2503(c) Trust
What is it?
A Section 2503(c) trust is an irrevocable trust established to hold gifts for a minor child until the child turns 21. It is named after Section 2503(c) of the Internal Revenue Code, which permits an exception to the general rule that only gifts of present interests (i.e., the right to immediately use, possess, or enjoy the property) qualify for the $18,000 (in 2024) annual gift tax exclusion. So although transfers to the trust are future interest gifts, they will be treated as present interest gifts that qualify for the exclusion. This exception is permitted because a Section 2503(c) trust requires the beneficiary to have the right to withdraw trust funds when he or she reaches the age of 21.
Unlike a Section 2503(b) trust, which requires the trust to distribute all income to the beneficiary at least once a year, a Section 2503(c) trust can retain all income while the minor beneficiary is under 21. In that event, the trust pays income taxes (at the special rates for trusts) on the trust's earnings. Meanwhile, the trustee may use the income, as well as the principal, for the child's benefit.
Alternatively, the trust can require or permit its income to be distributed directly to the child beneficiary, or to a custodial account for his or her benefit under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA). In that event, the income is taxed to the child beneficiary.
If trust income is used to satisfy a parent's legal duty to support a child, it will be taxed to the parent.
When the child reaches age 21, he or she typically receives the remaining principal and income. However, the trust document can grant the child the right to extend the trust term beyond age 21. This power can be a right for a limited time period (e.g., 60 days after the child's 21st birthday) or a continuing right. If the right is not exercised, then the trust terminates in accordance with its terms. If the right is exercised, then the trust term is extended. However, transfers cease to qualify for the annual gift tax exclusion, unless the trust document allows the beneficiary at least a limited period during which he or she may withdraw the gifts. This limited power of withdrawal is known as a Crummey power.
In order to be a valid Section 2503(c) trust under IRS rules, the trust must meet all the following requirements:
- The trustee must have the power to use the trust assets (principal and income) for the child's benefit until the child reaches age 21
- The property must be distributed or be made available to the child at age 21
- The property must be included in the child's gross estate if the child dies before age 21
The main difference between a Section 2503(c) trust and a Section 2503(b) trust is the distribution requirement. With a Section 2503(c) trust, distributions to the beneficiary prior to age 21 are discretionary, but the beneficiary must be given access to the trust funds at age 21. With a Section 2503(b) trust, the beneficiary must receive income from the trust at least annually, but there is no requirement that the beneficiary be given access to the funds at age 21, or ever for that matter.
Some estate planners recommend a Crummey trust rather than a Section 2503(c) or Section 2503(b) trust. With a Crummey trust, under current law, as long as the beneficiaries are given the right (for a certain period of time — usually 30-60 days) to withdraw any transfers to the trust, the gift to the trust will be considered a present interest and therefore qualify for the annual exclusion. The main reason that planners have favored the Crummey trust alternative is that it does not have all the restrictions and limitations that Section 2503(c) and Section 2503(b) trusts have. Unfortunately, because of perceived abuses, Crummey trusts have long faced opposition and scrutiny by the IRS. You should be mindful of the uncertain future of this common estate planning tool.
When can it be used?
You want to transfer assets to a beneficiary but do not want the beneficiary to have control of the assets
You may want to set up a Section 2503(c) trust if you would like to make gifts for the benefit of a minor, but you do not want the child to have direct control of the assets. Although the beneficiary may receive income from the trust, the trust document can specify that these payments be made to a custodial account rather than directly to the minor.
There must be a separate Section 2503(c) trust for each desired beneficiary.
You want to make gifts to a minor and achieve income tax savings
The income that is distributed from a Section 2503(c) trust to the beneficiary will be taxed to the beneficiary. However, be aware of the kiddie tax rules. Unearned income above $2,600 (in 2024) may be taxed at the parents' tax rates. The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn't exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn't exceed one-half of their support.
Strengths
Gifts are treated as present interest gifts that qualify for annual gift tax exclusion
Typically, a transfer of assets to a trust does not qualify for the federal annual gift tax exclusion because the beneficiaries of a trust typically do not have a present interest in the assets transferred to a trust. However, if a trust meets all the requirements of Section 2503(c), a transfer of assets to the trust will usually be treated as present interests that qualify for the annual exclusion.
May result in income tax savings
There may be substantial income tax savings if the beneficiary of the Section 2503(c) trust is not subject to the kiddie tax rules (see above).
May result in federal gift and estate tax savings
A Section 2503(c) trust must be set up as an irrevocable trust. If the trust document is properly drafted so that you do not attach any impermissible "strings," the assets in the trust, including any appreciation in their value, will not be includable in your gross estate for federal gift and estate tax purposes at your death.
You set up a Section 2503(c) trust and name your only child the beneficiary. Over the course of 10 years, you transfer $100,000 to the trust, utilizing both the annual exclusion and a portion your gift and estate tax applicable exclusion amount to avoid paying any federal gift and estate tax. The trust doesn't allow you to use trust assets to satisfy your legal duty to support your child. At your death, the assets are worth $300,000. The entire $300,000 is not included in your gross estate. By using this type of trust, you have removed a substantial amount of assets from your gross estate for little, if any, gift and estate tax cost.
Let's you earmark gifts to minor beneficiaries
With a Section 2503(c) trust, you can earmark gifts intended for college (but see Tradeoffs below), or other purposes.
Tradeoffs
Trust is irrevocable
A Section 2503(c) trust must be set up as an irrevocable trust. Once the trust is formed, a beneficiary named, and assets transferred to the trust, you lose the ability to alter or end the trust. For example, you cannot change the trust's beneficiary.
You will incur costs to establish and maintain the trust
You will incur the costs to hire an experienced estate planning attorney to draft the trust document and transfer assets to the trust. You may also want to hire a professional trustee (a bank trust department or a professional fiduciary), in which case you will have to pay trustee fees each year. You may also have to pay to have tax returns prepared for the beneficiary of the trust and for the trust entity.
Because of the costs associated with establishing and maintaining a Section 2503(c) trust, it generally makes sense to do so only if you set up the account with a significant lump sum.
It is not generally advisable for the grantor to serve as trustee. If the grantor dies while serving as trustee, trust assets may be included in his or her gross estate for federal gift and estate tax purposes. Moreover, trust income may be taxed to the grantor under the grantor trust rules.
Negative impact on your child's eligibility for financial aid
A 2503(c) trust is in your child's name and thus included in your child's assets when applying for financial aid. Under the federal financial aid methodology, a child is expected to contribute 20 percent of his or her assets toward college costs (parents are expected to contribute 5.6 percent of their assets). The more a child is expected to contribute, the less financial aid the child is likely to get.
Accumulated income and principal must be distributed or made available to the beneficiary when he or she reaches age 21
A Section 2503(c) must distribute accumulated income and principal to the beneficiary at age 21, even if the beneficiary is financially irresponsible. Alternatively, the trust document may grant the beneficiary the option to extend the trust term, though this does not guarantee that the beneficiary will actually do so.
How to do it
Hire attorney to draft trust
You should hire an experienced estate planning attorney to draft the Section 2503(c) trust document.
Transfer assets to the trust
Because you will incur costs to establish a Section 2503(c) trust, it usually makes sense to establish such a trust only if you can transfer a cost efficient amount to the trust. If you would like to transfer a more modest amount, it might make more sense to make a gift under the Uniform Transfers to Minors Act (UTMA) or under the Uniform Gifts to Minors Act (UGMA). Once a 2503(c) trust is established, you can make as many contributions to the trust as you like.
File annual tax return on behalf of trust
The trust will need to file a tax return and pay income taxes on the trust income that is earned but not distributed each year.
Distribute assets to child when child turns 21 (or as specified in trust)
The trustee must distribute the trust assets or make them available to the child when the child turns 21 (or as specified in the trust document).
Questions& Answers
The age of majority in your state is 18. Must the trust assets be distributed to your child then?
No. It does not matter when the child becomes an adult under state law. The only age-related requirement of a Section 2503(c) trust is that accumulated income and principal must pass to the beneficiary when he or she reaches age 21, unless the beneficiary elects to extend the term of the trust.
