Minor’s Trust – IRC 2503(c)

Take-Away: A “minor’s trust” is a statutory exception to the normal gift tax annual exclusion rules.

Annual Exclusion Rule: For a gift to qualify for the federal gift tax annual exclusion [$15,000 per donee starting this year] the subject of the gift must be a present interest. A present interest  is one that is available for the donee’s immediate use, possession or enjoyment. Treas. Reg. 25.2503-3(b). A gift of a future interest, i.e. a beneficial interest in an irrevocable trust,  does not satisfy the present interest condition. Thus, most gifts to an irrevocable trust are gifts of future, not present interests.

Exception to the Annual Exclusion Rule: But making a present interest annual exclusion gift directly to a minor is something few donors will pursue, out of a legitimate fear that the minor-donee will waste or mismanage the gift. Similarly, giving the minor child the ability to withdraw the gift into the trust (the classic crummey withdrawal right) will not work for the same reason- a deeply held fear that the minor will exercise the withdrawal right and squander the gift.

• Thus, the goal is to use a trust for the benefit of the minor donee-beneficiary to receive the annual exclusion gift, and still satisfy the present interest condition for an annual exclusion gift.
• Leading to the creation of an exception in the Tax Code to the present interest requirement for annual exclusion gifts to a trust (a future interest) for a minor trust beneficiary. IRC 2503(c).

IRC 2503(c) Exception: The gift in trust will qualify for the federal gift tax annual exclusion if it meets the requirements of IRC 2503(c).  Treas. Reg. 25.2503-4(a) requires:

• The trust property and income from the property must be expended by the trustee only to or for the benefit of the minor;
• Any trust income and principal not expended must be paid to the minor at age 21 years; or
• If the minor dies prior to reaching age 21 years, trust principal and trust income must be distributed to the minor’s estate.

The only other limitation, which is associated with any irrevocable trust, is that trust distributions cannot be used to defray a parent’s legal obligation to support their child; if that is the case, then the transfer is not a gift, as is the case with child support.

Other Exceptions to the Present Interest Rule: A transfer of property for the benefit of a minor pursuant to the Uniform Transfer to Minor’s Act or the Gifts of Securities to Minors Act is considered to be a completed gift of the full fair market value of the property, even though the minor does not have immediate access to the transferred property held by the custodian. The same treatment occurs with transfers to a 529 Account (which is essentially a revocable gift by the transferor until the funds are used for the beneficiary’s educational purposes.)

Planning Considerations:

• Draft the Minor’s Trust as a Crummey Withdrawal Trust: As I mentioned, lawyers have gotten ‘clever’ over the years and translated the ‘must be paid to the minor at age 21 years’ to be ‘must be made available to’ the minor beneficiary upon reaching the age of 21 years. Consequently, the minor’s trusts that I drafted over the years required the trustee to give the minor written notice, 60 days before the minor’s 21^st birthday,  of the minor’s right to withdraw all the trust’s assets. The trust instrument was then drafted, giving the minor beneficiary that exclusive withdrawal right, like a crummey withdrawal right.  But the trust instrument was also drafted to provide that if the trust beneficiary (formerly a minor) did not exercise their withdrawal right within 30 days after they attained age 21 years, then the withdrawal right lapsed, and the assets continued to be held in a more conventional type of irrevocable trust, e.g. discretionary distributions of income or principal to or for the benefit of the no-longer-minor but still very young beneficiary, with an age of distribution later point in time, e.g. when the beneficiary attains age 35 years. The IRS has approved this self-serving interpretation of ‘must be paid to..’ on several occasions.
• Damage Control: On one occasion the soon-to-be adult beneficiary indicated her intent to withdraw the assets shortly after she received the trustee’s notice of her right to withdraw the assets at age 21 years. Trustee-uncle was convinced his niece was a horrifically immature spendthrift. As damage control, uncle transferred the trust’s assets into an LLC in that 60 day window period [ the trust assets had grown to about $300,000 through some impressive investing over the years], with the uncle adding $15,000 of his own assets to the LLC. When niece reached age 21 she had distributed to her from the trust 95% of the LLC membership interests. Uncle held the remaining 5% as the managing member of the LLC. The LLC Operating Agreement provided that the LLC would liquidate in 7 years, i.e. when the niece was age 28. Niece was not happy this this damage control move, until the LLC started to make regular and substantial income distributions to her, and the LLC assets continued to rapidly grow in value through the manager’s shrewd investments.  In short, we continued the trust arrangement, but unilaterally shifted from a trust ‘wrapper’ to an LLC ‘wrapper.’ [I’ll probably burn in hell for giving this damage control advice to the uncle, but it all worked out well for all concerned.]