Irrevocable trusts enjoy a certain mystique and an implication of wealth, but the concept of a trust is really pretty simple. Party A creates the trust and transfers ownership of certain assets and property into its name. Party B oversees the trust, managing any investments it might contain and distributing the property and income to Party C, the beneficiary, according to the trust’s terms. It’s as simple as that, at least on the surface.
Trusts can have multiple beneficiaries and they can hold virtually any type of property, from an automobile to a business to a life insurance policy. The exact structure of trusts and the laws surrounding them can depend on the state where they’re formed, but some federal laws apply to them as well with regard to taxation.
Irrevocable Trusts vs. Revocable Trusts
Living trusts aren’t all the same – they come in several varieties – but all are either revocable or irrevocable. As the name suggests, an irrevocable trust is a forever thing, or at least it’s supposed to be. Its terms can’t be changed after it’s formed and it can’t be shut down. Party A, called the grantor or settlor in legal terms, can’t take back the property that he’s placed into it.
Contrast this with a revocable trust. The grantor can pull the plug on one of these any time he likes. Revocable trusts are sometimes referred to as grantor trusts for this reason. A revocable trust automatically becomes irrevocable when the grantor dies because he can no longer make changes to it or revoke it after the time of his death.
The Rights of a Grantor of an Irrevocable Trust
The grantor does get to dictate what happens to the property he places into the irrevocable trust, but he must do so at its inception. He makes his wishes known in the trust’s formation documents, and they’re ironclad as well when the trust is formed. For example, he might dictate that his son should receive all the income generated by the trust, but not all at once. His son might receive just enough yearly from the trust to pay his necessary living expenses, then receive additional lump sums at predetermined times.
The grantor of a revocable trust typically also acts as trustee, but the grantor of an irrevocable trust isn’t permitted to do this. The grantor must step aside after he's formed and funded the trust, relinquishing control to someone else he names as trustee – but he also gets to select this individual.
So why would anyone of sound mind want to part with their assets and possessions for all time, never to have any further say in what happens to them? People form irrevocable trusts because they offer numerous benefits that revocable trusts don’t. One common purpose is to avoid estate taxes.
If John Doe should die owning $15 million in assets, the federal government would take 40 percent of that value over $11.18 million as of 2018. That’s a big tax bill. But if had John had moved that $15 million into an irrevocable trust prior to his death, the IRS would not get a cut. Why? Because he no longer owns that property and cash. His trust does, and irrevocable trusts don’t pay estate taxes because they don’t die.
This isn’t the case with revocable trusts. Remember, the grantor/trustee of a revocable trust can take his property back at any time. The IRS, therefore, takes the position that he hasn’t really relinquished ownership so it's still part of his estate.
Irrevocable Trust Taxes
An irrevocable trust is taxed much like an individual would be, but according to its own income tax rates. Irrevocable trust taxes come into play when a trust earns $600 or more in income during the year, or when any beneficiary is a non-resident alien. Trusts must file their own income tax returns – IRS Form 1041.
The Irrevocable Trust Gift Tax
Of course, when you fund a trust, giving it your property, the IRS says you’re making a gift and this opens a whole new door to taxation. Funding a trust can trigger a gift tax, payable by the grantor because he’s the one who made the gift. The IRS defines a gift as anything the giver surrenders control of when he gives it without receiving compensation equal to its full market value.
But there’s still that $11.18 million estate tax exemption available as of 2018. This exemption doesn’t apply just to the estate tax. It’s shared with the gift tax. So you can give your irrevocable trust up to $11.18 million in cash, assets and property during your lifetime without triggering a gift tax.
Of course, there won’t be anything left of that $11.18 million exemption to shield your estate from estate taxes when you die if you do this, but you no longer have to worry about that. You no longer have an estate. You’ve moved it into the ownership of your trust. You can also give away up to $15,000 per entity per year without triggering a gift tax or dipping into the $11.18 million exemption as of 2018.
Irrevocable Trusts Provide Asset Protection
Another benefit of an irrevocable trust is asset protection. Maybe John Doe is still hearty, very much alive, but he works in a profession that makes him a likely candidate for high-dollar lawsuits. Maybe he’s a cosmetic surgeon or a rock star. Assets placed in an irrevocable trust are immune to judgment claims – again, John no longer owns that property. He no longer has access to that cash. But this is not the case with a revocable trust.
And irrevocable trusts aren’t just for the wealthy and rock stars. The same rule applies to everyday creditors. If John were of modest means, he would still benefit from an irrevocable trust if creditors should sue him for balances due. Maybe he had a medical emergency and he didn’t have health coverage and now he owes healthcare bills in the six figures. He doesn’t have enough cash on hand to pay them all. His creditors can’t seize or attach anything owned by the trust to collect from him. Likewise, if he were in a terrible car accident resulting in someone’s death and if he were to be personally sued for damages, the property in his irrevocable trust would be safe from this claim as well.
Property held in an irrevocable trust is only accessible by creditors or judgment holders if they can prove to a court that assets were moved into the trust fraudulently for the sole purpose of protecting property that might be vulnerable in a lawsuit. And formation of the trust would have had to have occurred within a prescribed period of time of the conditions that gave rise to the claim. If John formed the irrevocable trust years prior, the property he placed in it would be safe.
Irrevocable Trusts Can Address Long-Term Care
Another advantage of irrevocable trusts addresses Medicaid requirements. In the simplest terms, you’re not eligible for Medicaid coverage for long-term nursing home care if you own too much in the way of assets. This is why many elderly individuals try to spend down their estates in advance, giving their property away to their children and other relatives. They reason that if they don’t own it, it can’t be counted against them, but that’s only partially true.
Medicaid imposes a five-year look-back period. Let’s say John gives that $15 million to his children directly. He’s not eligible for full Medicaid coverage until five years passes from the date of the last transaction. This same look-back period applies to irrevocable trusts – you’d have to create and fund the trust, moving your property into it, at least five years before you need Medicaid coverage – but there are some exceptions. For example, the look-back period doesn’t apply if the trust’s sole beneficiary is disabled and younger than age 65.
Types of Irrevocable Trusts
Now that all this property is safely tucked away in the ownership of your irrevocable trust, what happens to it? It depends on exactly what type of irrevocable trust you’ve formed and the terms you’ve created for it. There’s pretty much an irrevocable trust for every need and concern.
If your child is notoriously bad with money or maybe she’s married to a money-hungry spouse, you might want to make sure she doesn’t inherit a huge lump sum that might be spent and gone within a year. This type of trust is aptly called a spendthrift trust. You can set its terms to trickle income to your child in dribs and drabs, giving the trustee the power to oversee distributions in such a way that her needs are always met.
An irrevocable life insurance trust holds just that single asset – an insurance policy on your life, owned by the trust, payable to beneficiaries at the time of your death. Because you don’t own the policy, the proceeds won’t hike up the value of your estate at the time of your death. You can fund the trust with enough cash to purchase the policy and pay the amount of the ongoing premiums into it each year.
Inheriting a lump sum of money can make a disabled beneficiary ineligible for benefits such as Supplemental Security Income and Medicaid. A special needs trust can prevent this from happening when it’s structured correctly. The trust owns the property. The beneficiary doesn’t own it outright. The trust’s terms must make it clear that the beneficiary has no immediate right to the property or funds contained in the trust. Nonetheless, he can benefit from it if the trustee manages the transactions in a certain way.
Breaking an Irrevocable Trust
An irrevocable trust is supposed to be forever, but forever is a long time. What if you set up your irrevocable trust in 1998 and the economy has changed so much that it no longer serves the purpose you intended 20 years later?
Although it’s true that you’ve relinquished all control over the trust and its property so you can’t undo it or make changes to it yourself, this isn’t necessarily the case for your trustee and its beneficiaries. They still have some options.
First, you can give them the authority to undo the trust at some future point in time subject to certain conditions set and determined by you in advance, provided they act unanimously. Another option is called judicial reformation. This might be appropriate if all your trust’s beneficiaries and the trustee don’t agree that changes should be made to the trust or on what those changes should be. They can involve the court in the absence of a unanimous agreement, asking a judge to order that the trust can no longer serve as you intended so it should be changed.
You can also name a trust protector, a party in addition to and other than the trustee, who can step in and make changes in emergency situations. You can set terms that the trust can be decanted under certain circumstances, which means it’s effectively closed down but its assets are moved to another, newly created trust with more appropriate terms.
Irrevocable Trust Form
This type of trust is obviously complicated, designed to cover one or more different scenarios, and it’s intended to be permanent. Yes, you can purchase forms from an office supply store or legal website and create your own, but this could be disastrous if you make an error. At the very least, you might want to have an estate planning attorney review your documents to make sure you’ve created what you think you’ve created before you sign on the dotted line.
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Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.