Irrevocable Trust What is It and Why Do I Need One?

What is the difference between a Revocable Trust and an Irrevocable trust, and how do I know which is right for me?

In an Irrevocable Trust, you are transferring assets into the trust, and effectively removing all of your rights of ownership to those assets. You dictate at the time of drafting the terms, rules, and uses of the trust assets, which will be administered by a trustee that you appoint.

The main reasons for setting up an irrevocable trust are for estate and tax considerations but they can also serve, in proper circumstances, as asset protection tools. The benefit of this type of trust for estate assets is that it removes all incidents of ownership, effectively removing the trust’s assets from your taxable estate. It also relieves you of the tax liability on the income the assets generate. The assets held in the trust can include interests in a business, investment assets, cash, and life insurance policies. Moving assets into a trust can have tax consequences, so should be used only under the tutelage of a CPA or tax lawyer.

Unlike a revocable trust, an irrevocable trust cannot be modified, amended, or terminated without the permission of your named beneficiaries. That is why the careful and thoughtful drafting of the trust upfront is so important.

Irrevocable trusts are either Living Trusts or Testamentary Trusts.

A Living Trust, also known as an ‘inter vivos’ (Latin for ‘between the living’) trust, is originated and funded by an individual during their lifetime. Some living trust examples are:

  • Irrevocable life insurance trust
  • Grantor Trusts
  • Charitable remainder trust and charitable lead trust (both forms of charitable trusts)

Testamentary trusts are trusts that only spring into use upon the death of the grantor. They are irrevocable by design during the lifetime of their creator. They are funded from the deceased’s estate according to the terms of their will. The only way to make changes to a testamentary trust (or cancel it) is to alter your will if it is part of your will, or to the trust itself, if outside of your will before you die.

An Irrevocable Trust has a grantor (you), a trustee, and a beneficiary or beneficiaries. Once the grantor places an asset in an irrevocable trust, it’s a gift to the trust and the grantor cannot revoke it. Irrevocable trusts can be very powerful tools in the preservation and distribution of an estate, including:

  • To maximize the use of the estate tax exemption and remove taxable assets from the estate. Property transferred to an irrevocable living trust does not count toward the gross value of an estate. Such trusts can be especially helpful in reducing the tax liability of very large estates.
  • To provide for the disposition of your assets to beneficiaries long after you are gone
  • To prevent beneficiaries from misusing assets, the grantor can set conditions for distribution.
  • To create immediate tax benefits by gifting assets to the trust while still retaining the income from the assets.
  • To remove appreciable assets from the estate while still providing beneficiaries with a step-up basis in valuing the assets for tax purposes.
  • To gift a principal residence to children under more favorable tax rules.
  • To take ownership of a life insurance policy that would effectively remove the death proceeds from the estate and allow for the proceeds to be paid out under predefined terms.
  • To deplete one’s property to ensure eligibility for government benefits, such as Social Security income and Medicaid (for nursing home care).
  • To help secure benefits and care for a special needs child by preventing disqualification of eligibility.
  • To create a device to shelter assets from creditors. But, be warned, this can only work in limited circumstances.

Irrevocable Trusts as an Asset Protection tool

Irrevocable trusts are especially useful to individuals who work in professions that may make them vulnerable to lawsuits or are engaged in risky business endeavors. Once property is transferred to such a trust it is owned by the trust for the benefit of the named beneficiaries. If done properly, this renders the assets safe from legal judgments and creditors. Done incorrectly, however, the transfers to the trust can be subject to attack by creditors as fraudulent transfers, and while the rules vary between jurisdictions, in most cases, the grantor can’t protect the assets inside a trust if they are the trustee of the trust. A trustee of an Irrevocable Trust should be an independent party who does not simply bend to the will of the grantor.

Why Revocable Trusts cannot be Asset Protection tools

Revocable trusts do not offer the same protection against legal action or estate taxes as irrevocable trusts. This is because the grantor is typically the trustee, and because revocable trusts may be amended or canceled at any time by their creator. They do offer the benefit of allowing their creator to cancel them and reclaim property held by the trust at any time before death. Revocable Trusts are not considered separate taxable entities so any property held in a Revocable trust still belongs to the trust’s creator and therefore may be included in their estate for tax purposes or when qualifying for government benefits. Once a revocable trust’s creator dies the trust can be deemed to become irrevocable, or can vaporize and the assets returned to the estate of the grantor.