A trust is a fiduciary (special) legal relationship. In a trust, one party, known as a trustee, holds the legal title (legal ownership, with the right to control) to trust assets. The trustee holds legal title to these assets on behalf of trust beneficiaries. Assets can include cash, stocks, and any other real or personal property. Trust beneficiaries are the holders of equitable title to the trust.
To have equitable title to something means the right to use or benefit from it. For many years, a type of trust known as a Clifford Trust enjoyed popular use. This popularity owed to the fact that a Clifford Trust could be used as a tax shelter. A tax shelter is a mechanism for avoidance of tax
How Did the Clifford Trust Operate?
The phrase “Clifford Trust” derives its name from a U.S. Supreme Court decision, Helvering v. Clifford, decided in 1940. A Clifford trust was created by a person known as a grantor, or settlor. The grantor is the individual who funds a trust. The grantor donates a “res” (money or property) to the trust. This money or property is managed by the trustee, on behalf of a beneficiary.
In the past, a grantor created a Clifford trust by setting up and funding the trust to last for at least ten years and one day. The trust would provide for the settlor, who was typically in a higher tax bracket, to pay income to a beneficiary to an individual (typically a child) in a lower tax bracket.
The income received by beneficiaries was income earned from investments (investment income). As long as the trust existed, the investment income would be charged at the tax rate paid by the child, not by the parent(s). As a result, the trust income would be tax-sheltered, meaning it would receive advantageous tax treatment.
The advantageous tax treatment applied as long as the trust income was not spent on basic childcare needs the grantor was legally required to supply. A Clifford trust was irrevocable for long as it lasted. As soon as the trust expired, the trust income immediately reverted back to the grantor. At that point, the income would be taxed at the parent’s tax rate.
What is the Kiddie Tax?
Through the Tax Reform Act of 1986, Congress required that Clifford trust income be taxed to the grantor. Federal tax law now contains a “kiddie tax” provision. Under this provision, trust investment income is considered to be unearned income for the child. As of 2020, the kiddie tax is applied to whatever amount of investment income there is that exceeds $2,200.
If, for example, there is $2,500 of unearned investment income, $300 is subject to the kiddie tax. The kiddie tax is taxed at the parent(s)’ marginal federal income tax rate. This rate can go up as high as 37% for ordinary income and short-term capital gains. The rate can go up to as high as 20% for long-term capital gains and dividends.
Are Cllifford Trusts Still Used?
Because the Tax Reform Act of 1986 eliminated the tax incentives for creating a Clifford trust, Clifford trusts are now infrequently used. Today, a trust known as a grantor trust is frequently used instead of a Clifford trust. Like a Cifford trust, a grantor trust allows the grantor significant control over trust assets. With a grantor trust, investment income is taxed to the grantor themselves, at the individual tax rate, as opposed to the trust rate. Since tax rates for individuals are usually lower than tax rates applied to trusts, a grantor trust offers advantageous tax treatment, just as a Clifford trust did.
A grantor trust gives the grantor enormous flexibility. Under a grantor trust, a grantor can change trust beneficiaries, assets, and investments. The grantor has the ability to order a trustee to make these changes. Most importantly, the grantor may give up control of the trust at any time. If and when the grantor relinquishes control, the trust goes from being a revocable trust, to an irrevocable one.
In an irrevocable trust, the trust terms generally cannot be changed, added to, or deleted. With an irrevocable grantor trust, the grantor has the power to dictate trust asset management or transfer after the grantor dies.
Once a grantor trust is made irrevocable, the trust itself (as opposed to the grantor, or beneficiaries) pays taxes on investment income. If certain conditions are met, the Internal Revenue Service will permit an irrevocable grantor trust to have some of the same favorable tax treatment that a revocable trust has.
Do I Need an Attorney for Help With Trust Creation or Modification?
Creating a trust can be a complicated endeavor. Therefore, if you intend to create a trust, or seek to modify the terms of an existing trust, you should contact a trust attorney. An experienced trust attorney can assist you with creating a trust, and, if necessary, modifying its terms.
The trust attorney can also assist you with trust taxation issues that you may encounter. The trust attorney can work with you to ensure the trust receives favorable tax treatment, to the extent the law allows.