We frequently receive inquiries from clients about income tax issues for their children. For example: Are there any income tax advantages for creating an irrevocable trust for your child? When does a child have to file an income tax return? What income tax rates will be applicable to your child? Does it depend on the kind of income that the child has? Does it make sense to employ your child on a part-time basis?

To help answer some of these questions, we have prepared a Memorandum entitled Income Tax Reporting and Planning for Dependent Children and their Irrevocable Trusts. Of special note are recent changes in the tax laws concerning the "kiddie tax." The Small Business and Work Opportunity Tax Act of 2007 expands the kiddie tax rules to apply to most children ages 18-23 who are full time students.

INCOME TAX TREATMENT OF AN IRREVOCABLE TRUST

The Trust as a Taxpayer. The trustee of an irrevocable trust must apply for and receive its own federal tax identification number and is subject to state and federal income taxes much like any other taxpayer. (Note, however, that if the irrevocable trust is drafted to be an intentionally defective grantor income trust, then the trust will not be a taxpayer. Instead, the grantor of the trust will be the taxpayer with respect to all trust tax items. In the alternative, the trust can be drafted as a grantor income trust to a beneficiary. This is discussed below.) Thus, each year the trust will pay tax on its taxable income. However, to avoid double taxation on trust income which is distributed out to a trust beneficiary, the trust will get what is referred to as a "distribution deduction" for amounts distributed out to beneficiaries.

For example, suppose an irrevocable trust has $10,000 of gross income and $4,000 of deductions, leaving it with $6,000 of net income. The trustee then distributes $3,000 of this net income to the beneficiary and accumulates $3,000 in the trust. In this example, the trust will have taxable income of $3,000, less a $100 exemption, and will pay tax at the trust tax rates on that taxable income. The trust will then prepare and send to the beneficiary a Form K-1 informing the beneficiary that the beneficiary will have $3,000 of taxable income arising from the trust. The beneficiary must then report that taxable income on the beneficiary's personal income tax return. In summary, the trust pays income tax on the taxable income which it accumulates, but does not pay income tax on the taxable income which is distributed to the beneficiary.

An irrevocable trust which accumulates all or part of its trust income rather than distributing it all to the beneficiary is permitted a $100 personal exemption. Simple trusts in which all of the income is distributed to the beneficiary are permitted a personal exemption of $300.

An irrevocable trust does not get the benefit of lower tax rates on long term capital gains. Such capital gains are taxed to the trust where the gain is added to principal. However, if the gain is actually distributed to the beneficiaries, it is included in the computation of distributable net income and thus is taxed to the beneficiaries.

Trust Income Tax Return Requirements. A trust must report its income tax on Form 1041, U.S. Fiduciary Income Tax Return. The Form 1041 is due by the 15th day of the fourth month following the close of the trust tax year. Generally, these returns will be due at the same time as individual income tax returns are due. The trust may also be required to make quarterly estimated income tax payments depending on the level of trust income.

For 2007, the trust federal income tax marginal rates are as follows:

The state of Oklahoma also requires that every resident trust make an annual return.

The trustee must file an income tax return for any trust that has any taxable income for the year, or for any trust that has gross income of $600 or more, regardless of whether it has taxable income for the year.

INCOME TAX CONSEQUENCES TO THE BENEFICIARY

Income Tax on Trust Distributions. As mentioned above, distributions of trust income to the beneficiary are deductible by the trust and includible in the beneficiary's income. Distributions to a beneficiary in excess of the trust's income are generally tax-free distributions of principal. (Note, however, that if the irrevocable trust is drafted to be an intentionally defective grantor income trust, then the trust will not be a taxpayer. Instead, the grantor of the trust will be the taxpayer with respect to all trust tax items. This is discussed below.)

For example, suppose the trust has $6,000 of income for the year and makes a $10,000 distribution to the beneficiary. In that event, the trust would have no tax to pay (since it had $6,000 of income less a $6,000 distribution deduction), and the beneficiary would have $6,000 of income from the trust distribution. The other $4,000 the beneficiary receives out of the trust would be a tax-free distribution of principal.

Computation of the Beneficiary's Tax. A beneficiary of an irrevocable trust is an individual taxpayer, just like any other taxpaying person or entity. The taxpayer beneficiary would report his or her income on a regular Form 1040 or the shorter Form 1040A.

INCOME TAXATION OF CHILDREN

Filing Requirements and Tax Rates. A dependent child must file an income tax return in 2007 if he or she has (a) unearned income of over $850; or (b) earned income of over $5,350; or (c) a total of earned and unearned income in excess of the greater of (i) $850 or (ii) earned income (up to $5,050) plus $300.

The child will not be allowed a personal exemption if the child is eligible to be claimed as a dependent on another taxpayer's return. However, the child will be entitled to the basic standard deduction equal to the greater of $850 or the sum of $300 plus earned income (up to the regular standard deduction amount for a single filer). Thus, a dependent child who has gross income of $850 or less will not be taxed on that amount and does not have to file an income tax return.
For 2007, the federal income tax marginal rates for single individuals, not the head of a household, are as follows:

The "Kiddie Tax". In 1986, Congress adopted what is referred to as the "kiddie tax". Under the kiddie tax rules as originally adopted, the unearned income of a child under age 14 that exceeded an inflation adjusted amount would be taxed to that child at tax rates that would apply if the income were included on the child's parents' return, if that rate is higher than what the child would otherwise pay. In year 2006, the threshold age for the kiddie tax was raised to age 18. Recently, the Small Business and Work Opportunity Tax Act of 2007 has further expanded the scope of the kiddie tax. For tax years beginning after May 25, 2007, the kiddie tax not only applies to children under age 18, but also applies to any child who is age 18 to 23 if (i) the child turns 18, or if a full time student turns age 19 to 23, before the close of the tax year; (ii) the child has earned income for the tax year that does not exceed one-half of the child's support; (iii) the child has at least one living parent at the close of the tax year; and (iv) the child doesn't file a joint tax return for the tax year.

Note that the kiddie tax applies to all "unearned income". Unearned income is defined to include not only investment income but also income from a trade or business or from any other source other than for services rendered.

The inflation adjusted protected amount for year 2007 is $1,700. This means that the kiddie tax will only apply to the income of the child in excess of $1,700. If the child's parents are married filing separately, the marginal tax rate of the parent with the greatest amount of taxable income applies. In the case of divorced parents, the custodial parent's highest marginal tax rate applies.

The child may make a separate return or the parents may elect to report the income on their return if certain conditions are met. Note that the kiddie tax rule requires the child, and not the parent, to pay the higher tax rate on the child's unearned income in excess of $1,700.

Because of the kiddie tax, no longer can a parent save overall family income taxes by shifting more than $1,700 of unearned income to a child subject to the kiddie tax.

In summary then, the first $850 of the child's income would be tax-free. The next $850 of income would be taxed at the child's 10% marginal rate. Unearned income over $1,700 will be taxed at the parents' marginal rate, which may well be the 35% top rate. Earned income over $1,700 would still be taxed at the child's marginal rate, which could be as low as 10%.

The expanded kiddie tax rules further restrict the ability of parents to shift income-producing property to children who are under age 18 or who are full time students ages 18 to 24. Investment decisions for a child subject to the kiddie tax will thus have many of the same tax considerations as for the child's parent. Preferred investments might include stocks and mutual funds that produce little current income but seek capital appreciation; tax-exempt bonds, stocks that pay qualified dividends at the maximum 15% (at least under current law) dividend rate, and U.S. Series EE savings bonds where interest may be deferred. Consideration should also be given to traditional or Roth IRAs for children who have earned income and "529 plans."

If the situation is appropriate, the family may want to consider employing the child in some family business or activity. The child's earnings would be earned income not subject to the kiddie tax and could generate a tax deduction for the family business. Also, note that if the kiddie tax applies because the child is age 18-23 and is a full time student, then if the child's earned income is more than one-half of the child's support for the year, the kiddie tax rules do not apply at all on the unearned income. Of course, employing the child raises employment tax and withholding tax issues.

An Example:

Now, let's take an example to try to put all of this in perspective.

Suppose Parent creates an irrevocable Crummey trust for minor Child and funds it with $24,000 gift-tax free by using Parent's and Parent's spouse's $12,000 annual exclusions and by giving Child withdrawal rights for a certain period of time after the gift is made to the trust. By December 31, it appears that the trust will earn $2,100 of income for the year. What are Parent's tax planning alternatives?

If Parent allows all $2,100 of income to accumulate in the trust, then the trust will have $2,000 of taxable income (that is, $2,100 of income, less a $100 exemption, less any other trust expenses, which we are assuming in this case are zero). Since the trust is in the 15% marginal tax bracket, it will pay $300 of federal income tax (15% tax rate times $2,000 taxable income). Note here that Child has no taxable income, since no distributions were made to Child. Also, note that the kiddie tax does not apply, since the kiddie tax only applies with respect to Child's unearned income in excess of $1,700, and does not apply to trust income.

On the other hand, suppose the trust distributes $850 to Child on December 31 and accumulates $1,250 in the trust? In that event, the trust's taxable income will decrease from $2,000 to $1,150, since the trust gets a distribution deduction for the income distributed to Child. The trust's income tax will decrease from $300 to $172.50 ($1,150 taxable income times 15% tax rate). Child still has no income tax liability, since up to $850 of income may be received by Child in any year without any taxpaying or tax return filing requirement.

Suppose instead that the trust distributes $1,700 out to Child on December 31 and accumulates $400? In that event, the trust's taxable income would only be $300 for the year ($2,100 income less $1,700 distribution deduction less $100 exemption), and the trust's income tax would be $45 ($300 taxable income times 15% tax rate). On the other hand, Child would have to file a tax return reporting $1,700 of income. The first $850 of income would be nontaxable, so that Child would have $850 of taxable income, taxable at Child's 10% marginal tax rate, for a tax liability to child of $85. Thus, the total taxes would be $45 of trust income taxes plus $85 of Child's income taxes for a total of $130.

Suppose that the trust distributes more than $1,700 to Child? Since Child is under age 18, then the amount of the distribution in excess of $1,700 will be subject to the kiddie tax, meaning that Child must pay tax on that excess at Parent's marginal tax rate. If Child were not subject to the kiddie tax, however, Child will pay tax at Child's 10% marginal tax rate.

If the trust has taxable income in excess of $2,150 for 2007, then the trust will go from the 15% marginal tax rate to the 25% marginal tax rate. Thus, it may make tax sense to distribute any trust taxable income in excess of $2,150 out to Child, since Child will be in the 10% tax bracket for taxable income up to $7,825, and the 15% tax bracket for taxable income up to $31,850, before Child will go into the 25% tax bracket. Of course, if the kiddie tax will apply to Child, then this extra income will be taxable to the beneficiary at the beneficiary's parent's rates, which could be as high as 35%.

OTHER CONSIDERATIONS BEFORE MAKING TRUST DISTRIBUTIONS

Distributions that Satisfy a Parent's Legal Obligation of Support. The tax laws provide that if trust income is used to support a minor, then the trust income will be taxed to the beneficiary's parent, who has the legal obligation to support the beneficiary, rather than the minor. Because it is the legal obligation of the parent to support the child, distributions of trust income which discharge that obligation are taxable as if the parent earned the money and then spent the funds for support of the child. For this reason, it is always advisable to have a clause in the trust instrument which specifically prohibits trust income from being used to discharge the parents' legal obligation of support.

The definition of what constitutes a legal obligation of support varies from state to state. Oklahoma law requires parents to provide support and education for their minor children suitable to the circumstances of the parents. What is considered suitable will depend upon the means of the parents and the interpretation of the courts.

What Should be Done with Trust Distributions to the Beneficiary? Let's suppose that it is decided for overall family income tax savings purposes to make a distribution of $850 to a minor beneficiary at the end of the trust's tax year. The $850 distribution would be nontaxable to the minor beneficiary (assuming the beneficiary does not have income from other sources), which serves a useful tax purpose. However, what should be done with this $850? If the beneficiary's parent/legal guardian turns around and recontributes that $850 to the trust, then the Internal Revenue Service could well take the position that the distribution never in fact occurred, and thus, the $850 of income should have been taxed to the trust. One suggestion here would be for the child's parent/legal guardian to put the $850 in a custodial account for the benefit of the beneficiary under the Oklahoma Uniform Transfers to Minors Act. Another possibility would be to go ahead and spend the $850 for the benefit of the minor beneficiary in a manner which would not satisfy the parent's legal obligation of support. Or, the $850 could merely be put in an account in the name of the minor beneficiary, which would then make it subject to the minor beneficiary's control.

Dependency Exemptions for Parents. A parent is entitled to a dependency exemption for a child, provided that (i) the child is under age 19 or is a full-time student, and (ii) the parents pay over half of the child's support. No gross income limitations apply to the child. Thus, the use of a trust for the child does not cause the loss of an exemption if the support test continues to be met.

INTENTIONALLY DEFECTIVE GRANTOR INCOME TRUSTS

It is possible through special drafting to create an irrevocable trust which is a grantor trust for income tax purposes but which is not a grantor trust for estate and gift tax purposes. Such a trust allows the grantor to make a completed gift to the trust, which moves the gifted property out of the grantor’s gross estate for estate tax purposes, but which nevertheless produces income and gain in the trust that is taxable to the grantor. Such a trust is often referred to as an intentionally defective income trust or "IDIT". The trust may be drafted where it is a grantor income trust to the grantor of the trust. Or, the trust may be drafted as a grantor income trust as to the beneficiary. Here are examples of each.

Example: Suppose Mom creates an IDIT for Son and funds the IDIT with $12,000. The IDIT generates $800 of taxable income per year. Since the IDIT is drafted as a grantor income trust to Mom, then Mom reports the $800 of IDIT taxable income on her personal income tax return. The IDIT pays no income tax. Likewise, if Mom were to sell some of her appreciated marketable securities to the IDIT, Mom would not recognize any gain on the sale, since she would in effect would be selling the securities to herself for income tax purposes.

Because Mom pays the income taxes, she has effectively transferred $12,800, rather than just $12,000 of benefit to the IDIT. However, the IRS has acknowledged in a private letter ruling that the income tax which Mom pays on the IDIT income will not be treated as an additional gift to the IDIT, if certain requirements are met. Thus, such an IDIT can be an important estate planning technique by allowing Mom to shift wealth down to a lower generation by subsidizing the payment of income tax.

Example: Suppose the same facts as in the above example, except that the IDIT has been drafted with special provisions which cause it to be a grantor income trust as to Son. This means that Son will be taxable on all IDIT income. Neither Mom nor the IDIT will pay any tax on IDIT taxable income. Thus, in this example, Son would report the $800 of taxable income on his personal return. Making the IDIT a grantor trust as to the beneficiary is often advantageous when the beneficiary is in a lower tax bracket than the IDIT or Mom. Because irrevocable trusts have much more accelerated marginal tax rates that individuals, it is quite often the case that the beneficiary will be in a lower tax bracket than the trust would be.

Of course, if Son is subject to the kiddie tax (described above), then the $800 of income may be taxable at Mom's rates. We often draft trusts which are grantor trusts as to both Mom and Son. In such a case, the grantor provisions as to Mom take precedence. Thus, the trust is initially grantor as to Mom, and she pays the income tax. When Son outgrows the reach of the kiddie tax, we extinguish Mom's grantor rights, and the trust becomes grantor as to Son.

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