If you’ve heard of an irrevocable trust but don’t really understand them or what they are used for, you’re not alone. Most people have only heard one thing about these types of trusts: They’re set up by the rich as a way to give assets to their loved ones after they have passed. However, only part of this popular belief is true.
Irrevocable Trusts are designed to allow a person’s estate to continue to be useful long after they pass away. These trusts aren’t only beneficial for the Kennedy’s or the Rockefeller’s. Ordinary citizens have the ability to greatly benefit from these trusts as well, and with a little research and work, you may be able to do it without paying thousands of dollars in legal fees. Many families only need a very simple version of the document and may want to consider using a template to complete the document themselves. An easy way to save money is for people attempt their own legal work, then have an attorney review the document if they don’t feel 100% comfortable. The attorney should be able to review it in 2-3 hours and provide guidance on any changes to the final draft of the document.
What is an Irrevocable Trust?
A trust is a fancy term for a three-party legal relationship. The trust involves the Settlor (person funding the trust), the Trustee (person managing the trust), and the beneficiaries (people who will receive the trust property).
When you create a trust you actually transfer ownership of property from yourself to your trustee(s). The trustee(s) then holds legal title to the property, the beneficiaries hold equitable title, and you, the Settlor, no longer have any title to the property. This is a significant step, especially where the trust is irrevocable. Irrevocable means that once you create the trust, you can't undo the trust and get the property back without the consent of the trustee and the beneficiaries.
To understand how an irrevocable trust works, consider this example. You’ve worked hard all of your life and built up a decent estate. You realize that down the road a decade or two you’re going to pass away, and you want your life savings to benefit the lives of the people you love or various causes you want to help.
Now, what if your loved ones are not as financially sophisticated as you are? You could be concerned about leaving them a lump sum gift because they might use it irresponsibly. Maybe you want to avoid the need to spend down assets in order to qualify for certain benefits, such as veterans benefits and Medicaid, protect your children from losing their inheritances in a messy divorce, guarantee college educations for your grandchildren, create lifetime income for a disabled child, provide for a devoted family pet, or just about anything you want your money to do. These are all reasons to consider setting up a trust.
Creating the Trust Document
You should always use a written trust document to define the terms and conditions of the trust.
You should use a model trust form and adapt it to your particular needs. You can find a good model by asking somebody you know who has already set up a trust, some advocate organizations have free templates you can use as a model, asking a local attorney for a form or purchasing a good form from a reputable online seller such as USlegalforms.com or legalzoom.com. Once you get a good document, it is merely a matter of reading through and filling in the blanks to make the trust say what you want it to say.
Fund the Trust Properly
You can place cash, annuities, CDs, stock, real estate or other valuable assets into your trust. You must apply for a tax ID number from the IRS so you can attach these assets to that number. Once you place assets in the trust, they no longer belong to you. They are now under the control of the trustee.
Sounds Too Good (and Easy) To Be True
Of course, there could be a few disadvantages to setting up this type of trust. The settlors must realize that they lose direct control over any assets they place into the trust and the annual costs of an independent trustee can be quite high. Many grantors appoint family members to be trustees to cut down on the costs of maintaining the trust.
But Why Use a Trust? Why Not Just Give the Money Away?
If someone is trying to protect assets and still qualify for long-term care benefits from the government, their strategy could be to gift away their assets to children or other family members. After the transfer, they apply for their veteran’s benefits, or in the case of Medicaid, wait five years before applying for benefits.
This strategy poses a number of dangerous risks. The person who receives the assets could die, become estranged, get divorced, invest badly, spend the money, or even lose the money to creditors.
Consider that a long-term care crisis could bring about the need for assisted living. If the assets have been lost or spent, there may be no way to pay for care.
An Irrevocable Trust Could Have Many Advantages Over an Outright Gift
The Settlor who creates and funds an irrevocable trust can establish the rules and determines the uses of the trust assets. The settlor can name the trustees and beneficiaries and retain the right to change beneficiaries through a power of appointment in the grantor’s will.
The Settlor can even choose to employ a Trust protector. You can design a trust to have a third party "trust protector" (see Forbes magazine: 8/25/2012 Trust Protectors), which is a position usually filled by a close relative overseeing the trustee. The protector has the power to change a trustee, remove a beneficiary, eliminate or reduce distributions, or even change the terms of the trust itself.
The settlor can decide to retain the income produced by the trust, even if there is no access to the trust principal. Receiving income tends to make the grantors feel like the assets still belong to them. This may ease their concerns about funding an irrevocable trust and losing the direct control of their assets.
An irrevocable trust offers many tax advantages over a direct gift, especially on the subject of capital gains taxes. If the trust is structured as a grantor-type trust, all appreciated assets transferred into the trust, such as real estate or a stock portfolio, can still receive a step-up in basis upon the death of the grantor. If these same assets were gifted directly to the beneficiaries, they would retain the same basis as the donor had, and in most cases owe a great deal more in capital gains taxes.
This style of trust also provides a tax advantage for a grantor’s principal home. The trust retains the grantor’s capital gains tax exclusion under 26 U.S.C. § 121, which would not be available if the residence was gifted directly to the beneficiaries during the lifetime of the owner.
Settlors can even set up their trusts so all of the trust income is tax deferred until the trustee distributes the income to beneficiaries. This can provide some incredible tax advantages to the grantor’s family.
Consider that you could designate your spouse as a "discretionary" beneficiary. The trust could be drafted so that a distribution could be made to your spouse when needed.
Another option would be for each partner to create a trust for the other. Each trust just has to have enough differences so that they aren't considered reciprocal.
Protection From Beneficiary Mistakes
Using a trust avoids the risk that a beneficiary could die and that the funds are inherited by the beneficiary’s heirs. It also protects the assets if the beneficiary loses money in a divorce.
Consider Your Options
Whether to create an irrevocable trust in any particular family situation requires a careful assessment of the settlor’s objectives, assets, income, health and care needs, family dynamics, and other considerations. For those families that are not rich but wish to leave money to children or charities and still control how that money is used, these valuable trusts can offer a low-cost way for the settlor to indirectly control their assets long after they pass on.