Revocable or Irrevocable Trust?

Clients often ask whether a trust should be revocable or irrevocable. This choice is influenced by the inherent features of the trust when possessed with either of these alternatives. More important, however, the choice will often be determined by the requirement of the particular estate planning and tax requirements the trust is designed to deal with. For married couples at net worth levels of $2,000,000 or less in 2003, credit shelter revocable living trusts are recommended. At higher net worth levels, certain irrevocable trusts are also called for in addition to the credit shelter trusts.

The matter of revocability is invoked by means of a simple trust clause. Any trust will have a clause stating that the person setting up the trust, commonly known as the settlor, either has or doesn’t have the power to revoke, modify or terminate the trust. If the settlor has the power, the trust is revocable; if the settlor doesn’t have the power, the trust is irrevocable.

The effects of revocability or irrevocability are most noticeable in two aspects: flexibility and convenience. In the event there is a change of mind, heart, relationship, or financial circumstances, the settlor has the right to amend, terminate, or transfer assets into or out of the revocable trust. With an irrevocable trust, once the trust is drafted, signed and funded by the settlor, it cannot be changed, and the assets in it cannot be removed. On one hand this might be a sign of commitment and permanence, on the other it is quite permanent. In terms of convenience, the revocable trust is once again superior. Creating a revocable trust invokes no additional tax identification or separate tax returns for the settlor during life. The assets in the trust continue to be treated as the settlor’s for income tax purposes during life. The same may not be true for the assets in an irrevocable trust. Once transferred, the trust may be treated as a separate taxpayer, with its own identity, its own tax return and taxation.

Most people choose a revocable trust wherever possible, and only revert to the irrevocable trust form when necessary to deal with a specific estate, gift or generation skipping tax planning problem. Most comprehensive estate plans for married couples include a living trust or trusts prepared for the purposes of asset management, probate avoidance, privacy, care of beneficiaries and reducing estate tax. The revocable type of living trust is most often used for these purposes.

The first level of estate tax reduction is accomplished using revocable living trusts by assuring that the lifetime exemption available to each person is not lost. In other words, assume a married couple had a net worth in 2003 of $2,000,000, and the exemption amount is $1,000,000 per person. If one were to die and leave all to the spouse, there would be no estate tax, because any amount left to a spouse is exempt. But upon the death of the surviving spouse, with a $2,000,000 estate, there would be an exposure of $1,000,000 to estate tax. However, if the first to die had left $1,000,000 in a revocable living trust, with certain provisions to care for the survivor without leaving the assets to the survivor’s estate, then upon the death of the survivor, there would be no estate tax. The reason is that the first $1,000,000 would have been exempt in the estate of the first to die, and the second exempt in the second to die. In this way, revocable living trusts preserve each individual’s exemption, reducing the estate tax exposure.

For estates of higher value, there will be additional levels of planning with trusts, besides the revocable living trusts described above to utilize the lifetime exemptions from estate tax, currently at $1,000,000 per person. Often, this planning involves removing assets from the taxable estate of the settlor, before the asset has appreciated, or in annual installments designed to take advantage of the annual gift tax exclusion amount, currently $11,000. An example would be an irrevocable life insurance trust, or ILIT. Annual contributions to the ILIT by the settlor can be made free of gift tax up to $11,000 per year in 2003. The death benefit will not be subject to estate tax because it is not part of the settlor’s estate, and is paid directly to the beneficiaries. This is often used by owners of small and medium businesses, to provide cash to heirs to pay estate taxes, without requiring the sale of the business.

Other objectives that can be achieved using irrevocable trusts include removing assets from the taxable estate, protecting assets from creditors, avoiding the 55% generation skipping transfer tax, funding a charity, and allowing a personal residence to pass to family members without gift, or estate tax on death, and reduced gift tax at the time of funding the trust. Trusts for these purposes include grantor retained annuity trusts or GRAT, Dynasty Trusts, Generation Skipping Trusts, Charitable Remainder Trusts, and Qualified Personal Residence Trusts.

Advanced planning involving sophisticated irrevocable trusts usually requires the advice and cooperation of tax, insurance, financial planning and legal experts, working in cooperation. The client’s decision about the types of trusts to use will not be made without the benefit of the knowledge and experience of the advisors.