Children’s Trusts

The “Children’s Trust” used for estate planning is also known as a 2503(c) Trust.  In the latter half of the 20th Century, these irrevocable trusts were the workhorse of estate planners dealing with larger estates.  The object was to move assets out of the large estate, where they would be exposed to huge (55%) estate taxes, and get the assets down to the children or grandchildren without any estate tax.  In addition, 2503(c) trusts were used to “shift income” to family members, usually the children, who were in a lower income tax bracket.  By the way, you don’t have to have children to use a children’s trust.  It is just an irrevocable trust established under IRS Code section 2503(c), and anyone under 21 can be a beneficiary.  However, most people who used 2503(c) had their children be the beneficiaries.

Shifting income became so popular that Congress enacted laws to put the brakes on it.  The “kiddie tax” was enacted in 1986 to make it harder to shift income to children within your household.  If a child receives more than a minimal amount (about $2100) in passive income or “unearned income,” the child has to pay income taxes on the income at the rate daddy would have paid.  Yes, the passive income the child receives is stacked on top of daddy’s income in order to establish the tax rate.  It doesn’t matter whether the child received the passive income through a shifting income program or the child flat out earned the income on investments he or she has made with money they earned by doing work. The kiddie tax affects any passive income a child receives, independent of the source of the income or the source of the capital used to generate the income.  When the child’s passive income stacks on top of daddy’s income, it could put daddy into a higher tax bracket, trigger Obamacare taxes, eliminate medical deductions, and cause a dozen other major income tax problems for daddy.

Another consideration that made children’s trusts less popular is the virtual inability for daddy to control the assets in a children’s trust or to have much if any leeway in distributing income from the trust.  When an asset is “given” to the trust, it is irrevocably gone.  The person trying to get the asset out of their estate for estate tax purposes basically loses all control over the asset.  The advantage is that because the asset is irrevocably gone, it is also gone as far as the person’s creditors are concerned. Once the asset is in the trust, it is outside of the person’s estate.  So the asset is protected from the person’s creditors.   (This is, of course, provided that no fraudulent conveyance issues are in play.)

In addition, if the asset goes up in value, all of the growth is “frozen” out of the person’s estate. Freezing assets is an old technique created long before Elsa was born. Once the asset is outside of daddy’s estate, the value of the asset is “frozen” as far as the gift taxes and estate taxes are concerned.

Moving assets out of mom and dad’s estate without subjecting the assets to an estate tax requires minding all your p’s and q’s. In order to get the estate tax benefits of the trust, lots of rules must be followed. When property goes into the trust, it counts as a “gift” to the beneficiaries.  In order to not let the gift value eat away at the uniform gift/estate tax limitations, it will have to qualify by coming under the annual exclusion rules. To qualify the gift for the annual exclusion amount (about $14,000 today), the beneficiaries have to be aware of the gift, have to be able to take control of the gift, and have the time to make decisions about how to use the gift. The gift needs to be announced by a letter given to each beneficiary.  This is called a Crummey letter because the people who sued the IRS and won the case establishing these rules were the Crummeys.  Truth be told, the whole process is just kind of crummy.

Today, we have a much better way to achieve almost anything that can be achieved in a children’s trust.  Because an LLC has both the corporate shield and the charging order asset protection, it provides asset protection for the assets in the LLC entity from daddy’s creditors. However, daddy can have more control over the LLC assets than he can over the children’s trust assets, and the assets will still be outside of daddy’s estate. Well, at least the value of the LLC held by the other members (children) will be outside of daddy’s estate.

When daddy forms the LLC and places assets into it, he will get all of the membership (ownership) of the LLC back in return for giving the assets to the LLC. At that point, daddy can give little amounts of the ownership interests to the children from year to year in chunks that qualify for the annual gift tax exclusion. The kid does not have to be under 21, and the gift of the membership interest does not have to go through all the Crummey shenanigans. It is a straightforward gift.

Provided the value of the membership interest is under the annual exclusion amount, the gift of membership interest will not affect the gift or estate tax unified credit. Note that when daddy puts the asset into the LLC, it is not a gift. The gift comes when membership interest is given to the child.

Shifting income in an LLC can be accomplished exactly like it can with a 2503(c) trust. However, the LLC gives more flexibility because in many cases (depending on how the LLC is established and taxed), the income shift can be directed to the recipients without consideration of their proportional ownership of membership. This can come in handy when you factor in that the kiddie tax still applies.

Today, I would probably use a limited liability company (LLC) instead of a 2503(c) trust.  Shifting income, estate tax reduction, asset protection and gifting are a lot easier in an LLC.  Although a 2503(c) trust still has a place in today’s planning, its major place is in the history books.