Income Shifting through Gifts and Trusts
Segal, Mark A., The National Public Accountant
One of the most fundamental yet far reaching means of shifting income while reducing one's taxable estate is through the making of gifts. While recent changes in the law have reduced some of the allure of gift giving, e.g, the Tax Reform Act of 1986 amendments largely eliminating the utility of a Clifford or Spousal remainder trust(1) and establishing the IRC Section 1(1) Kiddie Tax, the making of gifts remains a vital element in financial and tax planning. In order to maximize the benefits of gift giving, it is desirable to have the gift qualify for the annual exclusion from gift tax.(2) In certain instances it may be advantageous to make gift transfers in excess of the available exclusion amount. Gift tax on such transfers will generally be averted through use of the unified credit.(3) Making such sizeable gifts can be useful both to shift income and get property that is anticipated to appreciate in value out of one's estate and avoid being subject to a large income tax should the appreciated asset be sold.
Despite these beneficial aspects, many taxpayers are reluctant to make gifts for fear that in order to merit the gift tax exclusion a direct transfer to the intended beneficiary must be made. This reluctance is most prominent when the beneficiary is a minor or a person whom the taxpayer perceives as irresponsible. In large measure, this fear is based upon the requirement that to qualify for the gift tax exclusion the gift must be of a present interest in the property. Reg. 25.25033(b) defines a present interest in property as an unrestricted right to the immediate use, possession or enjoyment of property or the income therefrom.(4) Nevertheless, the tax law does provide relief from having to make such direct transfers by allowing the annual exclusion for transfers made to certain types of trusts even though the beneficiary may not actually get to currently enjoy the use of the transferred asset.
The Section 2503(c) Trust
Probably the most attractive arrangement enabling qualification for the annual exclusion without making a direct transfer to a beneficiary is the Section 2503 (c) trust. According to Section 2503(c) a transfer to a trust will be considered a transfer of a present interest in the property and the income therefrom:
1. May be expended by or for the benefit of the donee before his attaining the age of 21 years and
2. Will to the extent not so expended (a) pass to the donee or his attaining the age of 21 years and (b) in the event the donee dies before attaining the age of 21 years be payable to the estate of the donee or as he may appoint under a general power of appointment as defined in Section 2514(c).
On the face of it, Section 2503(c) already appears generous in that it enables qualification for the annual exclusion despite there being no guarantee that the beneficiary will receive anything from the trust prior to his reaching age 21. In reality however, Section 2503(c) has been constructed by both the courts and the service to be even broader than the language of the statute might suggest. Despite this latitude there does exist pitfalls which one must take into account in structuring the trust to assure its qualification under Section 2503(c).
One of the cardinal virtues of Section 2503(c) is that it enables qualification for the annual exclusion without requiring that a distribution made to a beneficiary. The provision does require, however, that the trustee have discretion to make such a distribution. While having no language interpretable as limiting the trustee's discretion is the safest means to assure satisfaction of this language, both cases and service pronouncements indicate that some qualifying language is permissible. According to Reg. 25.2503-4(b), sufficient discretion exists if "There is left to the discretion of the trustee the determination of the amounts, if any, of the income or property to be expended for the benefit of the minor and the purpose for which the expenditure is to be made, provided there are no substantial restrictions under the terms of the trust instrument on the exercise of such discretion. …