Considerable opportunity exists, but features of the gift tax laws do restrict your options somewhat. For example, you may have to pay gift tax if you give more than $10,000 ($20,000 if community property or through a split gift with your spouse) to a person in one year. You may be able to make tax-free gifts in excess of the $10,000/$20,000 annual exclusion amount for certain types of educational and medical expenses.

The following discussion illustrates these and other considerations in the context of financing the education of children or grandchildren. Note, however, that the principles identified here apply similarly to the support of a parent or other family members and, in those cases, without the additional tax consequences that apply to income of children under the age of 14.

It is crucial to note at the outset that the approaches discussed here are effective only if the income generated by the transfer is used for purposes for which you have no legal obligation. College or graduate school education for children and general financial support for a parent have typically not been considered legal obligations, although some state laws have been interpreted to the contrary by the courts. Because of the potential variation in interpretations under state law, you should seek the advice of your attorney in this regard.

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Children are taxpayers in their own right for any income they earn and for their investment income. Once they reach the age of fourteen, their separate tax status may permit a significant amount of investment income to be taxed at rates that may be significantly below the rates that apply to their parents.

Special rules apply for taxation of children’s investment income while they are under age 14. The general structure of taxation for children who are 13 years old and younger (at the end of the tax year) and have a parent living at the end of the tax year can be summarized as follows:

• A dependent child is allowed to receive an inflation-adjusted amount of unearned income ($700 in 2000) without paying any tax, as long as the child does not have any earned income.
  
  
• The child’s taxable earned income and an amount of unearned income equal to the applicable standard deduction ($700 in 2000) are taxed to the child at the child’s marginal tax rate.
  
  
• The balance of unearned income is taxed to the child as if it were the parents’ income. The tax is calculated by determining what the parents’ tax would be if the child’s net unearned income were added to the parents’ taxable income. As a result, some of the child’s income may be subject to tax at rates as high as 39.6 percent.

If the child’s parents do not file a joint return, additional rules determine which parent’s tax rate applies. If the parents are divorced, it is generally the custodial parent’s rate that is used. For 2000, parents may elect to include their child’s income on their return if the child’s income is between $700 and $7,000 and consists solely of interest and dividend income. If the parents make this election, the child is treated as having no gross income and therefore is not required to file a return. Beginning in the tax year in which the child reaches age 14, these restrictive provisions no longer apply.

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You can make gifts of income-producing property in a number of ways. The first that you should consider is a gift of cash, funded from annual cash flow. Such a transfer benefits you to the extent that the after-tax return that your children or grandchildren could earn on such funds over time exceeds the after-tax return that you could earn yourself.

An alternative is to transfer appreciated property, such as common stock, to your children or grandchildren. The appreciated stock could be held or liquidated and reinvested to generate a greater after-tax return for the children than it would for you. Moreover, the appreciation itself could be subject to less tax in their hands. (Keep in mind, however, that by making such gifts you have forfeited the tax-free step-up in basis available at your death.)

You generally would not want to give away property that is now worth less than your basis in the property, because the tax laws do not permit the unrealized loss to be passed through to the child. And you probably would not want to give a child property that requires ongoing management or that involves carrying costs, such as real estate.

Another point to consider is when the money will be needed. Any strategy involving a gift of cash (or other property converted to cash after the transfer) anticipates that the cash will be invested and produce income. The tax benefits that are the core of the gift program result only from the lower taxes on the child’s income as compared with the parents’ as time goes on. By its nature, a cash gift, then, is a medium- to long-term strategy lasting three or more years. Nevertheless, you can get a small advantage from funding a child’s current year’s education with cash gifts, such as making the gift in January for a September tuition payment.

On the other hand, a gift of appreciated property already contains an element of potential tax advantage (the appreciation, on which you would pay more tax than the child would pay). Consequently, a gift of appreciated property can be ideal for a short-range or even an immediate educational financing need.

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For this general income-shifting approach to be effective, the income-producing property must legally belong to the child. If making an outright gift directly to a child or grandchild is not appropriate, you can use one of several custodial or trust arrangements.

• Gifts Under the Uniform Gifts/Transfers to Minors Acts: To provide a way of making gifts to minors efficiently, most states have enacted either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). Gifts made under these statutes are treated as completed transfers for purposes of property tax, income tax, and gift tax laws.
  
  Under the UGMA/UTMA, the donor transfers cash or property to a custodian to hold, invest, reinvest, accumulate, or spend for the benefit of a designated minor beneficiary. Although the custodian has complete control over the property, limited only by the obligation of prudent management, the property belongs to the minor and may not be used for anyone else. The custodial property will be held and used for the benefit of the minor beneficiary until the beneficiary reaches an age specified in the state’s UGMA/UTMA, typically either 18 or 21, although in some cases it can be extended to age 25. The unexpended balance must be turned over to the beneficiary at the specified age or, if the beneficiary dies before reaching that age, to the beneficiary’s estate.
  
  The donor can act as custodian. However, it is generally advisable to appoint someone other than the donor to avoid having the trust’s assets included in the donor’s estate (if the donor dies while the custodial account is in place). The donor’s spouse is an ideal candidate, provided that the assets transferred were the separate property of the donor.
  
  
• Minor's Trust: The federal gift tax law permits certain gifts to a minor in trust to qualify for the $10,000 (or $20,000 split gift) annual gift tax exclusion even though the beneficiary’s right to use the gift is postponed until age 21. For the gift to qualify for the annual exclusion, the principal and income of the trust must be available for the child’s benefit during its term, at the trustee’s sole discretion, for the purposes specified in the trust document. In addition, the beneficiary must have the right to a full distribution of all income and principal at age 21. If the child does not choose full distribution after his or her 21st birthday, the trust may be continued for an additional period specified in the trust. This last feature can be especially attractive if your state, under its UGMA/UTMA arrangement, gives the beneficiary a right to demand distribution at age 18.
  
  If more than one child is to benefit from the trust, a separate share must be set aside for each child. A $10,000 ($20,000 split gift) annual exclusion will then be available for each child benefited by the trust.
  
  The minor’s trust can be a beneficial income-shifting technique for minors, even those under age 14. If income is accumulated in the trust for future distribution for college expenses, for example, the income is taxed to the trust. The trust will be taxed at the tax rates in Table 8-1.
  
  

  Table 8-1 Tax Rates for Trusts in 2000
  Trust Income	Tax Rate (%)
  Up to $1,750	15%
  $1,750 to $4,150	28%
  $4,150 to $6,300	31%
  $6,300 to $8,650	36%
  Greater than $8,650	39.6%

  
  These tax brackets are highly compressed; that is, you reach the maximum bracket at a low dollar level, when the trust’s taxable ordinary income reaches only $8,650. Thus, trusts will shelter only limited amounts of income at low tax rates. From a tax perspective, if the beneficiary would pay tax at a lower rate than the trust, you may want to consider accelerating some distributions. Any distribution could be deposited into a UGMA/UTMA custodian account until it must be spent or distributed to the beneficiary. Or you may want to consider investing in assets that you expect to appreciate but that will produce little current income (such as growth stocks) or in assets whose income is deferred (such as Series EE bonds) or exempt (such as municipal bonds) and then selling these assets when it is time to pay the child’s expenses.
  
  The donor may serve as trustee, but this is generally not advisable. A donor/ trustee’s powers must be specifically limited to management of the assets, and a separate cotrustee must have the power to control distributions or accumulations. If the donor/trustee fails to comply with these guidelines, and the donor dies while the trust is in force, the trust property will be included in the donor’s estate.
  
  There are other types of trusts that may be appropriate in your situation and should be explored with your advisers.

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Post-Transfer Investment Strategies

In most cases, the major investment factor in planning to prefund children’s education is the safety of principal. Because these funds are invested to cover expenses in the future, you should have considerable certainty that the amount invested will be available when the expenses arise. If the funds were invested in high-quality bonds or in savings certificates maturing at the time of the obligation, you could expect to have sufficient funds to cover the expenses. Therefore, these two types of fixed-income investment are especially appropriate when the expense is in the relative near term. Equity portfolios, which are subject to substantial short-term fluctuations in value, are generally only appropriate for longer-term prefunding.

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Below-Market-Rate Loans

You may shift investment income or provide financial assistance to family members through the use of below-market-interest-rate loans. This is a way of assisting your child with educational costs or a home purchase without making an outright gift.

Generally, when you make a below-market loan to a family member, the amount of interest calculated to be below the market interest rate is treated as transferred by the lender to the borrower and paid back to the lender as interest income. You will recognize interest income and the borrower may be entitled to a deduction. To avoid having to calculate and track the "imputed interest," you should charge a market rate of interest and give the cash difference (between the market and below-market rates) to the family member who would use the cash gift to pay you the market interest rate.

If you are considering making a below-market-interest-rate loan to a family member, you should consult your tax adviser to discuss the best strategy for your situation.

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Family limited partnerships (FLPs) have recently become important in tax planning because of their ability to shift income and because of the discounts that can be applied to the value of property transferred to the FLP in computing the value of the gift.

The value of a transferred interest in a family limited partnership is not determined simply as a proportionate share of the fair market value of the underlying assets. Rather, if the FLP interest is less than a majority, "minority interest" and "lack of marketability" discounts are applied, depending on the facts of the situation. Additionally, depending on the terms of the FLP, you may be able to use a valuation method other than the fair market value of the underlying assets.

Since FLPs are flow-through entities, all FLP income is taxed directly to the individual partners. To the extent that the partners (such as your children) are not in the highest tax bracket, the FLP may save income taxes as compared to the use of a trust. This advantage has become more important since the 1993 tax act, which increased the tax rates applicable to trusts (as shown in Table 8-1, above). Other benefits from the use of an FLP are:

• An FLP agreement can be modified; a trust agreement generally cannot.
• As with a trust, an FLP can be used to avoid the costs associated with out-of-state probate.
• Generally, the "Business Judgment Rule" (which applies to managing partners) is not as strict as the "Prudent Man Rule" (which applies to trustees).

An FLP is not for everyone, however. Experienced legal and tax advice is required to ensure that the FLP is recognized for both state law and tax purposes.

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Limited Liability Companies

One of the newer forms of doing business, the limited liability company (LLC), generally offers greater business, legal, and tax advantages than a regular corporation, S corporation, or general or limited partnership. A main advantage is that members can actively manage the LLC business without subjecting themselves to personal liability. Each LLC ownership interest may have various management, voting, and distribution characteristics similar to different classes of stock. Since an LLC is generally treated for tax purposes as a partnership, it also offers the use of special allocations for items of income and deduction and avoids tax at the entity level.

Use of the LLC form may present an opportunity for you to shift income to a child or family member, while retaining control and voting rights of the business.

There are many complex issues involved in the formation of an LLC. While existing partnerships may convert to the LLC form with no tax consequences, an existing C or S corporation may not convert to the LLC form unless the corporation goes through an actual or deemed taxable liquidation. It is not clear which members of an LLC may be subject to self-employment tax. Differences in the individual state statutes under which an LLC is formed may add complexity. You should contact your tax adviser to discuss the significant issues involved in setting up an LLC.

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Employing a Family Member

Employing family members to work in your business is another way to reduce the overall family tax bill by shifting income to other members of the family and providing them with employment benefits.

• Employing your Spouse. You are entitled to a business deduction for reasonable wages paid to your spouse. Since the wages will be subject to FICA taxes, these payments may qualify your spouse for certain Social Security benefits to which he or she might not otherwise be entitled. Your spouse may also be entitled to receive coverage under your business’s qualified retirement plan, and you may obtain a business deduction for health insurance premium payments made on behalf of your employed spouse. By providing your spouse with family health insurance coverage as an employee, you increase your business deductions while maintaining the same family coverage. These wages are subject to income tax.
  
  
• Employing your Child. The income tax advantages you may receive by employing your child include obtaining a business deduction for a reasonable salary paid to that child and reducing your self-employment income and tax by shifting income to the child. The salary paid to your child is considered earned income and thus is not subject to the rules that apply to children under age 14. As earned income, the maximum standard deduction available to your child in 2000 is $4,400. Therefore, if you pay your child $4,400 in compensation, the standard deduction eliminates all tax on this income. If your business is unincorporated, wages paid to your child under age 18 are not subject to social security taxes. In addition to the significant income tax advantages of employing your child, you may be able to provide him or her with fringe benefits such as group-term life insurance and qualified pension plan contributions.
  
  Your child may also make deductible contributions to an IRA of the lesser of earned income or $2,000. These contributions can offset earned and unearned income. Therefore, combining the IRA deduction with the standard deduction, your child could receive $6,400 gross income ($4,400 earned and $2,000 unearned) and pay no tax. If your child does not want to use his or her earned income to fund an IRA contribution, you should consider giving him or her $2,000 to do so (as part of your $10,000/$20,000 annual exclusion gift).

It is important to remember that, if you employ a family member in your business, you must make certain that the wages are reasonable for the work performed and that the services performed are necessary to the business.

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Generation-Skipping Transfer Tax

One way to preserve your family wealth is to decrease the number of times assets are subject to transfer (estate or gift) tax. Skipping a generation by transferring property to your grandchildren or great-grandchildren is a way to avoid estate taxes upon your death and your children’s deaths.

However, you may be subject to the generation-skipping transfer tax if significant assets are passed through generations without each generation paying an estate tax. Generally, a $1.03 million exemption is available to each donor for generation-skipping transfers of assets. If you are planning on transferring assets to grandchildren, you should contact your tax adviser.

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