Irrevocable Trusts

Michael Brennan • July 16, 2012

Irrevocable trusts are useful estate planning tools if you want to reduce your potential estate tax liability.

An irrevocable trust is created either during the life of the grantor or upon death, and, unlike a revocable trust , its primary use is to minimize transfer tax liability- namely through avoiding estate tax on any assets which the irrevocable trust holds. Unlike a grantor’s ability to freely amend or revoke a revocable trust, a grantor’s ability to amend or revoke an irrevocable trust is severely limited, if not impossible in most situations. This is because once assets are transferred to an irrevocable trust, for all intents and purposes, they are owned by the trust- not the grantor. However, the upside is that the grantor will not pay estate taxes on the assets held in trust upon his death. For this reason, irrevocable trusts present an effective vehicle for removing large portions of wealth from an estate and maximizing the amount a beneficiary inherits.

How it works

Like any trust an irrevocable trust has three main players (the same as a revocable trust): 1) the settlor or grantor (who creates the trust); 2) the trustee (who administers and operates the trust); and 3) the beneficiary or beneficiaries (who receive the benefit of the trust and any distributions the trust makes). The irrevocable trust is established by a trust agreement, which is a writing that sets forth the above relationships and lays out how the property that the trust holds will be managed and distributed. The trust agreement, which is typically drafted by an attorney, is then formally executed in a manner that is specifically dictated by state law.

The type of arrangement that an irrevocable living trust provides offers some advantages as well as some disadvantages. Here is a high-level view of five of each:

5 benefits of using an irrevocable living trust :

1) Property management

Much like revocable trusts irrevocable trusts offer a vehicle through which property can be managed by an outside individual or financial institution thereby removing stress from a grantor’s life. Any property transferred to the trust will be managed by a named trustee according to the terms of the trust agreement. In many cases the trustee is much better equipped than the grantor to handle complex investment accounts or manage property. For assets held in trust that do not require as much financial “know how” the benefits of having someone else manage money and property for the grantor’s benefit are evident, especially in the event the grantor becomes incapacitated and is no longer to make decisions for himself.

2) Avoid probate upon death

Like a revocable trust, an irrevocable trust shields assets from the probate process. Certain types of assets are not subject to probate proceedings including insurance proceeds, certain jointly held property and those assets that are held in trust. Therefore, an irrevocable trust that is properly funded and legally holds title to assets will avoid probate. The assets it holds will be managed for the benefit of those individuals named in the trust agreement as beneficiaries and income or property will be distributed to them as directed in the trust agreement. Therefore, irrevocable trusts have the potential to deeply cut the time and cost sometimes associated with the probate process.

3) Shifting income tax burden to lower tax brackets

Given that tax planning through irrevocable trusts is typically only used for sizable estates that do not fit under certain threshold dollar amounts, it would seem obvious that the tax rate of a grantor using them for tax planning would be in a high tax bracket due to high net worth. Typical beneficiaries, such as a grantor’s children, or grandchildren, are usually in a lower bracket. Properly drafted, an irrevocable trust will shift tax liability to the trust or to those individuals in lower paying tax brackets (preferable). By transferring assets to an irrevocable trust, the income of which is distributed to the named beneficiaries, the grantor can effectively change the amount of tax paid on the income. This is so because the lower paying beneficiary is taxed on the distribution rather than the higher paying grantor. Proper use of this technique can have a tremendous effect on the actual after tax amount a grantor is able to provide to his chosen beneficiaries.

4) Reducing estate tax liability

In 2012 the estate tax exclusion amount is $5.12 million, meaning that an individual dying this year will not be subject to estate tax unless the total value of his estate is greater than that amount. However, that threshold is set to revert to $1 million in 2013 which will subject a much higher percentage of estates to tax upon death. Further, the current estate tax rate is 35% on anything over that $5.12 million; however next year it will skyrocket up to the rate of 55% without further congressional action. While very few families may be in the $5 million range the $1 million mark hits much closer to home for a sizable population. Because assets transferred to an irrevocable trust are viewed as owned by the trust and not the grantor those assets are not includable in the calculation of the estate tax exclusion limit of $5.12 million this year or $1 million for a grantor who dies next year (or possibly beyond). Therefore, transfers to effectively drafted irrevocable trusts can reduce or even eliminate the portion of an estate that would be subject to any estate tax upon death.

5) Avoid gift tax on assets likely to appreciate

Transfers to non-grantor irrevocable trusts are subject to gift tax if they are in excess of the $13,000 annual exclusion permitted per individual donee. However, once the assets are transferred to a beneficiary the grantor or donor is not subject to gift tax on any appreciation of those assets. For example, if a grantor wants to maximize a gift to an irrevocable trust set up for his son while utilizing this annual exclusion amount he could transfer stocks worth $13,000 tax free to the trust. If those stocks increase in value to $30,000 the next month, he will still be viewed as only transferring $13,000 and will not be subject to gift tax on the transfer.

Five disadvantages of using an irrevocable living trust:

1) An irrevocable trust is just that- irrevocable

Unlike the revocable trust which may be freely amended or even entirely revoked, once created, an irrevocable living trust is permanent. Assets transferred to the trust cannot be removed and given back to the grantor if he changes his mind at a later date. The trust is viewed as the owner of the assets, so while a grantor can reduce tax liability he is also losing the ability to control the assets outside of what is dictated by the trust agreement.

2) Loss of Control

As would flow from naturally from the irrevocability of a trust, by transferring assets to the trust, the grantor loses his ability to control how they are used. Once the transfer occurs, the trustee retains control over sale and use of the assets in the trust consistent with the trust agreement. The grantor simply becomes a bystander.

3) Additional tax considerations

Irrevocable non-grantor trusts are viewed as separate entities and as such they must pay their own taxes. An irrevocable trust needs a separate FEIN and must file income tax returns annually which will include the disclosure of any distributions or allocations made to the beneficiaries. In addition the trust may be required to file an annual state income tax return. Trust accounting and tax preparation can get very complex so it may be necessary to employ a competent accountant experienced in the area. This, of course, comes with additional cost.

4) Higher income tax rates

Irrevocable trusts must pay tax on their income similar to an individual or corporation and those rates can get as high as 35% very quickly due to the low thresholds for bracket cutoffs. However, trusts are also able to claim deductions for expenses and, more importantly, distributions to beneficiaries. While a trust is taxed on income it retains, distributions of the income which are made to beneficiaries are taxed to the beneficiaries and not the trust. With proper planning this may effectively lower the amount of tax owed on the trust income if the beneficiary is in a personal income tax bracket lower than the 35% rate.

5) Won’t eliminate the need for a will or other estate planning documents

As with using a revocable trust as part of an estate plan, any grantor who is thinking about adding an irrevocable trust to his estate plan should also have a pour-over will which can effectively dispose of property that is not included in the trust upon death. It is also possible that property will be received after death but before the estate is wound up. A will can direct what is to be done in this situation. Additionally, it is wise to have other documents that do not directly affect property rights drawn up to round out an estate plan including powers of attorney for finances and healthcare and a living will.

While an irrevocable living trust offers benefits as an estate planning tool some goals are best accomplished through other means. An estate planning attorney can discuss the revocable living trust option in much more depth along with other possible tools to accomplish your estate planning goals. There is no one-size-fits-all solution to estate planning and the advice of an attorney is imperative to ensuring that your wishes are followed. For more information on revocable trusts and other estate planning tools feel free to explore my other posts or contact an estate planning attorney admitted in your state that is competent to give legal advice specific to your situation.

Michael F. Brennan runs a virtual law office helping clients in Illinois, Wisconsin, and Minnesota with estate planning and business law issues. He can be reached at michael.brennan@mfblegal.com with questions or comments, or check out his website at www.thevirtualattorney.com.

The information contained herein is intended for informational purposes only and is not legal advice, nor is it intended to create an attorney-client relationship. For specific legal advice regarding a specific legal issue please contact me or another attorney for assistance.

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Admitting a New Member to an LLC - Everything You Need To Know

By Michael Brennan • September 21, 2022

It’s a fairly common situation to find yourself in as a small business owner—for one of a wide range of reasons you’ve decided it’s time to being a new partner into your business in some capacity.

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[WATCH] Illinois Just Made it Easier Than Ever to Make a Power of Attorney

By Michael Brennan • September 9, 2021

Illinois Just Made It Easier Than Ever to Make a Power of Attorney

By Michael Brennan • September 2, 2021

A power of attorney for health care enables an individual to appoint a trusted agent to make medical decisions on his or her behalf if the individual is unable or unwilling to do so for themselves. For example, if a situation arises where you are in an accident and need emergency medical care, doctors will look to a trusted individual to make decisions on your behalf. Typically, this is family members, and technically, most state laws set an order of precedence on who doctors should turn to in the absence of any specific (and legally binding) instructions from the patient. However, the most ideal situation is one in which doctors rely on the instructions the patient has detailed in a valid power of attorney. Powers of attorney for health care do not have many specific requirements for validity. But, they do need to be signed by the patient and at least one witness (this varies by state). Often, someone may decide that they need a health care power of attorney in a pinch. For example, an older parent may be going in for surgery and want to cover their bases if something goes wrong. They may decide the day of the surgery that they would like to name an adult child as their health care decision-maker if something happens, so that child cannot serve as the witness. Typically, an estate planning attorney could witness the document, but that may mean scrambling at the last minute for an appointment or coordinating a meeting quickly on the way to the hospital. Not ideal. Now, however, Illinois has amended the Illinois Power of Attorney Act to permit electronic signatures. The Act states that: “The signature and execution requirements set forth in this Article are satisfied by: (i) written signatures or initials; or (ii) electronic signatures or computer-generated signature codes .” The Illinois Electronic Wills and Remote Witnesses Act permits those witnesses not only to sign electronically, but also to sign remotely. So, instead of a mad last-minute scramble to sign and witness an 11th hour power of attorney, one can be e-signed online through video conferencing with the principal and estate planning attorney quickly linking up on zoom from the comfort of their home, office, or even the hospital bed, with much more simplicity and convenience. The Power of Attorney Act was further amended to permit powers of attorney for health care to be in electronic format. So, it is no longer a requirement to dig the paper hard copy out of the basement filing cabinet and remember to bring it to the hospital. Instead, an electronic copy can simply be sent to the hospital through its patient portal, once that functionality is set up by the health care provider at least. The power of attorney can now easily form a seamless part of a health care record, neatly kept in an electronic medical file. The pandemic of 2020-2021 forced institutions to make things more efficient and reflective of the technologically-centric world we now live in. That is not more evident in many places as it is the area of law. And, few practicing attorneys would tell you that’s a bad thing.

Illinois Electronic Wills and Remote Witnesses Act Enacted

By Michael Brennan • August 5, 2021

On June 26, 2021, Illinois adopted the Electronic Wills and Remote Witnesses Act. Plainly, the Act is a generational game changer for estate planning. Gone are the days of scheduling a formal office appointment with your attorney to sign estate planning documents as the law office staff witnesses and notarizes those documents on the spot.

Illinois' Electronic Wills and Remote Witnesses Act is a Game Changer

By Michael Brennan • July 30, 2021

Preparing a last will and testament has always required the inclusion of original signatures of both the person making the will and witnesses. Understandably, coordinating the signing of the will could pose some administrative challenges, especially for small law firms and solo practitioners—not to mention the many people who elect to draft a will without an attorney’s help—who may not have a crowded office full of willing witnesses. Along with wills, estate plans typically include powers of attorney for finances and health care decision making as well. Those documents also require original signatures from their creators, witnesses, and notaries. Predictably, COVID-19 and the resulting government shutdowns of businesses and encouragement of social distancing and remote work complicated the task of signing and witnessing these important estate documents (Notaries are also now permitted to act remotely under a separate but related piece of legislation). Luckily, in many states, temporary orders permitted the remote execution of many documents, and a framework for conducting remote document signings began to take form. On June 26, 2021, Illinois adopted the Electronic Wills and Remote Witnesses Act. Plainly, the Act is a generational game changer for estate planning. Gone are the days of scheduling a formal office appointment with your attorney to sign estate planning documents as the law office staff witnesses and notarizes those documents on the spot. Now, under the EWRWA, the need for the conference table signing is gone. Wills, powers or attorney, and other important estate documents can be validly signed and witnessed remotely through audio-video communications. More so, “electronic wills”—those not physically printed on paper—are now an acceptable form of will in Illinois that can be probated just as paper wills have for decades. Some of the highlights of the new law are below. Electronic Copies of wills are now valid. Electronic Wills are now an option. The new law defines an electronic will as simply “a will that is created and maintained as a tamper-evident electronic record.” What is “tamper-evident” exactly? Well, the statute defines it as a “feature of an electronic record by which any change to the electronic record is displayed.” So, popular document signature software like Docusign and Hellosign would do the trick. Individuals and Witnesses can now sign on multiple signature pages with one master document being compiled later on. If a platform like Docusign is not used to create and sign an electronic will, there is now an option to use multiple signature pages for the testator and witnesses. In practice, this enables a testator to sign a will while the witnesses watch over audio-video means, like Zoom. They can then each sign the signature page sitting with them at their physical location. The testator and witnesses can then send the originals to a central location (likely the estate planning attorney) to be compiled into one master document. Previously, this was impermissible, as the document would have had to have been signed in the conscious presence of each other. The Electronic Wills and Remote Witnesses Act redefines “presence” to expressly include, “being in a different physical location from another person, but able, using audio-video communication, to know the person is signing a document in real time.” Witnesses can witness signings (and sign) remotely through video-conferencing. As mentioned, witnesses to a will previously had to be physically present with the testator. Under the new law, witnesses can now be remote. If an electronic will is prepared for signatures, the witnesses can simply sign the electronic will after watching the testator sign. If a paper copy is being used, then the witnesses can watch the testator sign his or her own paper copy, and then sign a separate signature page in their remote location. For paper copies, the witnesses and testator must physically compile all the signature pages within 10 days. The person appointed by the testator to compile all the signature pages must state that the signature pages were attached within 10 business days of signing and that the pages were attached to the testator’s complete and correct will for the will t be admitted to probate. So, best practice is to attach those statements to the will at the time of its signing or the time at which the master document is compiled. Wills can be signed electronically. Electronic signatures have previously not been permissible forms of signing a will. Now, however, the new Act changes everything. Testators and witnesses alike can not e-sign wills. To do so validly, the will must designate Illinois as the state of its execution, be signed by the testator or by some person at the testator’s direction and in their presence, and be attested to in the presence of the testator by two or more credible witnesses who are located in the United States at the time of execution. The change of the “presence” requirement is revolutionary, as “presence” now includes being in a different physical location from another person, but able to know the person is signing a document in real time using audio-video communication. Additional Documents, like Powers of Attorney can now be signed virtually Wills are not the only estate planning documents that require witness signatures. Powers of attorney and living wills are just as essential to creating a comprehensive estate plan. Illinois’ Electronic Wills and Remote Witnesses Act also authorizes the witnessing of any document other than a will using audio-video communication. The signatures of the principal and witnesses may be on the same or different pages provided the master document is compiled within 10 business days. While COVID-19 forced the legal industry to adjust, it appears that some of those adjustments were just what was needed to bring estate planning into the 21st century.

Irrevocable Trusts