Using trusts to shift income to children

Shifting assets and the related income to minors on a regular and recurring basis can be an effective income and estate planning technique. Despite the tax benefits of transferring property to children, parents may be reluctant to give up control of a substantial amount of assets. Thus, parents normally do not make sizable outright gifts to their minor children because they do not want them to have unrestricted access to the property. Instead, both transfers in trust and custodial accounts are commonly used to accomplish the property transfer (and related income shifting), while allowing the parents to maintain control of the property (at least until the child reaches majority).

Using a Sec. 2503(c) trust

The Sec. 2503(c) trust (or minor’s trust) should be considered as a possible tool in education planning. However, the practitioner should be aware that the compressed trust income tax rate structure (graduated rates beginning with a 10% rate on the first $2,600 of taxable income and increasing to a maximum rate of 37% on taxable income over $12,750 (for 2019)) not only curtails the overall tax savings but essentially penalizes trusts that accumulate income. As income accumulation is one of the features of a Sec. 2503(c) trust, the usefulness of the trust has been diminished. However, a transfer to a Sec. 2503(c) trust ensures that the child will not have access to trust assets until he or she is at least age 21.

A Sec. 2503(c) trust is a trust that complies with the requirements of Sec. 2503(c), which grants an exception to the general rule that only gifts of a present interest qualify for the annual $15,000 gift tax exclusion (for 2019) ($30,000 if gift-splitting is elected). Generally, a trust qualifies if (1) the trustee has the power to expend the trust property and income for the child’s benefit until the child attains age 21; (2) the child must receive the trust property at age 21; and (3) the trust property must go to the child’s estate (or as the child appoints in a testamentary power) in the event of the child’s death before age 21.

The Sec. 2503(c) trust is diagrammed below.

Caution: The courts, regulations, and revenue rulings have interpreted and amplified the statutory requirements of a Sec. 2503(c) trust. For example, to qualify for the annual gift tax exclusion, the trustee’s powers must not be substantially restricted (Regs. Sec. 25.2503-4(b)(1)). Thus, the trustee must be given broad discretionary powers concerning distributions to the minor before age 21. In the context of education planning, this means the trust instrument should not limit the trustee to distributions only for education purposes or to mandatory accumulation to a specific age. Also, if a donor names himself trustee of a Sec. 2503(c) trust, the discretionary power to control distributions (i.e., the “beneficial enjoyment of the property”) would cause the property to be included in his gross estate under Secs. 2036 and 2038. In this situation, the trust may also be treated as a grantor trust for income tax purposes.

As previously mentioned, Sec. 2503(c) requires that the child receive the trust property at age 21. This raises a practical issue — in some cases, the parents do not want to make large amounts available to their child at age 21. In that case, if the trust instrument gives the beneficiary the power to extend the term of the trust, the exercise of that power will not cause the trust to fail to qualify under Sec. 2503(c); i.e., such a provision will not negate the opportunity to benefit from the annual exclusion with respect to gifts to the trust. The power may be a continuing right or a right for a limited period (e.g., 30 days after the 21st birthday) to demand distribution. If the right is not exercised, the trust continues to a later age in accordance with the terms of the trust instrument.

If the trust is extended beyond the child’s 21st birthday, it becomes a grantor trust to the child during the extension period. Thus, the beneficiary should treat all transactions within the trust as his or her own for income tax purposes.

Another alternative to avoid distribution of the trust assets to the beneficiary at age 21 is to structure the trust so that the gift of the income interest qualifies for the annual exclusion while the gift of principal does not. In this situation, the trust instrument must require distribution of the income interest at age 21. The trust principal can remain in the trust for distribution after the child attains age 21 or can be redirected to other beneficiaries. In this arrangement, the assets transferred into the trust should produce income and be susceptible to valuation.

The practical benefit of the Sec. 2503(c) trust is as an alternative to a Uniform Gifts to Minors Act/Uniform Transfers to Minors Act (UGMA/UTMA) gifting program. Property in an UGMA/UTMA account must be delivered to the child at the age specified in the state’s UGMA/UTMA statute, typically age 21, but potentially age 18. The Sec. 2503(c) trust defers the required distribution until at least age 21. In many cases, by age 21, the bulk of the funds in the trust may have been expended for college costs.

Another benefit of a Sec. 2503(c) trust is that it is more flexible than one created under an UGMA/UTMA statute. For example, the trust instrument can grant or withhold specific administrative powers, and the grantor can include in the trust instrument a list of successor trustees or direct that multiple trustees act together. On the other hand, the UGMA/UTMA custodian is uniformly governed by the requirements in the state’s UGMA/UTMA statute. The minor’s trust also offers the opportunity to combine separate trusts for administration purposes.

Sec. 2503(c) trusts also have disadvantages, which include the following:

• The cost of establishing and maintaining a Sec. 2503(c) trust will be more than the cost of an UGMA/UTMA account (e.g., costs of drafting the trust instrument and preparing annual tax returns);
• The Sec. 2503(c) trust has one beneficiary, and the assets in the trust are irrevocably his or hers (i.e., the assets cannot be redirected to another beneficiary);
• Because the trust is irrevocable, the grantor gives up total control of the assets;
• The trust income tax rates may penalize those trusts that accumulate income; and
• The assets of a Sec. 2503(c) trust can adversely affect the beneficiary’s college financial aid eligibility regardless of whether distributions are being made.

Note that a Crummey trust may be preferable to a Sec. 2503(c) trust or an UGMA/UTMA account. Under Crummey, 397 F.2d 82 (9th Cir. 1968), a transfer to a trust that would otherwise be a gift of a future interest is the gift of a present interest if the beneficiary has the unrestricted right to withdraw the contribution to the trust even if that right exists for only a limited period of time (typically 30 days). If structured properly, the annual gift tax exclusion can be used, and if the beneficiary did not exercise his or her Crummey withdrawal rights, the trust assets could be maintained by the trust beyond age 21.

To fully leverage tax rates and minimize taxes, trust income to the extent of the 10% bracket ($2,600 for 2019) could be retained in the trust and the remainder distributed to an UGMA/UTMA account for the benefit of the child beneficiary. Even if the child is subject to the kiddie tax, this strategy minimizes overall income taxes by taxing a portion of the additional income at a 10% or less tax rate.

Observation: Parents who are considering a Sec. 2503(c) trust primarily for funding a child’s future education costs might be better served by investing in a Sec. 529 qualified tuition savings program (QTP) account for the child. QTPs offer many of the advantages of the Sec. 2503(c) trust without the additional costs associated with establishing and administering a trust. Although there may be more flexibility regarding how the funds are invested if a trust is used rather than a QTP, the QTP offers two key advantages: The income is tax-deferred, and contributors can reclaim the funds if they desire (i.e., the QTP is effectively a revocable trust but with the income taxed to the contributor only if the contributions are refunded). Also, many QTPs allow trustees to establish a QTP account for the trust beneficiary. This may be an opportunity for existing Sec. 2503(c) trusts to avoid income taxes by transferring the trust funds to a QTP, the earnings of which will be tax-free if the funds are ultimately used for qualified education expenses. Trustees considering this option should ensure that investing the trust funds in a QTP is permissible under the terms of the trust instrument.

As mentioned previously, up to $2,600 of taxable income of a trust can be accumulated in the trust and taxed at the 10% tax rate (based on 2019 tax brackets), thus avoiding the kiddie tax, if applicable, on income distributions to a child. Income in excess of $2,600 that is accumulated in a trust may be taxed at a rate equal to or higher than the rate under the kiddie tax. Thus, accumulating income in a trust sometimes results in higher income taxes. To minimize the income tax effects, the trustee could be authorized to invest in tax-exempt securities or growth securities, which distribute little, if any, current income.

This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 20th edition (March 2019), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).