Asset Protection

Why do People Create Irrevocable Trusts?

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What is an Irrevocable Trust?

Many people often ask me, “What’s an irrevocable trust?”  Or some clients come ready to ask the follow-up question, “If an irrevocable trust means I cannot change it, why would anyone want to create one?” 

Let’s get one thing straight.  No one wants a trust they can’t change.  Rather, it’s simply the price you pay for the benefits you get.

So the question really should be, “What’s the advantage of an irrevocable trust?”

3 Main Reasons to Create an Irrevocable Trust

Generally, there are 3 reasons why someone would create an irrevocable trust.  

First, to minimize taxes.  Estate taxes are a complicated affair and one of the tools we use to limit or eliminate the estate tax is to create an irrevocable trust.  We discuss this more fully below.  Additionally, when it comes to tax reduction, irrevocable trusts can also zero out state income taxes (e.g.,  -ING trusts).

Second, to maximize asset protection.  A properly created (irrevocable) asset protection trust can offer creditor protection to your beneficiaries.  By gifting assets in a trust that you don’t own any longer or have rights to income over, your creditors cannot force you to distribute money from there to satisfy their claims.

Third, to qualify for governmental benefits.  Irrevocable trusts are a tool that can be used in special needs planning and/or Medi-Cal planning, for instance, whereby your assets are gifted into a trust that you or your loved ones can still benefit from, but which will not disqualify you from qualifying for certain governmental benefits since you do not own the assets any longer.

Types of Irrevocable Trusts

There are many kinds of irrevocable trusts, including the following, just to name a few:

How Does an Irrevocable Trust Reduce my Estate Taxes?

Assets held inside of an irrevocable trust, if drafted correctly, can grow outside the taxable estate of the original owner of the property.  This means if I gift a $1 million property into my irrevocable trust, I would have used $1 million of my coupon in making a taxable gift to my irrevocable trust.  However, the benefit is that the property can now grow estate-tax free within the irrevocable trust!  If I pass away 30 years from today, that $1 million real estate may be worth $10 million.  In other words, I have passed on a $10 million property to my children outside of my taxable estate — no part of the $10 million is added in my estate tax calculation at my death and, hence, my estate will pay no estate taxes on the property.  It’s as if I don’t own it, because – in actuality – I don’t (my trust does).  Furthermore, if the trust is set up in the right jurisdiction, not only will I not need to pay estate taxes, but when my children die, they will not owe estate taxes either.  Same with their children and onwards.  We call this feature a “dynasty trust.”

Compare the result however if I had not created the trust.  When I die, this $10 million property will be counted in my taxable estate along with all my other assets at death.  If the total value is above my coupon value, there will be an estate tax upon my death.  My children will then inherit the property, and when they die (and the property is now worth $20 million), again, an estate tax will be due.  Each generation will pay another estate tax on the same property, which will be appreciating over time as well.

Use of irrevocable trusts is instrumental especially before a large appreciation or liquidity event occurs.  Trapping this growth outside your taxable estate will allow for the asset to grow free of estate taxes for multiple generations, while still offering protection against creditors, divorce, lawsuits, or judgments.

How Does an Irrevocable Trust Protect me from Creditors?

Every trust names 3 people:

  • Grantor/Settlor -the creator of the trust
  • Trustee – the controller of the trust
  • Beneficiary – the consumer of the trust

In a revocable living trust (generally created as a probate-avoidance tool), you are all three of these people.  You are the grantor/settlor (which means you can amend/rewrite the trust), you are the trustee (which means you can sell, liquidate, buy, invest the assets), and you are the beneficiary (which means you can enjoy the fruits of the assets).

In an irrevocable trust, many times you are simply the grantor, that is, you are gifting your assets to the trust, which will be managed by an independent trustee, for the benefit of your beneficiaries.  Many times, this means that the trustee and beneficiaries are not you.  In other instances, you may still retain certain limited rights or control.  For example, you might be able to serve as an investment trustee, or in certain jurisdictions, you might even able to be a beneficiary of the trust.  But in most cases, be prepared to involve an independent trustee and be prepared to name others as the beneficiaries.  

This makes sense from an asset protection standpoint.  If you get sued, you can honestly say “I am not the trustee of the trust I created — someone else is.  I am not even the beneficiary of the trust I created — my child is.”  This means that you have gifted the asset away, out of your estate, both from a tax perspective as well as from an asset protection standpoint.  Your creditors should have no way of undoing that transfer (unless it was a fraudulent transfer in order to evade liability).

Can I Make Changes to an Irrevocable Trust?

The short answer is, “No, not really.” 

The longer answer is, “No, but there are certain powers you might be able to hold onto such that major changes in the future may not be necessary.  Furthermore, there are provisions built into the trust to allow for flexibility as well.”

Some examples of these powers and provisions include the power to hire and fire trustees, the power to add or modify beneficiaries through the use of a trust protector, the power to distribute income and principal among the beneficiaries, the power to change the venue/situs of the trust, and/or the power to decant the trust.

In other words, while an irrevocable trust is irrevocable to a large extent, there are certain exceptions — and those exceptions are broad enough that most people who create irrevocable trusts are able to “have their cake and eat it too.”

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