the annual “income” will, each year (unless it’s tax exempt income) incur the require­ment of a report and payment of income tax to the tax authorities.  Thus, it is important to differentiate between the two and to note the tax effects of each when deciding how one is going to structure a gift.

You have probably already guessed from the hints in the foregoing paragraph, that any gift postponed will consist of some form of structuring of how the income and/or the principal are distributed over time.  It should be noted that the usual vehicle for structur­ing such a gift is a “trust” which is usually a written document or contract between the giver of the gift (the “donor”) and the “trustee.”  This document sets out the rules and conditions under which the gift is to be transferred and then administered for the benefit of the “beneficiary,” the person whom the donor wishes to benefit.

The best way to approach the structuring of such a gift is to first determine how the principal is going to be distributed and then look to the administration of the income during the period between the transfer of the property to the trustee and the final distribu­tion of the principal of the trust to the beneficiary.  One approach to the distribution of principal is to require distribution, on specific dates, of a fraction of the total (say 1/3) or a sum certain (say $50,000).   Such distributions might also be predicated upon the occurrence of a specific event, such as gradua­tion from college or birth of first child.  Or, distributions can occur based on the age of the beneficiary.  For example: “Distribute one-half of the principal when the beneficiary reaches age 35 and the balance when the beneficiary reaches age 50.” 

Another option is to postpone any distribution of principal until after the death of the beneficiary, at which time the gift could either be held in further trust for someone else, or distributed to the beneficiary’s descendants, or transferred to the beneficiary’s estate for distribution as he or she may direct. 

It should be noted that rigid distribution requirements such as those described above can be ameliorated some­what by a provision allowing the trustee to distribute additional principal for certain specific reasons (to build a house, to start a business, in case of major medical need) during the benefi­ciary’s lifetime.  Another option is to allow the beneficiary to withdraw a portion of the principal.  One often-used option is to give the beneficiary the right to withdraw the greater of $5,000.00 or 5% of the value of the trust.  This is called a “five and five power.”  Its popularity stems from the fact that IRS rules provide that such a power does not require the inclusion of the principal of the trust in the estate of the beneficiary.  This allows for some flexibility while avoiding poten­tially adverse tax consequences (which result when the benefi­ciary is given too much control over the trust property). 

Having determined how the principal of the gift is to be distributed, one must then turn to dealing with the income stream that will arise out of the invested principal.  Thus, if there is a gift of 100 shares of IBM to the trust and the distribu­tion of the stock is postponed to some day in the future, there will be a stream of quarterly dividends which either need to be distributed to the beneficiary or retained in the trust.  Here is where the income tax makes for a difficult decision.  Congress, in its infinite wisdom, has estab­lished a very com­pressed tax “ladder” for trusts that retain “ordinary” income (dividends and interest).  Whereas an individual taxpayer filing jointly with their spouse would be required to pay tax at the maximum income tax rate (in 2007) of 35% when their joint income reaches $336,550, a trust which retains its income reaches the same tax bracket when the retained income totals $10,450.  Clearly, Congress has created a significant bias towards forcing trusts to disgorge their income.  Thus the usual trust income provision is to require that the trustee pay out the net (after expenses) income to the beneficiary annually.  The trust gets a “deduction” for the distribution and therefore pays no tax.  The benefi­ciary bears the burden of the income tax at (presumably) a much lower rate than would otherwise be the case in the trust. 

In the case of a gift placed in trust for the benefit of a minor child, the income is usually retained in the trust despite the tax burden because the overall purpose of the trust is to retain income and grow the principal.  A minor children’s trust (sometimes called Section 2503(c) trusts) has three functions: (1) to allow significant gifting (up to the $12,000 annual exclusion limit - 2007) by parents/grandparents (or others) without the need for a guardian­ship (2) to provide a pro­tected reserve for the child in the event the parents fall on hard times and (3) to provide a nest egg for the child to start out on after becoming an adult.

A variation on the strict income and principal distribution patterns noted above is what is called a “uni­trust” approach.  It is the result, in part, of the unprecedented boom in stock market values that has occurred over the past decade. 

A little history is in order.  Back in the “old days,” common stocks were con­sidered very risky (and they were and are!).  There was little regulation, little information, and a lot of fraud.  As a consequence, a trustee who invested in common stocks was risking a lawsuit for mismanage­ment.  In some jurisdictions, only the bonds issued by a limited number of com­panies which had passed muster and were approved by statute were deemed safe enough for investment of trust funds.  The pendulum has, of course, shifted, and today, many view the risk of invest­ment in common stocks as minimal.  That may or may not be the case.  More impor­tantly, common stocks are generally viewed as “growth” vehicles and only minimally as income producers.  As a conse­quence, a trust which provides only for the distribution of income to a beneficiary and which is fully invested in common stocks will generate substantially less income than would have been the case had the investments been allocated partially or completely to interest-paying debt instrument (corporate or government bonds).  To ameliorate the paucity of income from common stocks and to allow the trustee to focus on maximizing growth by investing in common stocks, a unitrust approach to income distribution has been devised.  In its simplest form, this system requires that the trust be valued at the beginning of the year, and that a certain percentage of that value be paid out as “income” to the beneficiary, regardless of whether or not that amount was actually generated as dividends or interest by the investments held by the trust.  In other words, in all likelihood, a certain amount of the principal “growth” (appreciation in stock values) that occurs during the year will be peeled off and paid out as “income” to the benefi­ciary.  The selection of the “unitrust amount,” that is, the percentage of the value of the trust to be paid out, is crucial.  By setting the unitrust percentage too high, one can easily distribute all of the income and all of the growth, thereby leaving the principal of the trust, at the end of the year, very close to where it was at the beginning of the year, thus negating the whole purpose of investing in common stocks: the growth of the principal over time.  There is a general consensus that a unitrust amount of 4% or 5% is reasonable in today’s market.

In conclusion, it should be noted that one can easily get wrapped up in the technicalities of income and principal distributions and lose sight of the objective which is to take care of the beneficiary while preserving the gift.  By first deciding what would be best for the beneficiary, one can then craft the income and principal distribution rules to achieve that objective.