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Income Shifting: How To Use Trusts To Shift Income To Children

Income Shifting: How To Use Trusts To Shift Income To Children

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Using Trusts To Shift Income To Children

Transferring assets and income to minors on a regular and ongoing basis might be a good income shifting strategy and estate planning strategy. Despite the tax advantages of transferring property to children, some parents may be hesitant to relinquish ownership of a sizable sum of money. 

As a result, most parents do not give their minor children large outright presents because they do not want them to have unrestricted access to the property. Instead, trust transfers and custodial accounts are typically used to complete the property transfer (and corresponding income shifting) while allowing the parents to retain control of the property (at least until the child reaches majority).

You Can Use A Sec. 2503(c) Trust For Minor Beneficiaries

The Sec. 2503(c) trust (also known as a minor’s trust) should be considered as an educational planning tool. The practitioner should be aware, however, that the compressed trust income tax rate structure (graduated rates beginning with a 10% rate on the first $2,600 of taxable income and rising to a maximum rate of 37 percent on taxable income over $12,750 (for 2019)) not only reduces overall tax savings, but also effectively penalizes trusts that accumulate income. Because one of the qualities of a Sec. 2503(c) trust is revenue accumulation, the trust’s utility has been reduced. A transfer to a Sec. 2503(c) trust, on the other hand, ensures that the kid does not have access to trust assets until he or she reaches the age of 21.

A Sec. 2503(c) trust is one that meets the conditions of Section 2503(c), which makes an exemption to the normal rule that only gifts of a present interest are eligible for the annual $15,000 gift tax exclusion (for 2019) ($30,000 if gift-splitting is chosen). In general, a trust qualifies if (1) the trustee has the power to use the trust property and income for the benefit of the child until the child reaches the age of 21; (2) the child must receive the trust property at the age of 21; and (3) the trust property must go to the child’s estate (or as the child directs in a testamentary power) if the child dies before reaching the age of 21.

Income Shifting Rules For Section 2503(c) Trust

The legislative requirements of a Sec. 2503(c) trust have been interpreted and expanded by courts, regulations, and revenue rulings. For example, the trustee’s powers must not be considerably limited to qualify for the yearly gift tax exclusion (Regs. Sec. 25.2503-4(b)(1)). As a result, the trustee must be given significant discretionary powers over disbursements to minors before they reach the age of 21. 

This means that the trust instrument should not limit the trustee to disbursements just for educational purposes or to mandatory accumulation to a specified age in the context of education planning. Furthermore, if a donor names himself as trustee of a Sec. 2503(c) trust, the discretionary power to control distributions (i.e., “beneficial enjoyment of the property”) will cause the property to be included in his gross estate under Secs. 2036 and 2038. For income tax purposes, the trust may also be considered as a grantor trust in this circumstance.

As previously stated, Sec. 2503(c) requires the child to receive the trust property when he or she reaches the age of 21. This poses a practical issue: some parents are hesitant to give their child huge sums of money at the age of 21. If the trust instrument gives the beneficiary the power to extend the trust’s term, the beneficiary’s exercise of that power will not cause the trust to fail to qualify under Sec. 2503(c); i.e., such a provision will not prevent the trust from benefiting from the annual exclusion with respect to gifts to the trust. The ability to demand distribution may be a permanent right or a temporary one (e.g., 30 days after turning 21). If the right is not exercised, the trust will continue in line with the terms of the trust instrument until the beneficiary reaches the age of majority.

If the trust is prolonged past the child’s 21st birthday, it becomes a grantor trust for the child for the duration of the extension. As a result, for income tax reasons, the beneficiary should regard all transactions within the trust as if they were his or her own.

Another way to avoid giving the trust assets to the beneficiary at the age of 21 is to set up the trust so that the income interest gift qualifies for the annual exclusion but the principal gift does not. In this case, the trust document must stipulate that the income interest be distributed at the age of 21. After the kid reaches the age of 21, the trust principal can either stay in the trust or be allocated to other beneficiaries. The assets transferred into the trust should generate income and be valuable in this structure.

The Sec. 2503(c) trust can be used as a substitute for the Uniform Gifts to Minors Act/Uniform Transfers to Minors Act (UGMA/UTMA) gifting programme. Property in a UGMA/UTMA account must be delivered to the kid at the age indicated in the state’s UGMA/UTMA statute, which is normally 21 years old but might be as young as 18. The obligatory distribution is postponed until at least the age of 21 in the Sec. 2503(c) trust. By the age of 21, the majority of the monies in the trust may have been spent on educational expenses.

A Sec. 2503(c) trust is also more flexible than a trust established under the UGMA/UTMA Act. For example, the grantor can include a list of successor trustees in the trust instrument or mandate that numerous trustees act jointly, and the trust instrument can grant or withhold specific administrative authorities. The UGMA/UTMA custodian, on the other hand, is bound by the requirements of the state’s UGMA/UTMA statute. The minor’s trust also allows for the management of many trusts to be combined.

Sec. 2503(c) trusts have a number of drawbacks, including the following:

1) The cost of establishing and maintaining a Sec. 2503(c) trust will be higher than the cost of a UGMA/UTMA account (e.g., the costs of drafting the trust instrument and preparing annual tax returns);

2) A Sec. 2503(c) trust has only one beneficiary, and the assets in the trust are irrevocably his or hers (i.e., the assets cannot be redirected to another beneficiary);

3) The grantor relinquishes total control of the assets because the trust is irreversible.

4) Trust income tax rates may penalize trusts that accrue income; and

5) Whether or not distributions are made, the assets of a Sec. 2503(c) trust can impair the beneficiary’s college financial aid eligibility.

A Crummey trust, rather than a Sec. 2503(c) trust or a UGMA/UTMA account, may be preferred. A transfer to a trust that would otherwise be a gift of a future interest becomes a 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, according to Crummey, 397 F.2d 82 (9th Cir. 1968). Typically, in 30 days. The annual gift tax exclusion can be used if the trust is correctly established, and if the beneficiary does not exercise his or her Crummey withdrawal rights, the trust assets can be held by the trust beyond the age of 21.

To fully leverage tax rates and minimize taxes, trust income up to the 10% bracket ($2,600 for 2019) could be kept in the trust and the remaining given to a UGMA/UTMA account for the child beneficiary’s benefit. Even though the child is subject to the child tax, this technique reduces overall income taxes by taxing a portion of the extra income at a rate of 10% or less.

Better Alternatives To Sec. 2503(c) Trust

Parents who are considering establishing a Sec. 2503(c) trust for the purpose of paying a child’s future educational expenses might be better off opening a Sec. 529 qualified tuition savings programme (QTP) account for the child. Many of the benefits of a Sec. 2503(c) trust are available through QTPs, but without the additional costs of establishing and administering a trust. 

Although using a trust rather than a QTP may provide more freedom in terms of how the assets are invested, the QTP has two major advantages: Contributors can recoup the cash if they wish, and the income is tax-deferred (i.e., the QTP is effectively a revocable trust but with the income taxed to the contributor only if the contributions are refunded). 

Moreover, many QTPs permit trustees to open a QTP account for the trust beneficiary. Existing Sec. 2503(c) trusts may be able to avoid paying income taxes by moving trust funds to a QTP, whose earnings will be tax-free if the funds are used for qualified education costs. When contemplating this alternative, trustees should make sure that investing trust money in a QTP is allowed under the trust instrument’s conditions.

As previously stated, 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), avoiding the kiddie tax on income distributions to a child, if applicable.

Income accumulated in a trust that exceeds $2,600 may be taxed at a rate equal to or greater than the kiddie tax rate. As a result, accumulating money in a trust might lead to higher income taxes. To reduce income tax consequences, the trustee could be allowed to invest in tax-exempt or growth securities that pay out little or no current income.

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