Top 10 Awesome Benefits of Irrevocable Living Trusts
An irrevocable living trust is a trust you create during your lifetime, which you cannot revoke. Once you put assets in an irrevocable trust, you can’t withdraw them. You can’t change the beneficiaries of the trust or change its terms. And you surrender ownership of the property.
While the beneficiaries can agree to change some of the terms of an irrevocable living trust, you mostly give up control of the assets you put into an irrevocable trust when you create it. So why create one?
There are so many irrevocable trust benefits, which would motivate a grantor (or settlor) to relinquish total control over his or her property. This article discusses the Top 10 irrevocable trust benefits, which are:
- Removing Assets from Your Taxable Estate.
- Asset Protection.
- Generate Income Revenue from Assets Gifted to the Trust.
- More Flexibility in Planning During Your Lifetime.
- Step-up in Cost Basis
- Can Remove a Life Insurance Policy from Your Gross Estate.
- Protect Eligibility for Government Benefits and Entitlements.
- Great Way to Pass Principal Residence to Children,
- Can Prevent the Misuse of Assets by Beneficiaries.
- It’s Private (Mostly).
Overview of Trust Types
The term living trust (also called inter vivos trust) simply means any trust enacted during your life. Living trusts can be revocable or irrevocable.
A revocable trust is mostly used to avoid probate. But, for higher wealth estates, a revocable trust is usually drafted with standby irrevocable trusts which absorb the estate upon the grantor’s death. The obvious benefit to this kind of planning is that you maintain complete control over the trust property and also provide significant tax advantages to your estate after your death.
If you want to know more about revocable trusts check out our article called “7 Advantages of Revocable Trusts that You Need to Know.”
Testamentary trusts are trusts that are created by the settlor’s (or grantor’s) will after he/she passes. For example, you might create a will that says that on your death, all of your estate should be held in trust for the benefit of your children.
In earlier times, many wealthy families created perpetual trusts that were intended to last long beyond the lifetime of their creator. No U.S. jurisdiction currently allows perpetual trusts.
But there is still a special type of trust called a “dynasty trust,” which is intended to pass wealth to trust beneficiaries for generations after the grantor has died. A dynasty trust is subject to the gift tax, generation-skipping transfer tax, and estate tax, only if the initial gift to the trust exceeds the estate exemption. For 2020, the exemption is $11.58 Million.
A revocable trust and an irrevocable trust will allow you to keep assets out of probate, which has two main advantages. First, it lowers your tax burden. Second, a will becomes public record after your death. If you want to maintain the privacy of your heirs, a trust is the only way to protect their privacy.
Why Do Estate Planners Recommend Irrevocable Instruments in Some Situations?
Revocable living trusts allow the grantor(s) far more control after creating the agreement. So, why do estate planners ever recommend irrevocable trusts to their clients?
Two significant advantages of an irrevocable trust are:
1. Removes Assets from Your Taxable Estate
Under current U.S. federal tax law, you can exclude up to $11.58 million from estate taxes.[i] This means that you can give your heirs and beneficiaries up to $11.58 million free from estate tax and income tax.
The federal government will want $0.40 for every dollar your children inherit over $11.58 million. This is called the estate tax. An irrevocable living trust is the only way to give more than $11.58 million to your children or heirs without incurring the 40% estate tax.
While the current exemption from estate taxes seems generous at $11.58 million per person, Congress can always change federal tax law. In fact, just three years ago, the exemption was $5.49 million. Ten years ago, it was $3.5 million.
Having a creative estate plan that incorporates irrevocable trust documents can help protect your estate from the volatile and politicized estate tax exemption.
2. Protect Your Assets from Lawsuits and Bankruptcy
One of the other prominent irrevocable trust benefits is asset protection.
When you put property or money into an irrevocable trust, you no longer own those trust assets. Since you no longer own the assets, they can’t be awarded as damages in a lawsuit against you. Nor can these assets be attached in bankruptcy proceedings. The simple reason is that they are not yours; they belong to the trust.
Thus, if you have a home in an irrevocable trust, there is (almost) nothing a creditor can do to take it – even if you file for bankruptcy or have a judgment against you.
Another really cool thing about irrevocable trusts is that almost all irrevocable trusts require discretionary payments of trust income to the trust beneficiaries. But an irrevocable trust is also a kind of spendthrift trust. That means that the trustee of the trust can cut off the discretionary payments if he or she believes they will be used to satisfy a creditor or judgment.
This protects the trust property from claims against the beneficiaries of the trust.
So if you are engaged in a profession where lawsuits are common, such as doctors, lawyers, and people who own companies that build products vulnerable to class-action lawsuits, an irrevocable trust can help you protect some of your assets. Additionally, an irrevocable trust may be good if you are involved in risky economic sectors or investments.
Specific Irrevocable Trust Benefits
Aside from the general benefits listed above, some other irrevocable trust benefits are:
3. Gift Assets from the Estate While Continuing to Receive Income from the Assets
As discussed above, you can create an asset protection trust to help shield trust assets from judgment-creditor claims. If you create an inter vivos (meaning during your lifetime) asset protection trust, you can gift the trust up to $15,000 per year free from the gift tax. Additionally, you can gift up to $11.58 million without paying any estate tax.
Moreover, you can still enjoy the benefit of the trust property while you are alive. An asset protection trust may make periodic distributions of income to you while you are alive. Additionally, (depending on the language of the trust document), you may be able to receive payments from the principal of the trust to the extent it is used to pay for your health, education, maintenance or support.
This is a great option to immediately protect assets from creditors while still retaining the income from them during your lifetime. This can allow you to enjoy the fruits of your labor while ensuring that you can pass them on to your heirs.
4. Can Combine with the Estate Tax Exemption to Remove Some Assets from Your Estate While Retaining Control Over Others
The inability to change the trust after creating it worries many clients. Your estate planner can use a combination of different testamentary instruments to meet your specific needs. For example, you can exempt up to $11.58 in a revocable trust to retain control over some of your assets during your life, while protecting other assets in an irrevocable trust.
Moreover, if you are married, you can create a bypass trust and/or a “qualified terminable interest property trust (also known as a QTIP trust) to double your $11.58 million dollar exemption.
This kind of estate plan also allows your surviving spouse to retain control over a large portion of the estate while preserving maximum tax advantages.
5. Will Provide a Step Up in Cost Basis for Assets
The IRS imposes taxes on any gain in value on the sale of a property, which is measured by the sale price of the asset minus the cost basis (which roughly correlates to the purchase price). This is known as the capital gains tax. While you won’t retain control of any property you put into an irrevocable trust, your trust beneficiaries will get a step-up in cost basis to the market value of the asset at the time they receive the benefit.
Since assets like securities and real property tend to increase over time, this step-up can save significant money on capital gains taxes when your beneficiaries sell the asset.
For example, suppose you bought a home for $100,000 in 1950. You sell if today for $1,000,000. Your “basis” in the home is $100,000 (the amount you purchased the home for in 1950. The amount subject to the capital gain tax is the difference between the sales price and your “basis.” In this example, you would pay capital gains tax on $900,000.
But, if you transferred the home to an irrevocable trust, then the trust gets a “step-up” in basis. This means that the “basis” for the home is the fair market value of the home when it is transferred to the trust.
6. Can Remove Life Insurance Benefits From Your Estate
Under normal circumstances, any asset your heirs or beneficiaries receive upon your death will become part of your estate for purposes of calculating the estate tax exemption. You can remove death benefits from your estate by placing your life insurance policy in an irrevocable life insurance trust (ILIT).[ii]
The way an ILIT works is the creator (or grantor) of the ILIT gifts money each year to the trust. The trustee then notifies the beneficiaries that they have a right to withdraw the gift from the trust.
If the beneficiaries do not withdraw the gift (and they won’t as long as your family is all on the same page), then the trustee of the ILIT uses the gift to pay the premium on a life insurance policy insuring the life of the grantor. Thus, when the grantor dies, all of the life insurance proceeds pass to the beneficiaries tax-free.
Another major advantage of using an ILIT is its flexibility. You can structure a life insurance trust so that the payments of the life insurance proceeds do not pass in a lump sum to your beneficiaries. Instead, you can specify how the life insurance proceeds are paid, when they are paid, and to whom they are paid.
This can be an excellent way to fund your entire estate and provide the needed liquidity to retain large illiquid assets (such as a family home).
One major disadvantage to an irrevocable life insurance trust is that you need to appoint someone as a trustee who can navigate the complexities of paying the insurance premiums and giving proper notice to the beneficiaries.[iii] Thus, you need to take greater care in choosing a trustee that you might otherwise for a different kind of trust.
This is another tool to use in your quest to avoid death taxes.
7. Protect Eligibility for Government Benefits and Entitlements
Trusts aren’t just for the wealthy. You can use an irrevocable trust to remove assets from your control, which could cause you or your beneficiaries to exceed the asset caps for federal benefits and entitlement programs like Medicaid and Social Security.[iv]
There are two major kinds of irrevocable trusts that either preserve government benefits or help you qualify for government benefits: the Special Needs Trust and the Veterans Trust.
A special needs trust is created to help a person with a disability qualify for (or remain qualified for) some type of government benefit. It provides a person with special needs funds for assistance with the necessities of daily life that are not already covered by a government benefit.
For example, if your child is high functioning autistic, he or she may be eligible for many government programs such as housing assistance, Medicaid, disability benefits, and more. If you leave your estate to your autistic child, then it could disqualify him or her from these benefits (because he or she will be outside the maximum income and asset levels).
But, if instead, you leave your estate to a special needs trust, then your child can remain qualified for government benefits, and receive payments from the special needs trust to supplement his or her needs.
A veteran’s trust is designed to help veterans of foreign wars to qualify for the pension benefits and aid and attendance benefits provided by the Department of Veterans Affairs. For example, if you are a veteran and served at least one day during a time of war, you qualify for a number of benefits provided by the VA.
Some of these benefits, like aid and attendance, and the pension have set income and asset cap limits. A veteran’s trust is an irrevocable trust that received the veteran’s assets to allow him or her to qualify for these benefits.
8. Can Pass Principal Residence to Children Under Favorable Tax Rules
Under normal circumstances, when you die, estate taxes are calculated based on the gross fair market value of your estate at the time of your death. Thus, if you have a home worth $2 Million at the time you die, you could pay estate taxes on the entire $2 Million value.
But, if you set up a Qualified Personal Residence Trust (“QPRT”) during your lifetime, then you can leverage highly favorable tax rules and significantly reduce your tax burden.[v]
When you set up a QPRT, you put your home into an irrevocable trust for the benefit of your beneficiaries (typically your children). But, you retain the right to use the residence for a term of years specified in the trust.
The best part is, on your death, the value of the home is calculated on the fair market value of the home at the time you transferred it into the QPRT.
For example, if you transfer a home worth $500,000 into a QPRT and on your death, it is worth $2 Million, then you would only pay tax on $500,000 – not $2 Million. Of course, if you have sufficient exclusion left, you may not pay any taxes at all.
Irrevocable Trust Benefits Shared with Other Trust Types
9. Can Prevent Misuse of Assets by Beneficiaries
One of the many benefits of trusts is their flexibility. You can create a trust for any (licit) purpose. You can put as many conditions as you want on the terms of the trust. For example, you can specify that your beneficiaries only get access to the trust funds at a particular age and only after certain events.
One of the typical ways to prevent misuse of assets by beneficiaries if to ensure that trust funds are held until there are of an age to spend it responsibly. I usually recommend a tiered approach when trust funds are given to beneficiaries at age 21, 25, and 30. I also have recommended that the distribution of trust funds be tied to certain life events, like graduating from university, getting married, or having kids.
Moreover, you can use a spendthrift provision in a trust to prevent a beneficiary’s creditors from accessing trust fund to satisfy debts and judgments.
10. Maintain Privacy
Wills become part of the public record as part of the probate process. Additionally, the probate orders identifying who the beneficiaries are, and how much of the estate they get are also part of the public record. If you don’t want the public to have access to your estate, creating a trust avoids this problem. Trusts do not become part of the public record.
But this is not always the case. If you are a fan of the Denver Broncos (like I am), then you know a lot about Pat Bowlen’s Trust. Probably more than Mr. B would like you to have known. The reason Mr. B’s trust has become so public is because of the lawsuits filed by his children. So if privacy is a major factor in your decision-making process, understand that your beneficiaries can make the terms of your trust exceedingly public.
Additionally, irrevocable trusts require special notice to the beneficiaries. So even though a trust is not part of the public record, there is little you can do to prevent the beneficiaries of your trust from learning the terms of the trust itself.
Types Of Irrevocable Inter Vivos Trusts
Now that you have a general overview of why you might want to create an irrevocable trust and what you can achieve using such an instrument, we’ll drill down to some specific types of irrevocable inter vivos trusts to give further detail on what you can achieve with these vehicles.
Irrevocable Living Insurance Trusts(ILIT)
As mentioned above, you can use an ILIT to remove your life insurance policy from your estate.
Special Needs Trusts
A special needs trust (also known as a “supplemental needs trust”) is designed to protect someone with a disability from being disqualified from government benefits. It is also a vehicle to provide long term care for persons with special needs.
This type of trust is designed to provide for beneficiaries who might be disabled or require other types of long-term care. If you pass enough assets to support them for the remainder of their life, you will almost assuredly exceed the asset caps for government benefits they’d otherwise be eligible for such as Medicaid, Supplemental Social Security Income (SSI), and housing benefits.
The income from the trust can even pay for education and vacations aside from providing resources for their maintenance.
Intentionally Defective Grantor Trusts (IDGT)
Under IRS rules for grantor trusts, under certain conditions, the IRS will consider the grantor the owner of the assets held in an irrevocable inter vivos trust for tax purposes. Estate planners can use these rules to pass more wealth to your beneficiaries.
Using this strategy, the grantor will be liable for property taxes on assets put into the IDGT. To lower the value of the creator’s estate, the creator will sell the asset to the trust in exchange for a promissory note. Typically, you will put assets that you expect to grow more than the interest on the note in such a trust. For example, you could place real estate in an ascending market or an index fund in an IDGT.
This trust type enables you to pass more wealth to your beneficiaries by gifting an appreciating asset at a locked-in valuation. You also remove those assets from your taxable estate.
QTIP Trusts
The Qualified Terminable Interest Property Trust (QTIP) enables couples to remove assets from the estate of one spouse and push back estate taxes until the second spouse passes. Delaying tax events is a key strategy for estate planners to preserve wealth.
Bypass Trusts
Estate planners can use this trust type to lower the estate taxes of the second spouse upon their death. At the death of the the first spouse, the deceased spouse’s exempt property is placed into the bypass trust. The second spouse can use the trust assets, including any income, but never becomes the legal owner. When the second spouse dies, the assets pass to that spouses’ beneficiaries but are not considered part of the estate.
Generation-Skipping Trusts (GST)
The GST is a useful tool for, especially wealthy grantors. This structure allows the grantor to “skip” a generation and typically pass assets to their grandchild or grandchildren. The children can use and receive income from the property, but will never own it. However, the IRS imposes a GST tax on assets passed in this manner.
Charitable Trusts
Irrevocable Trusts are useful to pass your assets for charitable purposes. The three basic types of charitable trusts are:
1. Charitable Remainder Trust
This trust structure allows you to pass assets to a charity upon the death of your beneficiaries. The way this trust works is you give your estate to a charity, but allow your children to receive all income from the estate while they are alive. On their death, the estate goes to the charity you select.
2. Pooled Income Trust
You can pool assets with other donors and receive an income from the trust for a set time. In this trust structure, the charity is the trustee and will receive the assets after the grantors pass.
3. Charitable Lead Trusts
Instead of leaving assets to a charity, you can mandate that the charity receives an income from the trust assets for a set amount of time, and then pass the asset to another beneficiary. This type of trust is the opposite of the Charitable Remainder Trust.
The way this works is your beneficiaries are given your estate, but a charity (or charities) you select can receive the income from the trust for a set period (e.g., one year, five years, ten years, etc.). After that period ends, your beneficiaries receive the estate in full.
Spendthrift Trusts
This type of asset protection trust passes assets to beneficiaries who you worry may not be able to handle their affairs. You fund the trust with assets and appoint a trustee to control disbursements to the beneficiaries. You get to create the trust terms governing the circumstances under which the trustee can disburse assets.
Trust prevents the beneficiary from accessing the assets without trustee approval and directs the trustee to refuse distribution to any of the beneficiaries’ creditors. Of course, the beneficiaries control any funds disbursed to them under the terms of the trust.
Some states allow you to create a self-settled-spendthrift trust in which you hold your assets as trustee and can refuse to pay your creditors from your trust estate.
Grantor-Retained Interest Trusts
These trusts can come in multiple flavors (GRAT, GRIT, and QPRT), but the essence of these structures is to pass assets to beneficiaries while retaining some control over the assets for a set period. Once the time limit expires, ownership passes to the heirs whether or not the grantor still lives. You can fund such a trust with the right to live in a home (QPRT), a fixed annuity (GRAT), or an income stream (GRIT). The “flavors” listed above are a partial list. You can use any number of financial vehicles with structured payments for this purpose.
Summary
This survey is simply a brief primer for a complex topic. Irrevocable trusts are a great way to create asset protection trusts, and tax shelter trusts that can protect you and your beneficiaries from creditors, judgments, and taxes. Be sure to consult with an experienced estates and trusts attorney before starting any kind fo estate planning, particularly when using an irrevocable trust.
[i] Internal Revenue Service: Estate Tax
[ii] When an Irrevocable Trust is Not: Giving New Life to Insurance Trusts
[iii] How to Relieve the Plight of Unskilled Irrevocable Life Insurance Trust Trustees with Their Duties.
[iv] Establishment and Administration of First Party Supplemental Needs Trusts
[v] Trust Me! A Discussion of the Many Uses of Trusts for Wealth Transfer Planning
