Uniform Transfer to Minors Accounts- Protecting Required Distributions Part II

Take-Away: When the minor nears the age 21 years and is entitled to receive the balance of his/her Uniform Transfer to Minors Act (UTMA) account, the parents of the minor, or the UTMA custodian, can take a few steps to try to control the assets before the reach the minor’s hands, but none of these steps is all that helpful to preserve the assets.

Background: In Part I,  the basics of a UTMA account were covered, including the impact of the 2107 Tax Act that taxes the UTMA as an irrevocable trust for income tax reporting purposes. This Part II addresses how the minor’s parents, and/or the UTMA custodian, can take some admittedly limited steps in an effort to protect the UTMA asset that are about ready to be distributed to the minor upon attaining age 21 years. Some steps are pretty obvious, some steps are close to Machiavellian.

1. Spend Down the UTMA Before Distributions: Spending down the UMTA balance before the minor is 21  is pretty obvious. This is superficially attractive, considering that the original purpose of the UTMA presumably is to accumulate wealth for a beneficiary’s use. This may also not prove to be effective in light of the amount held in the UTMA. Example: Grandparents, who reside in Florida, each year on their grandchild’s birthday starting with birth, transfer the federal gift tax annual exclusion amount to a UTMA for their grandchild. Over the 18 years the grandparents would have transferred $222,000 to the UTMA which, if growing at 5% a year would result in the grandchild’s UTMA worth $354,000 when the grandchild attained age 18. Spending down $354,000 just to avoid those funds reaching the grandchild’s hands is problematic to say the least.
2. Use an LLC ‘Wrapper’ for the UTMA Assets: The custodian could transfer the UTMA assets to an LLC or family limited partnership just prior to the minor attaining age 21. The stated purpose of using the LLC is to protect the distribution from the minor’s creditors or future creditors. The parents might even contribute some of their own assets to the family LLC with the goal of accessing better investment opportunities. The upshot is that the UTMA does distribute its assets to the minor, but the minor receives unmarketable LLC units and not cash or investible assets. The LLC ‘wrapper’ also makes sense if the minor is planning on a marriage, as it will segregate the UTMA assets from other marital assets, and is easily classified as the minor’s separate property in the event of a future divorce. The statutory redemption rights of a member’s LLC interest will have to be addressed in the LLC’s Operating Agreement. In sum, the decision to use an LLC wrapper will have to be well documented to withstand a challenge by the minor when they receive ‘only’ LLC membership interests upon reaching age 21 years,  along with some ‘light at the end of the tunnel’ e.g. a ‘put’ right to the LLC after 5 years.
3. Purchase an Illiquid Asset with the UTMA: The UTMA custodian possesses great latitude in the type of assets in which it can invest. Accordingly, the custodian could invest the UTMA assets in a life insurance policy or an annuity that is illiquid and which carries large surrender charges.  But the risk is that the minor may not be nearly as concerned about surrender charges or the income tax consequences of terminating the annuity or insurance policy as is the custodian. Most 21 year olds will look at the asset as ‘free money’ despite the form in which it comes into their hands.
4. Convert the UTMA to a 529 Account:  Since the transfers to the UTMA were completed gifts by the donor, there should be no additional gift tax imposed if the custodian uses the UTMA assets to fund a 529 account. But there are problems with this approach. First, 529 accounts take only cash, so the UTMA would have to liquidate its investments, and probably incur some capital gains, in going to cash which is then used to fund the 529 account. Moreover, the use of 529 accounts are far more restricted [used towards ‘higher education expenses’] than for what UTMA assets can be used. Moreover, the custodial 529 account must still be paid out to the account beneficiary at the age of majority that was used in the UTMA account.
5. Convert the UTMA to a ‘Minor’s Trust’: A few state statutes, e.g. Florida and Illinois, permit the UTMA custodian to transfer the UTMA assets to an IRC 2503(c) minor’s trust. With a minor’s trust, distribution can be extended beyond age 21 years if the minor is given notice of a right to withdraw all assets held in the trust 30 days prior to attaining age 21 years. If the minor does not timely exercise that right of withdrawal in that ‘window period’ then the assets remain in the minor’s trust until a much later age, e.g. age 25 or 30. Usually with a minor’s trust the minor is given the right to all income generated by the trust during that ‘extended’ term of the trust which might induce the minor to not exercise his/her withdrawal right, but the principal is protected with a spendthrift provision added to the trust. Other states, e.g. New York, require that the minor’s written permission be obtained before the UTMA assets can be rolled into a minor’s trust. Why a minor would agree to extend the UTMA through a minor’s trust is the question, but if a parent or grandparent added assets to the trust as ‘sweetener’ then the minor might go along with this delay, knowing that they would receive all income not only from the original UTMA assets but also the additional ‘sweetener’ added to the trust corpus.
6. Distribute UTMA Assets to a Revocable Trust: Since the minor is over the age of 18 and nearing the age of 21, the minor can create his/her own revocable grantor trust as part of their estate plan. The UTMA custodian could then distribute the UTMA assets directly to that trust. The trust would be revocable in name only, because the revocation of the trust could be conditioned upon the consent of a third party like a parent, which essentially makes the trust irrevocable from the settlor-beneficiary’s perspective. Or, the trust could contain a trust protector provision with the power to suspend the settlor’s right of revocation and withdrawal rights for a period of time on certain events, creating the illusion of a revocable trust which is swiftly be converted to an irrevocable trust.
7. Think Ahead- Use Another State’s UTMA: As noted earlier, Ohio and California permit a UTMA account to be extended until the minor attains the age 25 years. Other states, like Florida, permit the custodian to notify the minor of the custodian’s intent to extend the UTMA beyond age 21 years; the minor is give the right to withdraw the UTMA funds 30 days prior to attaining age 21, and if that ‘window period’ comes and goes, then the assets remain held in the UTMA until the later age that the UTMA custodian identified in the notice to the minor. Michigan’s UTMA statute is not as flexible as these other states, so looking ahead to the place where the UTMA is initially created makes a lot of sense, especially if the long-term goal is to simply let the assets grow inside the UTMA as a wealth accumulation device for the minor.
8. Enter into a Contract with the ‘Adult’ Beneficiary: The UTMA assets could be distributed to the minor. The minor, now an adult and able to enter into a contract, could then contract with the custodian to manage the distributed UTMA assets. The minor could give to the custodian an irrevocable durable power of attorney for a period of time, e.g. 5 years, to manage the distributed assets, and any distribution from the managed account would require the consent of both the minor and the custodian. This might protect the distributed assets from the minor being prone to peer pressure, and would also permit the custodian to mentor the minor on investment strategies and budgeting. If the minor was asked to sign a contract and durable power of attorney, it would also be the time to have the minor sign a Will (to avoid intestacy) and health care directive- all part of acting like a responsible adult who owns wealth. The risk, of course, is that the minor suggests that the custodian ‘go jump in the lake.’
9. Distribute UTMA Assets to an Irrevocable Trust: The parents could create for their child an irrevocable trust and then ask the child to transfer the distributed UTMA assets to the irrevocable trust, of which the parent is the trustee. Why the minor would agree to this would depend upon several factors, including the terms of the trust, e.g. the child’s right to all income, when the trust terminated, e.g. upon the child attaining age 30 years so the delay is not oppressively long,  and if the parents committed to add assets of their own to the trust corpus.
10. Parental Persuasion: The obvious rhetorical question is why would a teenager, or a young adult go along with any of these ideas, like forming a trust controlled by another, not exercising a right of withdrawal in a 30-day ‘window period’ or agree to give complete control over ‘their’ assets to another person.  After all, the UTMA assets are theirs, with no controls and no restrictions, so why give away something that you already have? Parents, however, have a remarkable ability to direct and control the decisions of their children. In short, parents always have financial leverage. They can either induce their child’s compliance with one of these strategies by the positive act of adding even ‘more money to the pot’ that someday will be available to their child, or they can use the negative by reminding their child that they, his/her parents, control his/her ultimate inheritance- in other words, ‘disappoint us to day, and expect to be disappointed some day into the future.’

The “Good Old Days’: Long ago I worked with a client who had created a ‘too successful’ UTGA account at a local bank for a son. The client-father had divorced the son’s mother, a highly contentious and nasty divorce, and the son continued to live with his mother. The UTMA created for the son was worth about $300,000 as the son approached age 18 (it was a UTGA account when that was the age of required distribution.) The client was obsessed that if his son got his hands on the $300,000 he would turn it over to his mother, and she would promptly spend it on herself and not her son. So a practical solution was followed. The client was a very large customer of the bank where the UTMA was located, and the trust department tacitly agreed to turn a blind eye and agreed to follow the client’s directions associated with the UTGA since the client had obtained from his 18 year old son a durable power of attorney. The client told his son that he would pay all of his son’s income taxes while the son attended college which the client agreed to pay for (not depleting the UTMA for that purpose). Which practical, but not legal, approach occurred over the course of several years. The son liked downhill skiing so he attended (at his father’s expense) the University of Utah but proceeded to spend 6 years before finally getting his degree after all that free time on the slopes. All six years the father completed, signed, and filed income tax returns reporting the income that the UTMA generated. After the son graduated and started a job on the west coast, the father finally got around to telling his son about the UTGA account that had been maintained at the local bank for over 24 years. The distribution to the son when the funds were finally released was about $400,000. Those were the good old days when custodians turned a blind eye to the age of distribution, adopting a ‘what the child does not know if probably good for the child.’ These days regulators have told financial institutions that they can no longer permit a custodian to turn a ‘blind eye’ to when a beneficiary reaches the age of distribution from a UTMA. In fact, in a couple of reported situations, when parents have strong-armed the banks where the UTMA is located to look the other way when the child attains age 21, the regulators have required the institution to put a freeze on the UTMA until the minor is give legal notice of the right to withdraw the balance of the UTMA account.

Conclusion: The days of ‘ignorance is bliss’ when a child reaches majority and possesses the right to all of the assets held in a UTMA account are over. But there are ways, working with the minor, to extend the control over the assets accumulated in the UTMA account. Probably the best approach, all things considered, is a combination of parental persuasion with the use of an LLC ‘wrapper.’