What is it?

A Section 2503(b) trust is an irrevocable trust often established for the benefit of a minor child, although it can be established for anyone. It is named after Section 2503(b) 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. Although transfers to a Section 2503(b) trust are future interest gifts, they are treated as present interest gifts that qualify for the exclusion. This exception is allowed because the trust must distribute to the beneficiary all the income earned at least once a year.

Unlike a Section 2503(c) trust, which requires that all principal be distributed or made available to the minor beneficiary when he or she reaches age 21, there is no set time at which the principal in a Section 2503(b) trust must be distributed. In fact, a Section 2503(b) trust can be drafted so that the principal is never actually paid out to the minor child beneficiary. The trust can be written so that someone of your choosing, other than the minor child beneficiary, will eventually receive the principal, or the trust can allow the minor beneficiary to make that choice.

For federal gift tax purposes, the minor child beneficiary’s income interest in a gift made to a Section 2503(b) trust is the actuarial value of the right to receive annual income from the gift for life (or a term of years). The value of the income interest depends on the beneficiary’s life expectancy (or the term of the trust), as well as the Section 7520 rate (an assumed rate of return set monthly by the IRS) in effect at the time of the gift. This income interest — calculated in advance — should not to be confused with the actual income produced by the trust assets each year.

Under Section 2503(b), all income from the trust must be distributed to the minor child beneficiary at least once a year. However, the income does not have to be directly transferred to the beneficiary. You (the grantor) can direct the income to a custodial account set up under the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). The money can then be held in the custodial account until the beneficiary is older or it is otherwise appropriate to make distributions.

The income that is distributed from a Section 2503(b) 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.

If trust funds are used to satisfy a parent’s legal duty to support the child beneficiary, those funds will be taxed to the parent.

Some estate planners recommend a Crummey trust rather than a Section 2503(b) or Section 2503(c) 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(b) and Section 2503(c) 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. Need a mortgage!!! A few minutes, a few clicks, up to 5 competing mortgage quotes

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(b) 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 must receive all income from the trust at least annually, the trust document can specify that these payments be made to a custodial account rather than directly to the minor. Furthermore, you can arrange for the trust to invest in low-income high-growth assets to limit the income the trust earns, and hence lower the distributions to the beneficiary.

There must be a separate Section 2503(b) 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(b) 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. Need a mortgage!!! A few minutes, a few clicks, up to 5 competing mortgage quotes

Strengths

Gifts are treated as present interest gifts that qualify (to some extent) 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 the trust. However, if a trust meets all the requirements of Section 2503(b), a transfer of assets to this trust will usually be treated as a present interest that qualifies for the annual exclusion.

In most cases, the entire value of the transfer to the trust will not qualify for the annual exclusion. Transfers to the trust must be divided into an income portion and a remainder portion. The income portion qualifies for the annual gift tax exclusion, while the remainder portion is considered a taxable gift. There is a complicated calculation to figure out what part of the transfer is income and what part is remainder (your estate planning attorney can make this determination for you). However, when the beneficiary of the trust is a minor, the income portion of the gift will always be a very high percentage of the gift. Need a mortgage!!! A few minutes, a few clicks, up to 5 competing mortgage quotes

Allows flexibility on distribution of principal

Unlike a Section 2503(c) trust, where the trust principal must be paid out or be made available to the beneficiary when he or she turns 21, there are no limitations on when the principal in a Section 2503(b) trust must be distributed. In fact, there is no requirement that the principal ever has to be paid out to the beneficiary. The beneficiary could simply receive income from the trust until his or her death, and then the principal could be paid to a third party.

May result in income tax savings

There may be substantial income tax savings if the beneficiary of the Section 2503(b) trust is not subject to the kiddie tax rules (see above).

May result in estate tax savings

A Section 2503(b) 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 estate tax purposes at your death. Need a mortgage!!! A few minutes, a few clicks, up to 5 competing mortgage quotes

You set up a Section 2503(b) 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 exemption to avoid paying any federal gift 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 tax cost.

Tradeoffs

Income must be paid out each year to beneficiary

One of the biggest tradeoffs to setting up a Section 2503(b) trust is that the income from the trust must be paid out each year to the beneficiary of the trust. With a Section 2503(c) trust or a Crummey trust, the income does not have to be paid out to the beneficiary. In many cases, especially if the beneficiary is a minor, you may not want income to be paid out (even though the income can be paid to a custodian) every year.

Trust is irrevocable

A Section 2503(b) 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.

Because of the costs associated with establishing and maintaining a Section 2503(b) trust, it generally makes sense to do so only if you set up the account with a significant lump sum. Need a mortgage!!! A few minutes, a few clicks, up to 5 competing mortgage quotes

Entire transfer to trust will not qualify for annual gift tax exclusion

Another tradeoff to a Section 2503(b) trust is that the entire transfer will not qualify for the annual exclusion from the federal gift tax. When a gift is made to a Section 2503(b) trust, the gift must be divided into an income interest (a present interest) and a remainder interest (a future interest). (Your attorney or accountant can compute the division of the gift for you; there is a complicated formula that must be used.) The income interest part of the gift will qualify for the annual exclusion, but the remainder interest will not qualify. If the beneficiary is a minor, then usually 90 percent or more of the transfer will be considered an income interest (and thus be treated as a present interest that qualifies for the annual exclusion). The remaining percentage will be a remainder interest and not qualify for the annual exclusion. You must use your gift tax exemption or pay the applicable federal gift tax on this portion.Need a mortgage!!! A few minutes, a few clicks, up to 5 competing mortgage quotes

You set up a Section 2503(b) trust and name your 10-year-old son the sole beneficiary of the trust. You make an initial transfer of $10,000 to the trust. Your accountant tells you that $9,000 of the transfer will be treated as a present interest that qualifies for the annual exclusion. The remaining $1,000 is subject to the federal gift tax. You can then use a portion your gift and estate tax applicable exclusion amount (if available) to offset the applicable gift tax.

How to do it

Hire attorney to draft trust

You should hire an experienced and competent estate planning attorney to draft the Section 2503(b) trust document. There are some fairly complicated estate and income tax issues that must be considered when drafting and operating the trust. As noted, you will also need your attorney (or accountant) to calculate what percentage of any transfer qualifies for the annual exclusion and what percentage is subject to the federal gift tax.

Transfer assets to the trust

Because you will incur costs to establish a Section 2503(b) 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 Gifts to Minors Act (UGMA) or under the Uniform Transfers to Minors Act (UTMA). Once a Section 2503(b) trust is established, you can make as many contributions to the trust as you like. Need a mortgage!!! A few minutes, a few clicks, up to 5 competing mortgage quotes

Beneficiary must file income tax returns

Because income from a Section 2503(b) trust is distributed to the beneficiary, that person must file an income tax return (if the income is above the minimum threshold).