To begin to understand revocable vs. irrevocable trusts you first need to know first what a trust is AND how it works.
This article will review some trust basics and then will dive into the pros and cons of revocable vs. irrevocable trusts for you or your favorite clients.
A Trust is An Agreement
A trust is an agreement that is used to accomplish any number of goals. The PARTIES to a trust agreement are:
- the trustmaker, trustor, settlor or grantor
- the trustee
- the beneficiary
- the trust protector (if one is appointed)
As the names of the parties suggest, if you were to create a trust, you as the trust maker would be deemed party #1 above AND you would need to appoint a trustee (#2). Irrevocable trusts require an independent trustee (someone who isn’t you) located in the jurisdiction where the trust is filed (the situs of the trust). Just FYI, with a revocable trust, you can serve as your own trustee.
You would also designate who the beneficiaries (#3) are in the trust document. Most of the time, children (or adult children) are the designated beneficiaries. Although, some states allow “self settled” trusts which allow you to set up an irrevocable trust naming yourself as beneficiary. Your beneficiary designation will also be influenced by your goals which will be discussed in more detail to follow.
You also might appoint a trust protector (#4) in order to assure that if changes need to be made to the trust document itself, and you aren’t allowed to make them, the trust protector could do so at your direction.
The BASIC GOALS for any trust agreement are:
- probate avoidance
- disability planning
- asset protection
- estate tax planning
- gifting to younger generations with control
- pre-Medicaid planning
We’ll talk more in a bit about the above goals and how they can be accomplished with revocable vs irrevocable trusts after wrapping making sure you understand what we’re talking about.
Revocable vs. Irrevocable Trust Agreements
The revocable trust, aka living trust, aka inter vivos trust, can be revoked after it has been created. Further, the revocable living trust can be easily amended to make changes, such as to the trust beneficiaries or changing the trustee and successor trustee, simply by amending the existing living trust.
The revocable living trust IS NOT a separate legal entity from the trustmaker NOR is it assigned a separate tax id number. The revocable trust is operated with the trustmakers social security number and can thus be easily terminated or amended at any time while the trustmaker retains capacity to do so. Similarly, trust assets may be transferred easily both IN and OUT of the asset title name of the revocable trust.
An irrevocable trust is the type of trust agreement that CANNOT be revoked after it has been created.
By definition, the irrevocable trust is distinguished from its more flexible counterpart the revocable trust which may be revoked at any time.
The irrevocable trust is an entirely different animal from the revocable trust for these reasons:
- Irrevocable trusts are a separate legal entity from the trustmaker
- Irrevocable trusts are assigned an independent tax id number and a closely scrutinized for tax purposes.
- Irrevocable trusts cannot be terminated after they are established and this means that transfers of trusts assets are restricted.
- Irrevocable trusts cannot be easily amended (changed) or revoked due to their restrictive nature, although some safeguards may be implemented to add some flexibility.
Estate Planning with Revocable vs. Irrevocable Trusts
[Top Pros and Cons]
Without delving into estate planning goals and revocable trusts, the following sections will highlight the various estate planning goals listed above that can be uniquely accomplished through irrevocable trusts.
Revocable and irrevocable trusts BOTH offer significant estate planning benefits highlighted as follows:
Asset Protection with Revocable vs. Irrevocable Trusts
The concept of asset protection and protecting assets from creditors is explained in detail in another article. There are also numerous asset protection pitfalls to avoid as discussed in another post. I encourage you to review those articles to get up to speed on asset protection in general.
For our purposes here, revocable vs. irrevocable trusts offer asset protection benefits in different ways.
Revocable trusts ONLY offer asset protection benefits following the death of the trustmaker. So, these trusts are effective at providing asset protection for beneficiaries. The way this works is that the revocable trust becomes irrevocable upon the death of the last surviving trustmaker and thereby becomes an asset protection trust for the surviving beneficiaries and their heirs.
The irrevocable trust already is a separate and independent entity from the trustmaker so they don’t need to die in order for it to become asset protected. The fact that it is a separate entity makes this an ideal place for the trustmaker to “park assets” intended to be beyond the reach of creditors.
The reason for this, simply put, is that the irrevocable trust is a legal person and that isn’t you. The way this plays out in a legal skirmish is that if a judgment is entered against you personally, you can rightfully claim that the trustee has no authority to release the assets. This move would be especially effective is the beneficiary of the trust is not you but rather your children or other heirs.
The ability to protect assets in an irrevocable asset protection trust also will depend upon the laws of the jurisdiction regulating that trust.
This is why certain locations, both foreign and domestic, are classified as asset protection havens due to the legal situation in those jurisdictions. This is also an important distinction pertaining to whether you choose a domestic asset protection trust or a foreign aka offshore asset protection trust.
As a rule, offshore asset protection trusts are more expensive to administer and thus are typically sought out by those holding the largest estates. The trustee fees and other administrative costs in these jurisdictions can be substantial. Perhaps the old adage applies…if you have to ask, you can’t afford it.
Jurisdictions for offshore trusts, whether in Nevis, Lichtenstein or Puerto Rico, or any number of other countries, should be carefully considered, accounting for the stability of the location as well as the long standing protection offered by the jurisdictional laws. Some of asset protection havens with a relationship to the U.K. were impacted by brexit and so this among other things should be considered.
It is also important to know, concerning offshore asset protection, that while they offer protections that are theoretically beyond the reach of U.S. Courts, the trustmaker can still be held in contempt in the U.S. and jailed for refusing to disclose trust assets.
As alternative to offshore asset protection is a domestic asset protection trust based in any one of a number of states such as Nevada, Alaska, Wyoming, South Dakota, or Delaware. Similar to offshore trusts, these locations are governed by state laws that tend to support a high level of anonymity and protection for trustmakers and their beneficiaries.
The net affect of the favorability of state laws means that a court in a less favorable jurisdiction (like California) may be obliged to apply Alaska law to a creditor lawsuit involving an Alaska trust under the doctrine of full faith and credit. Applying Alaska law may result in a finding that the creditor should have NO access to the trust funds.
For offshore trusts, the protection is theoretically greater because those jurisdictions, even if a court finds that the creditor should have access to the assets, the foreign courts and trustee can disregard the court order from the U.S.
Estate Tax Planning and Gifting
[Revocable vs. Irrevocable Trusts]
Goals for estate tax planning and gifting to heirs with control tend to merge because they both offer estate tax planning advantages, so we’ll discuss them together here.
Gifting to Trusts
Gift transfers to a revocable trust are NOT really a gift for all of the reasons discussed above but to repeat that the revocable trust is NOT a third party (independent legal entity) from you and this would be gifting back to yourself.
However, revocable trusts are used for other kinds of estate tax planning strategies such as spousal planning and generation skipping taxes. For many years revocable A-B trusts have been used to make sure that one spouse can take full advantage of a deceased spouses federal estate tax exemption.
Revocable trusts also commonly have generation skipping tax provisions to make sure that this exemption is preserved when transferring wealth to future generations. These strategies are implemented upon the death of the last surviving trustmaker.
Irrevocable trusts ARE subject to gifting rules because they are recognized as a third party (independent legal entity). For this reason, just as an irrevocable trust is ideal for asset protection, it is also ideal for any number of estate tax planning strategies.
Under current estate tax laws, any transfer of assets to a third party is closely scrutinized because those seeking to limit estate taxes naturally would be inclined to transfer the assets to adult children or other heirs prior to death.
The amount that may be transferred to a third party is limited by IRS rules under both a lifetime and annual basis.
On a lifetime basis, the gift tax exclusion in 2018 is tracking along with the recently increased federal estate tax exemption at 11.2 million per individual and 22.4 million for married couples.
On an annual basis, the gift tax exemption is $15,000 per beneficiary, to any number of beneficiaries.
So, the net effect of transferring assets to an irrevocable trust is the same as if you transferred the asset to an heir or other third person. Thus, transfers are viewed with scrutiny and must be disclosed to the IRS as part of one’s tax returns. However, the beauty of this strategy is that the transferred asset can continue to appreciate OUTSIDE of the trustmaker’s estate and thereby NOT subject to federal estate taxes.
Irrevocable Life Insurance Trusts
A common way that an estate tax savings strategy is applied is through an Irrevocable Life Insurance Trust (ILIT) a.k.a. “Wealth Replacement Trust“.
Simply put, if you had 3 children, you can gift $15,000 per year to EACH of them and make them the beneficiary of an ILIT. The annual gifted proceeds can be used to fund a permanent cash value life insurance policy that can accrue cash value and death benefit outside of the trustmaker’s estate.
Sometimes a second to die policy used to fund an ILIT is beneficial if the surviving spouse won’t need the death benefit proceeds. Using an ILIT with life insurance is a way to gift to children with CONTROL reserved to the parents as defined in the trust. Although the parents will not retain direct control by serving as trustee, they will maintain practical control by being able to direct the trustee.
Other common estate tax planning approaches include charitable remainder trusts and charitable lead trusts, and other grantor trusts. Each of these strategies is unique and based upon the tax savings objectives of the parties.
In short, charitable trusts (charitable lead trusts and charitable remainder trust) provide a way to save substantially on income taxes and capital gains as well as estate taxes depending upon the strategy elected.
A charitable trust may be included in a revocable trust to become effective upon the trustmaker’s death OR, more commonly, may be created as an irrevocable trust during the trustmaker’s lifetime so thus are mostly recognized in the irrevocable trust category.
Charitable remainder trusts can allow an income producing asset that has been acquired by the trust to pay income during the specified period of time with the remainder passing to charity at the end of the term without estate taxes. These trusts can be used for business exit strategies where the business is transferred to the trust and then sold, with the proceeds of sale then used to purchase the income producing asset.
Charitable lead trusts provide that income may be paid to a charity at an amount to be based upon a specified formula for a defined term, with the remaining assets to pass to estate beneficiaries free of estate taxes.
The formula for calculating the amount to be paid to either the trustmaker or the beneficiaries will determine whether the trust as defined as an annuity trust (CRAT) or unitrust (CRUT). The simplified way to explain this difference is that income payment in an annuity trust is calculated based upon the value of the initial account contributed to the trust with a possibility for adjustments.
A unitrust calculation is based upon a percentage of the value of the entire trust account that is usually reviewed annually. The unitrust can be either favorable or unfavorable depending upon the goals of the trust.
For example, in a charitable lead trust, where the intent is to transfer as much of the remainder assets as possible to beneficiaries, the unitrust may NOT be desired. Similarly, in a charitable remainder trust where the goal is to have increasing income every year reserved to the grantor, the unitrust may be the preferred option.
Grantor trusts, again may be known as either a revocable or irrevocable trust because they are both created by a GRANTOR or SETTLOR and refer to trusts where the trustmaker (a.k.a grantor) retains an interest in the trust.
However, if a grantor trust is created for income tax or estate tax planning advantage, then it is referring to an irrevocable grantor trust. If a grantor trust is irrevocable, the grantor may have reserved certain controls over the trust assets such as the right to “swap” trust assets.
Another test is whether the grantor has retained the right to the trust income. If these or other aspects of the trust are present, then an irrevocable grantor trust has been created and the trust income will be taxable to the grantor/trustmaker.
A charitable trust may be either a grantor trust or non-grantor trust. It also may be designed in different ways so that the assets either revert to the grantor or to the beneficiaries. A full discussion of charitable trusts is high detailed and the subject of a future article. Just know that there are many options for drafting these trusts.
A grantor trust may NOT always be for charitable purposes and these non-charitable grantor trusts are called grantor retained annuity trusts (GRATs) or grantor retained unitrusts (GRUTs). Like charitable trusts, the formula applied to calculate the income will determine whether the grantor trust is GRAT or GRUT.
Another example of a non-charitable grantor trust might be where an ILIT, discussed above, is established that allows the grantor to retain the right to income from the trust, and they thereby remain responsible to pay taxes on that income. This can be an advantage where the income may otherwise constitute an additional gift to the trust, thereby depleting the lifetime gift tax exemption.
Medicaid Planning with Trusts
Another type of grantor trust that is specifically used for long term medical care planning is a Medicaid trust or income only trust for Medicaid planning.
Revocable trusts can be used for pre-Medicaid planning by allowing the trust to administer assets in order to maximize qualification for Medicaid and SSI disability benefits.
Other strategies use irrevocable trusts for Medicaid planning.
For example, the grantor’s assets may be “gifted” to an irrevocable trust and thereby transferred outside of the estate. This is a grantor trust because the trustmaker retains the right to all income paid from the trust. The income will remain taxable to the grantor for AND for this reason, it will not constitute an additional gift to trust.
This strategy can accomplish a couple of important objectives.
First, it reduces the size of the grantor’s estate. In this case, the purpose is NOT to limit federal estate taxes but rather to enhance the likelihood of qualifying for “need based” Medicaid benefits without having to “spend down” the estate assets.
Second, allowing for the payment of income, if the amount is not too high, allows the assets outside the trust to continue to be spent down, and thereby utilized, while possibly allowing for qualification under the Medicaid income rules.
Medicaid Lookback Penalties
For strategies that use irrevocable trusts for Medicaid planning, it is important to remember that transfers to non-spouses are reviewed under state Medicaid laws and in most jurisdictions there is a 5 year lookback period for transfers. In some states, such as California, the lookback period is 36 months. Penalties under Medicaid will result if transfers for less than fair market value are discovered during the Medicaid application process that occurred during the applicable lookback period.
As always, all of the above strategies are complicated and the end result can vary widely from case to case depending upon your specific objectives. Topics should be considered general information and we are NOT therefore recommending any specific options as this warrants an in depth fact finding discussion. Call or e-mail us today to start a formal fact finding process.