A trust is a fiduciary agreement allowing a third party (trustee) to hold and manage assets on behalf of your beneficiaries. In the case of a revocable living trust, you as the grantor retain control over the trust assets and you can revoke or amend the revocable living trust at any time.
In terms of asset protection, the trust assets still belong to you and your creditors and the IRS view the trust assets as yours. While revocable trusts avoid probate, they remain subject to state and federal estate tax.
To protect trust assets from lawsuits and creditors, you can establish an irrevocable trust. The transfer of assets into an irrevocable trust is permanent, and you can’t amend, modify, or revoke the trust terms without your beneficiaries’ permission. In other words, you give up ownership and control over the assets, and they no longer form part of your taxable estate.
The Administration of an Irrevocable Trust
A trustee has a legal, or fiduciary, responsibility to protect the assets in an irrevocable trust and ensure compliance with the grantor’s provisions and directions in the trust document.
With the establishment of a trust, the grantor is usually also the trustee. However, if your intention with the irrevocable trust establishment is to exclude assets from your estate, you cannot be the trustee, and you must choose someone else.
A trustee should be reliable, unbiased, and capable of taking legal title to real estate and other property. A natural person or legal entity, such as a bank, brokerage firm, or trust company, can be the trustee of an irrevocable trust. Grantors often name a trusted friend, accountant, or lawyer.
The functions of the trustee include:
- Protecting the trust property
- Reporting to the beneficiaries
- Diversifying investments
- Managing trust funds
- Keeping complete and accurate records
Types of Irrevocable Trust
Irrevocable trusts fall under two categories: living trusts and testamentary trusts. Living trusts include the irrevocable life insurance trust (ILIT) and split-interest trusts under California trust law.
The split-interest type of trust provides income to one group of beneficiaries for a specified period. Then, it provides income to a different set of beneficiaries for a specific period. Examples of irrevocable trusts include:
- Charitable remainder trust (CRT)
- Charitable lead trust (CLT)
- Grantor-retained annuity trust (GRAT)
- Grantor-retained income trust (GRIT)
- Qualified personal residence trust (QPRT)
- Spousal lifetime access trust (SLAT)
- Special needs trust (SNT)
A testamentary trust is inherently irrevocable as its establishment takes place after the creator’s death. Funding of a testamentary trust takes place according to the will of the deceased. The only way to amend or revoke a testamentary trust is to change the terms of the will while its creator is still alive.
The Applications of an Irrevocable Trust
An irrevocable trust can be instrumental in successful personal finance and estate planning. By setting distribution conditions, this type of legal entity protects assets from misuse by beneficiaries. As a grantor, you can also gift assets to beneficiaries while retaining income in the form of interest, rent, or dividends.
You can also establish an irrevocable trust for tax purposes. Transferring taxable assets to an irrevocable trust can reduce your estate’s tax liability and ensure your eligibility for government benefits, such as Medicaid or Supplemental Security Income.
When are Modifications Allowed Under California Law?
California state law allows for the modification of irrevocable trust terms under specific circumstances with court approval. Common reasons to petition for a modification include:
- The principle has become too low to cover administration
- Adherence to changing tax legislation
- A charity named as a beneficiary has undergone a structural change
For the court to approve a modification, at least one beneficiary and the grantor or all beneficiaries must agree to the modification.
Modification/Termination of Trust Through Court Action (“Petition to Modify Irrevocable Trust)
Given changes in the tax law, it is quite common to see revocable trusts designed with an “AB” or “ABC” structure. The “A” stands for a survivor’s trust, the “B” stands for bypass trust, and the “C” generally stands for the marital trust. When the estate tax exemption was a lot lower ($1 million or less) at one point, estate planning attorneys drafted trusts in a way where the first spouse’s assets were allocated to a “B” trust, or bypass trust. The purpose of the bypass trust was to bypass the estate, and not have those assets included in the estate for estate tax purposes (that way you could use up the $1 million estate tax exemption each spouse possessed). If a spouse died with assets worth more than $1 million, then the surplus amount was allocated to the “C” or marital trust, which took advantage of the marital deduction. Spouses can leave each other as much wealth as they would like without triggering the estate tax under the marital deduction (you can think of it as a way of deferring estate taxes, since they eventually will be owed on the death of the surviving spouse).
However, with changes to the estate tax law, and the increase in the estate tax exemption to approximately 11.2 million for each spouse (22.4 million combined), it is no longer necessary to have the revocable living trust be split into two(2) or even three (3) trusts on the death of the surviving spouse. The additional trusts lead to increased costs over time, and negative income tax consequences due to the fact that there is no “step-up” in basis for assets in the bypass trust. In other words, capital gains will build up in the bypass trust, when they could have been eliminated if everything was just left to the surviving spouse outright.
Thus, estate planning attorneys frequently petition the court to modify and/or terminate outdated bypass and marital trusts, to make things easier on the surviving spouse, and to help eliminate capital gains. By changing the terms of the trust through court so that assets owned by the first spouse transfer to the surviving spouse, there is a huge income tax break available to the beneficiaries and heirs of the surviving spouse.
Modifying and/or terminating an irrevocable trust through court (known as “Petition to Modify Irrevocable Trust” or “Petition to Terminate Irrevocable Trust”) can be a great way to save on income taxes. However, typically, probate courts in California are backed up, and with Covid, the length times have increased from what was 2-3 months in the past to 4-5 months currently. However, our firm has developed a way of going to court on an emergency basis to get these types of petitions approved in a matter of weeks! The emergency Petition to Modify Irrevocable Trust is not always possible and it depends on the set of facts and the interested parties involved, so contact us today to see if we can get your Petition to Modify Irrevocable Trust approved quickly.
Which is Best: An Irrevocable Trust or a Revocable Living Trust?
Establishing an irrevocable trust is worth considering if you want to minimize your estate taxes or stay within the income limits for government benefits. An irrevocable trust also offers better asset protection against creditors and lawsuits than living trusts. For example, architects, land developers, and surgeons are more vulnerable to lawsuits and may need the protection this type of trust has to offer.
However, an irrevocable trust has several drawbacks, with the most significant being that you lose control over the assets you transfer. If estate tax doesn’t affect you and you want to keep the door open to beneficiaries, a revocable trust is the better option.
We have written a blog post on this topic, read more here.
Contact Klosek Law Offices
At Klosek Law Offices, we can help you set up an irrevocable trust. If you want to increase creditor protection and estate tax savings, contact us to schedule an initial consultation. Also, if you have an irrevocable trust that is no longer necessary and you would like to modify a bypass trust (also known as “B” trust or credit shelter trust) so that capital gains are eliminated upon the surviving spouse’s death and children receive income tax-free gifts, please contact us and we can assist with you going to court and petitioning the judge to terminate and/or modify the bypass trust.