What Is An Irrevocable Trust And Why Do I Need One?

Locksley A. Rhoden, P.L.
Irrevocable Trust, U.S. Federal Estate Tax, U.S. Income Tax

An irrevocable trust is most commonly established by written trust agreement amongst family members and cannot be modified or terminated unless ordered by the Court or all parties to trust otherwise agree. An irrevocable trust may also be created upon death via last will or revocable living trust. While there are several reasons for establishing an irrevocable trust under Florida law, the most common reasons are funding the trust to leave a source of income for a disabled or minor beneficiary, to pay estate taxes, to insulate assets from creditors, to help qualify persons for government benefits and to manage and receive investments separate and apart from the estate of trust beneficiaries.

How Is An Irrevocable Trust Structured?

An irrevocable trust designates three parties to trust, namely, the trust’s settlor (grantor), trustee and beneficiary. The settlor is the party that creates the trust agreement and is responsible for funding the trust, i.e. contributing cash or property into the name of the trust. While not directly controlling trust assets, the settlor designates the trustee who is considered the legal owner of trust assets. The primary obligation of the trustee is to protect and manage the trust assets and distribute trust income and principal according to terms of the trust agreement for the benefit of the trust beneficiaries, the beneficial owners of the trust assets.

How Is An Irrevocable Trust Different From A Revocable Trust?

The rights and obligations of the parties to trust is determinative of whether the trust is deemed revocable or irrevocable. A key consideration is whether or not the settlor has the right to change or modify the trust terms or control trust assets. A revocable trust is primarily settled with the settlor, the trustee and the beneficiary each being the same party. In this case, the settlor can at any time control the trust assets, change the beneficiaries or otherwise modify or revoke the trust in its entirety. When structuring an irrevocable trust, the settlor gives up the discretion to control and the right to receive trust assets. In other words, so long as the settlor is not the trustee with discretion over trust assets nor the beneficiary with right to receive trust assets, the trust shall be deemed irrevocable.

What Is The Process For Funding An Irrevocable Trust?

It is important that an irrevocable trust agreement reflect the true intentions of the settlor because, once the settlor gifts assets to an irrevocable trust, the settlor cannot recover the assets nor modify the trust terms without the agreement of parties to trust or authorization of the Court. Upon funding the trust, e.g. gifting cash to a trust account or retitling an asset in the name of the trustee, the trustee takes over as the party responsible for managing trust assets according to the settlor’s wishes defined in the trust agreement. Because assets placed into the trust are considered gifts and cannot be distributed until a predetermined point in time or upon the occurrence of a particular event, it is the duty of the trustee to manage and protect the trust assets for the benefit of the trust beneficiaries until the triggering event authorizing distribution. As transfers to an irrevocable trust are generally subject to gift tax, the settlor should consult a CPA to prepare and file an IRS Form 709 United States Federal Gift Tax Return to report gifts made in excess of the annual gift tax exclusion or annual gifts valued at more than $16,000 to any gift recipient.

What Key Benefits Do Irrevocable Trusts Provide?

Because an irrevocable trust can be designed to remove equitable assets from the settlor’s U.S. taxable estate, they are great tools for estate planning to reduce potential federal estate tax liability. Additionally, irrevocable trusts that place trust assets under control of a trusted third party may prevent them from becoming subject to lawsuit judgment against the trust settlor. Some of the other key legal benefits or purposes for settling an irrevocable trust include:

gifting a life insurance policy to trust
transferring assets or cash to children or grandchildren
protecting trust assets from settlor’s judgement creditors
gifting real property to loved ones with minimal tax implications
growing and investing income generating assets for beneficiaries
preventing misuse or waste of trust assets by spendthrift beneficiaries
receiving lifetime gifts of assets to use up settlor’s lifetime gift exemption
estate tax minimization, i.e. removing appreciating assets from the settlor’s estate
transitioning ownership of equitable assets to beneficiaries in a tax efficient manner

What Are The Negatives Of Settling An Irrevocable Trust?

Giving Up Control of Assets: When a settlor executes and funds an irrevocable trust in Florida, any assets gifted to the trust will no longer remain under settlor’s control. Because the trust agreement cannot be amended or changed by design, the settlor is unable to reclaim ownership of the trust assets. Because an irrevocable trust is designed to limit the settlor’s control of the assets while held in trust under management of the trustee, an irrevocable trust may be a correct choice if the primary planning goal is to protect the trust assets from the settlor’s creditors and make them available for the future use and benefit of trust beneficiaries.

Paying a Higher Effective Income Tax Rate: One of the main differences between revocable and irrevocable trusts is the requirement that an irrevocable trust be treated as a separate taxpayer for federal income tax purposes. Typically, income from revocable trust assets is carried onto the settlor’s federal income tax return whereas income earned from an irrevocable trust asset is taxed on the irrevocable trust’s tax return. By way of example, if an irrevocable trust’s assets earn more $600 annually, the trustee is required to file an IRS Form 1041 federal income tax return on behalf of the trust reporting any income taxes due. In 2022, irrevocable trusts pay income tax at the top tax bracket (37%) after earning income of $13,450 where individual taxpayers do not reach this tax bracket until after earning income of $523,600.

Filing a Federal Estate and Gift Tax Return: In 2022, a gifting settlor can convey property up to the annual gift tax exclusion amount per individual ($16,000) to an irrevocable trust before the gift becomes subject to federal gift taxes. That being said, because only present interest gifts will qualify for the annual gift tax exclusion pursuant to the provisions of Section 2503(b) of the Internal Revenue Code of 1986, individuals transferring cash or assets to an irrevocable trust will not necessarily escape gift and estate tax exclusion. In this regard, to assure gifts will qualify as a “completed” present interest gift with no estate or gift tax consequences, the trustee should provide beneficiaries with a Crummey Notice to each beneficiary so when annual gifts are made the gifted amounts will be deemed a completed gift for IRS purposes.

What Are The Negatives Of Settling An Irrevocable Trust?

Why Are Crummey Notices Required For Irrevocable Trust Administration?

Crummey Notices are a crucial part of the irrevocable trust administration because they are required to classify the settlor’s gift as a “completed gift” for federal gift and estate tax purposes. Unless a gift is considered “completed,” it will not qualify for the annual gift tax exclusion. For settlors that do not want trust beneficiaries to have access to trust assets right away, the trustee shall provide beneficiaries with a Crummey Notice when annual gifts are made so that the gifted amounts will be deemed a completed gift for IRS purposes.

The following is an overview what information to include for a Crummey Notices to satisfy Internal Revenue Code requirements:

The Notice must be sent by the trustee to the beneficiaries when a gift is made to the trust.
The Notice must state the amount of the gift.
The Notice must state that the beneficiaries have a right to withdraw the amount of each gift for up to 30days after the gift is made.
The right to withdraw begins immediately after the gift is made.
The Notice should state that if the beneficiary does not withdraw the gift within the 30-day period, the withdrawal right lapses. The money then remains in the trust until it is distributed according to the trust terms.