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You can use a custodial account for support, and doing so won't necessarily create a tax problem.
A custodial account under the Uniform Transfers to Minors Act can be used to pay expenditures for the benefit of the child. It's frequently said, incorrectly, that the expenditures cannot be for something that is included in a parent's support obligation. The Uniform Act plainly says exactly the opposite:
A custodian may deliver or pay to the minor or expend for the minor's benefit so much of the custodial property as the custodian considers advisable for the use and benefit of the minor, without court order and without regard to (i) the duty or ability of the custodian personally or of any other person to support the minor, or (ii) any other income or property of the minor which may be applicable or available for that purpose.
It says the expenditure is proper without regard to a duty to support the minor. In other words, even if someone (including the custodian) has a duty to support the minor, the custodian can go ahead an make the expenditure, provided that it's for the benefit of the child. You can read in many places on the Internet and elsewhere that a custodial account cannot be used to pay for items that are within the parent's support obligation, but the language quoted above from the Uniform Act makes it clear that those statements are not literally correct. Perhaps what they mean is that you shouldn't do this because of the tax issue described below.
Note: The issue we are discussing involves the use of the custodial account to pay for things like food and shelter that are part of the parent's support obligation. We are not discussing the use of these accounts to make child support payments after a divorce. In my view, those payments are not a proper use of a custodial account.
IRS rulings on custodial accounts create a concern that if the account is used for expenses that are within the parents' support obligation, then the parents may have to pay additional tax. It's a gross exaggeration to suggest that these rulings mean you can't use a custodial account in this way, or even that you shouldn't use a custodial account in this way. The rulings do not in any way imply that it is improper to use custodial money for the minor's support. They simply provide a tax rule that applies when this happens. In most cases, the tax rule will not be terribly costly. Furthermore, as explained later, there is some question as to whether the rule even applies to custodial accounts under the Uniform Transfers to Minors Act.
Here is the essence of the rule, as paraphrased from Revenue Ruling 56-484:
Income derived from property transferred under the model custodian act which is used in the discharge or satisfaction, in whole or in part, of a legal obligation of any person to support or maintain a minor is, to the extent so used, taxable to such person. However, the amount of such income includible in the gross income of a person obligated to support or maintain a minor is limited by the extent of his legal obligations under local law.
Let's take a close look at what that really means.
Using the custodial account this way doesn't disqualify the account in any way. It is still a custodial account. The proper tax treatment of the account income in prior years or future years is not affected. The rule tells us how the income is treated only in the year the account is used for support.
This rule does not create any additional income that didn't exist before. It merely tells us who has to pay tax on the income generated by the custodial account. Without this rule, the income would be taxed to the minor. The rule says income that would otherwise be taxed to the minor may be taxed to the parent.
Example: You use $10,000 from a custodial account to pay for items that are within your support obligation. The only income in the account that year was $500 of interest income. The result is that the parent has to pay tax on $500 that otherwise would have been reported as the child's income.
This result may be unfortunate but it certainly won't be devastating. The tax cost of shifting $500 from your child's tax return to your tax return may be trivial compared with your need to use the $10,000 for this purpose.
For minors subject to the kiddie tax, the tax cost of this rule will never be terribly high because their investment income, beyond a limited amount, is taxed at their parents' rate in any event. (Click here for an explanation of the kiddie tax.) Now that the kiddie tax applies generally up to age 18 and to many minors up to age 24, it is rarely the case that the tax cost of applying this rule would be significant.
The rule wouldn't apply to a situation where you spend money from the custodial account for something that is for the minor's benefit but not something you're legally required to provide as part of your support obligation. Unfortunately, there are differences from one state to the next as to what is considered part of a parent's support obligation, and in many states the standard is somewhat vague. Perhaps this is one reason there are very few cases where the IRS has tried to apply this rule.
The legal experts who created the Uniform Transfers to Minors Act were aware of this rule and seemed to believe it was undesirable to have the parents pay tax on this income. In their official commentary on the Act, they note that the income tax regulations say a legal obligation to support another person exists only if under local law (that is, whatever state law applies) the obligation is not affected by the dependent's own resources. Here's what that means.
The laws of some states may say that a parent has to provide the child's support even if the child has enough money to support herself. In this case, the parent would have to pay tax on income from the child's assets if that income was used to satisfy the parent's support obligation.
The laws of other states may say that if the child has enough money to cover her own support, the parent is relieved of the support obligation. In this case, income produced by the child's assets would be taxed to the child even if used to cover expenses that are normally would be considered part of a parent's support obligation.
Based on this understanding of the tax law, the drafters of the Uniform Act included provisions designed to place custodial accounts in the second category. The IRS has never ruled on this issue, so we don't know if they will accept the interpretation of the drafters of the Uniform Act. (The ruling cited earlier was issued long before the Uniform Transfers to Minors Act was created.) It's certainly possible that they would accept this approach (or that a court would rule against them if they rejected it), so at this point it isn't clear that the rule we're discussing even applies to accounts governed by UTMA. This escape hatch may not be available for accounts governed by the older law (Uniform Gifts to Minors Act), but nearly all states have replaced UGMA with UTMA.
There is another tax consequence that is seldom mentioned in connection with custodial accounts. It appears that money used from a custodial account for support items would be treated as support that was not provided by the parent, even if the parent was the original source of the money that went into the custodial account. If the result is that the parent provides less than half the child's support, the parent will not qualify for the dependency exemption.
Strictly speaking, this problem is not caused by using a custodial account to pay expenses that are part of a parent's legally obligated support. The support test that is used for purposes of the dependency exemption appears to apply to a broader definition of support, including items that may not be part of legally required support. IRS Publication 501 says: "Total support includes amounts spent to provide food, lodging, clothing, education, medical and dental care, recreation, transportation, and similar necessities."
All this fuss is over a rule that may not even apply to UTMA accounts, and usually has a relatively small tax effect even if it does apply. It would make sense to consult someone with expertise in these rules if you're in the rare situation where the tax cost of the income shifting rule would be great and you want to tap the custodial account for something that may be considered part of a support obligation. To reiterate the initial point, though, it is plainly incorrect to suggest that custodial accounts cannot be used for this purpose.
There may be situations where you have a family obligation, as opposed to a legal obligation, not to use the account this way. If you're the custodian of an account that contains money earned by the child or given by someone other than yourself, you should consider whether it is improper, even though legal, to use the account this way.
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