What Is a Clifford Trust and How Does It Work?

A Clifford Trust is an irrevocable trust that was once popular for shifting income to beneficiaries in lower tax brackets. However, changes in tax laws have largely eliminated its advantages. While no longer widely used, understanding how these trusts function provides historical context and estate planning insights.

Purpose and Structure

Originally designed for income splitting, a Clifford Trust allowed a grantor to transfer assets while temporarily shifting taxable income to a beneficiary. Before 1986, the trust had to last at least ten years and a day before assets could revert to the grantor. During this period, income was taxed at the beneficiary’s rate, often lower than the grantor’s.

The trust was irrevocable, meaning the grantor had no control over the assets until the term ended. A trustee, often an independent party, managed the assets and distributed income to the beneficiary, who had no role in trust management. Investments typically included dividend-paying stocks, bonds, or rental properties to maximize income.

Funding Arrangements

Assets placed into a Clifford Trust were chosen for their ability to generate steady income while maintaining liquidity for distributions. Common investments included dividend-paying stocks, municipal or corporate bonds, and income-producing real estate. These ensured a reliable cash flow for the beneficiary.

Since the trust had to remain in place for at least ten years and a day, contributions were structured with long-term financial planning in mind. Trust agreements often outlined reinvestment strategies to balance growth and cash flow. Liquidity management was essential, requiring a mix of short-term fixed-income securities and longer-term investments with staggered maturities. In some cases, excess income was reinvested to sustain cash flow.

Gift and Estate Tax Aspects

Transferring assets into a Clifford Trust was considered a completed gift for tax purposes, potentially triggering gift tax liability. In 2024, the federal gift tax exemption is $13.61 million per individual, meaning contributions below this threshold do not generate immediate tax consequences. If a grantor’s total lifetime gifts exceeded this exemption, any excess would be subject to a 40% federal gift tax.

A common strategy to minimize gift tax liability was using the annual gift tax exclusion, which allows individuals to gift up to $18,000 per recipient in 2024 without reducing their lifetime exemption. By structuring contributions over multiple years, a grantor could reduce or avoid gift tax liability. This was particularly useful when transferring fractional interests in assets like real estate or closely held business shares, where valuation discounts for lack of control or marketability could lower the taxable value of the gift.

Although assets in the trust were removed from the grantor’s taxable estate, IRS rules prevented abuse. If the grantor retained control or a reversionary interest beyond what was permitted, the assets could be pulled back into the estate under Internal Revenue Code 2036 or 2038, negating estate tax benefits. Trust agreements had to be carefully drafted to ensure the grantor retained no control over investment decisions or beneficiary distributions.

Income Tax Implications

During its term, a Clifford Trust shifted taxable income away from the grantor, allowing the beneficiary to report earnings at their tax rate. This was advantageous when beneficiaries were in lower tax brackets, reducing the overall tax burden. However, the Tax Reform Act of 1986 changed this by enacting Internal Revenue Code 673, which classified most Clifford Trusts as grantor trusts for income tax purposes. As a result, the grantor remained liable for tax on the trust’s earnings, eliminating the original tax benefits.

Under the new rules, income generated by the trust was taxed to the grantor, regardless of whether distributions were made. Even if the beneficiary received payouts, the grantor was responsible for reporting and paying taxes on all trust income. Dividends, interest, and rental income were subject to ordinary income tax rates, while capital gains were taxed based on the holding period of the assets.

Termination Conditions

A Clifford Trust expired according to its original agreement, with assets reverting to the grantor once the required term ended. Since the trust was irrevocable, the grantor could not accelerate termination or reclaim assets early without violating tax regulations.

Upon termination, tax implications depended on how the assets were structured. If the trust held appreciated securities or real estate, the grantor assumed ownership at the trust’s original cost basis, meaning any subsequent sale could trigger capital gains taxes. This differed from assets inherited through an estate, which typically receive a step-up in basis. To mitigate potential tax burdens, grantors often transferred assets with minimal appreciation or used tax-loss harvesting strategies before the trust ended.