Irrevocable Trust

When a trust is created, the person creating the trust (the “grantor”) transfers ownership of certain specified property and financial assets to it for the benefit of others he has named as “beneficiaries.” A third party (a “trustee”) is designated by the grantor to manage the trust according to the directions given. In a regular, or “revocable trust,” the grantor has the ability to make any changes he likes while he is still alive, including adding, removing, or changing assets and beneficiaries. In an irrevocable trust, however, the grantor permanently transfers ownership of the specified assets to the trust, and therefore to the beneficiaries, and cannot change it later. To explore this concept, consider the following irrevocable trust definition.

Definition of Irrevocable Trust

Noun

1. A trust created by an individual that cannot be revoked, altered, or amended.

What is an Irrevocable Trust

When an individual creates a trust, he transfers ownership of certain, specified assets to the trustee, who holds legal title to the assets for the benefit of the named beneficiaries, who hold equitable title. This is an important aspect that should be well thought-out before finalizing an irrevocable trust, as the grantor cannot “undo” the trust, or reclaim the assets, once it has been signed, unless he has the specific written consent of the trustee and all of the named beneficiaries.

All irrevocable trusts have certain attributes in common, including:

1. The grantor gives up all right, title, and interest to the assets placed in an irrevocable trust.
2. The grantor cannot alter or terminate the trust without the consent of the trustee and beneficiaries.
3. The assets held by the trust are used for the benefit of beneficiaries specifically stated in the trust document.
4. If anyone is entitled to receive a remainder interest, or what is left over after the trust as served its purpose and has terminated, those interests are spelled out specifically in the trust document.

Types of Irrevocable Trust

Many types of irrevocable trust exist, each designed to serve a different purpose. The most common reasons to create an irrevocable trust are to protect assets from creditors or from being frivolously wasted by an incompetent heir, and to reduce the tax burden.

Irrevocable Trusts to Protect Assets

• Spendthrift Trust – allows the grantor to protect gifts given to someone who may not be able to manage the assets themselves.
• Special Needs Trust – provides for the financial and other needs of an individual with special needs, without interfering with his ability to qualify for government benefits, such as Medicaid, or housing assistance.

Irrevocable Trusts to Reduce Taxes

• Bypass Trust – used to reduce the estate tax burden when a second spouse dies. The first spouse’s assets are transferred into the bypass trust on his or her death, where the surviving spouse can use the assets, but never owns them. When the surviving spouse dies, the assets in the trust are not included in his or her estate for tax purposes.
• Charitable Trust – used to reduce both income and estate tax burdens through making gifts to charity.
• Life Insurance Trust – a trust designed to protect the proceeds of a life insurance policy from taxation. In order to reap tax benefits, a life insurance trust must exist for a minimum of three years before the grantor’s death.
• Generation-Skipping Trust – a trust in which the final beneficiary is a grandchild, or group of grandchildren, who benefit from the trust’s income. Because the beneficiary grandchildren never own the assets in the trust, the assets are not subject to estate taxes when the grandchildren die. There is, however, a generation skipping transfer tax.

Revocable vs. Irrevocable Trust

The concept of an irrevocable trust is fairly straight forward, as once the grantor places assets into the trust, they are there to stay, and he cannot alter the trust or remove the assets again. A revocable trust is a little more complex, however. The creator of a revocable trust can place any assets he desires into the trust, and may later change his mind, taking assets back out. He can also change other terms of the trust, such as who serves as trustee, and who the beneficiaries are. The grantor can also simply terminate the trust, taking all of the assets out. A revocable trust becomes irrevocable, however, once the grantor dies. The tax consequences of a revocable trust differ substantially from an irrevocable trust, and so it is important to consult a professional before creating such a trust.

Advantages of Setting up an Irrevocable Trust

The primary reason individuals set up irrevocable trusts is to manipulate estate and tax consequences. Assets placed in an irrevocable trust are effectively removed from the grantor’s ownership, eliminating the tax liability on those assets had they been left in the estate. Transferring ownership of income or interest earning assets to such a trust also eliminates the income tax for those items. These tax benefits apply only in situations in which the trustee is someone other than the grantor.

Another advantage of placing valuable assets into an irrevocable trust is to protect them from creditors. This is because the grantor no longer has control over the assets. Assets that may be held in an irrevocable trust include, but are not limited to, such items as cash, investment assets, real property, life insurance policies, and businesses.

How to Create an Irrevocable Trust

While most people use an attorney to draft trusts, it is not a requirement. A trust must be a written document specifically defining the terms and conditions of the trust. Trust forms and templates are available from certain organizations. An individual who obtains a quality trust template only needs to read through the text, adding specific details as prompted. The most important thing to remember is to be very specific about everything, from exactly what property or financial assets are to be transferred to the trust, who the beneficiaries are, who the trustee is, and when, and under what conditions, the assets will be distributed to the beneficiaries. The trust must be signed before a notary public, and in some states, witnesses.

Funding the trust is the next step, and is vital, as until ownership of the assets is actually transferred into the trust, it is a useless document. Individuals creating a trust can obtain guidance on how to transfer assets into the trust from qualified attorney, as well as some banks, accounting professionals, and real estate professionals.

Ultimately, the provisions included in any trust can be personalized to the needs of the grantor, and the character of his estate. The named trustee may be one or more individuals, and may serve jointly or in succession. The grantor may name alternate trustees, as well as alternate beneficiaries. For example, if Ronald places $500,000 in trust for his granddaughter, Tina, but Tina dies in an accident before the trust is distributed, her children might receive the assets and benefits instead. These are important considerations to be specifically stated in the terms of any trust.

What is an Irrevocable Life Insurance Trust or “ILIT”

The term “ILIT” refers to an irrevocable life insurance trust. An ILIT is the same as a regular irrevocable trust, but given the acronym to distinguish it as a trust set up to shelter life insurance benefits from taxes. Many people know that life insurance proceeds are not subject to income tax, but not many realize that these benefits are subject to estate tax. Life insurance policies that are purchased by, or transferred into, an ILIT are not subject to estate taxes.

For example:

George has planned well to provide for his children and grandchildren after his death. Not only has he invested wisely, but he has purchased a $1 million term life insurance policy, though his wealth has placed him in the 45% tax bracket for estate taxes. When George passes away, the life insurance policy will pay out $1 million, and the IRS will take 45%, or $450,000 to satisfy the estate taxes just on the insurance payout.

If George had set up an irrevocable life insurance trust, transferring the life insurance policy into it, the insurance proceeds would have gone straight to the named beneficiaries, avoiding estate taxes, and saving his heirs nearly half a million dollars.

Avoiding Gift Taxes with an ILIT

When an individual gives a gift over a certain value to someone, he himself is responsible for paying the gift tax. The gift value of a life insurance policy placed into an irrevocable life insurance trust is the dollar amount it cost to purchase the policy, not the amount it will pay out upon the grantor’s death. Such an insurance premium is rarely high enough to be on the radar of gift taxes, though the policy payout is removed from the estate and therefore estate taxes. Because of this, a seemingly small gift (the price of the policy) actually becomes a large gift when it is finally distributed.

For example:

Margery transfers $20,000 into an irrevocable trust for the benefit of her two grandchildren. When Margery dies, the $20,000 is split between the children tax free. If, on the other hand, Margery had placed $20,000 into an irrevocable life insurance trust, and the trustee used the funds to buy a $500,000 life insurance policy, the children would split half a million tax free dollars on her death.

Irrevocable Living Trust

Trusts, both revocable and irrevocable, specify how the grantor’s assets will be distributed after his death. Alternatively, the terms of a “living trust” go into effect while the grantor is still alive. This means that an irrevocable living trust goes into effect during the grantor’s lifetime, and cannot be revoked, altered, or terminated. One reason an irrevocable living trust may be used is to fund a beneficiary’s education while the grantor is still living.

Related Legal Terms and Issues

• Assets – Property or finances owned by an individual or entity, and regarded as having value.
• Beneficiary – A person or entity that receives benefits or advantages from something; a person or entity designated to receive property or assets under a will, trust, or life insurance policy.
• Equitable Title – A person’s right to obtain full legal ownership of an asset or property at a future point.
• Notary Public – An individual appointed by the state government to serve as an impartial witness to the signing of important documents.