In my estate planning and elder law practice, many clients express curiosity about Irrevocable Trusts, wanting to know what an Irrevocable Trust is used for and how it works. Here are five things to know about Irrevocable Trusts.
1. An Irrevocable Trust has beneficiaries who have rights to the Trust property. It is a common misconception about Irrevocable Trusts that no distributions can be made from the trust. That is not true. Very often, a parent or grandparent will create an Irrevocable Trust for the benefit of a child or grandchild. The parent or grandparent may want to make a gift but does not want the beneficiary to have unlimited access to the gifted funds. This could be because the beneficiary is young, has a disability, or simply has not demonstrated good judgment in money matters in the eyes of the grantor (the person creating the trust and making the gift). The grantor may also want the gifted assets to be protected from the beneficiary’s creditors. The grantor will specify in the trust document when and for what reasons the Trustee (think “manager”) may make distributions from the trust for the beneficiary. For example, the trust might direct the Trustee to pay the beneficiary’s education or health expenses. Alternatively, the trust may permit the Trustee to use the trust funds for the benefit of the beneficiary for whatever reason the Trustee determines to be appropriate.
2. Under some circumstances, an Irrevocable Trust can be amended. As a general rule, the person who creates an Irrevocable Trust cannot amend it. However, some Irrevocable Trusts contain a provision allowing someone else to amend the trust. For example, parents who have a child with disabilities will often create an Irrevocable Trust to ensure that the assets the parents leave for the child will not cause the child to lose eligibility for government benefits. These trusts may include a provision permitting the Trustee to amend the trust if the law changes and impacts the trust, causing the child to be ineligible for such benefits.
3. The Trust creator can retain the right to change the ultimate beneficiaries. A person who creates an Irrevocable Trust can retain the power to change how the trust property will ultimately be distributed – this is called a power of appointment. For example, say Mary creates an Irrevocable Trust that states that when she dies, the trust assets will be distributed to her three children in equal shares. After the trust is created, Mary’s son Alan becomes embroiled in a nasty divorce. Mary is worried that if she dies while the divorce is ongoing, that Alan’s one-third of the trust property could end up going to Alan’s soon-to-be-ex-spouse.
Even though Mary’s trust is irrevocable and she cannot sign an amendment changing the trust terms, Mary can change how the trust assets will be distributed at her death via her Will because she reserved a power of appointment over the trust assets. A reserved power of appointment over the ultimate distribution of the trust assets allows Mary to change the distribution so that Alan’s share of Mary’s trust assets will not be reachable by Alan’s divorcing spouse.
4. The Trust creator may still be considered the owner of the assets in the Irrevocable Trust. When you transfer assets to an Irrevocable Trust, you may or may not still be the “owner” of the assets in the trust for tax purposes. Sometimes it is advantageous to be deemed to be the owner and sometimes it is not. For example, life insurance is taxable in the insured’s estate for estate tax purposes if the policy is owned by the insured. If the policy is large and the insured has a taxable estate, this means that between 10 and 40 percent of the life insurance proceeds will be lost to estate taxes. If the insurance policy is owned by an Irrevocable Life Insurance Trust, then the life insurance policy will not be deemed to be owned by the insured and the proceeds will not be taxable in the insured’s estate. On a $1 million life insurance policy, this could save between $100,000 and $400,000 of estate tax.
On the other hand, sometimes it is desirable to be deemed to be the owner of Irrevocable Trust property for tax purposes. For example, say Harry has a total estate of $850,000. He has a house that he bought for $30,000 many years ago and that is now worth $350,000 and CDs totaling $500,000. Harry does not need to be concerned about estate taxes because his total estate is valued at less than $1 million and there is no Massachusetts estate tax on estates of less than $1 million (the federal threshold is $5,490,000). However, Harry should be concerned about capital gain tax. If he is not the “owner” of his house for tax purposes when he passes away, then when Harry dies there will be capital gain tax payable on the difference between Harry’s tax basis in the property ($30,000) and the sale price ($350,000). The capital gain tax on $320,000 ($350,000 — $30,000) would be about $64,000.
If the Irrevocable Trust included provisions that caused Harry to be deemed to be the owner for tax purposes, then when the house is sold following Harry’s death, there would be no capital gain tax payable because the house would receive a “stepped-up” basis at Harry’s death. This means the tax basis in the house is equal to the fair market value at Harry’s death.
5. The person who creates the Irrevocable Trust may be the beneficiary. Clients often assume that if they transfer assets to an Irrevocable Trust they give up all rights to the assets. This is not necessarily true. A very common Irrevocable Trust used for long-term care planning is an Irrevocable Income Only Trust. In this type of trust, the grantor (the person creating the trust) receives the income generated by the assets in the trust. For example, let’s say that Jane owns a three-family rental property and is worried that if she needs long-term nursing home care, the property will be consumed by the costs of that care. She doesn’t want to give the property to her children because she is worried about her children’s creditors (divorcing spouse, bankruptcy, tax lien, etc.). In addition, Jane wants to keep receiving the rental income. Jane can transfer the property to an Irrevocable Income Only Trust and continue to receive the net rental income. After the five-year ineligibility period for gratuitous transfers has passed, the property in the Irrevocable Trust would not be deemed to be owned by Jane in the event she applies for Medicaid (MassHealth) benefits to pay for her long-term care under the current law.
These are just five facts to know about Irrevocable Trusts. If you want to know more about whether an Irrevocable Trust is right for your situation, contact an experienced estate planning to discuss your goals.
Attorney Suzanne R. Sayward is a partner with the Dedham firm of Samuel, Sayward & Baler LLC which focuses on advising its clients in the areas of estate planning, estate settlement and elder law matters. She is certified as an Elder Law Attorney by the National Elder Law Foundation, a private organization whose standards for certification are not regulated by the Commonwealth of Massachusetts. This article is not intended to provide legal advice or create or imply an attorney-client relationship. No information contained herein is a substitute for a personal consultation with an attorney. For more information visit www.ssbllc.com or call 781/461-1020.
© 2017 Samuel, Sayward & Baler LLC
In an irrevocable trust created that transferred the home to the trust i think there
is a problem in getting a step up basis when one spouse dies. Also if the home is sold
in the irrevocable trust isn’t there a problem of the spouse that survives getting to claim
the 250,000 exem ption.
Hi Joe,
Thanks for reading and commenting. If the Trust is properly drafted, then a stepped-up basis for the one-half interest of the first spouse to die is available just as it is when property is owned jointly by spouses. Similarly, if the Trust is properly drafted, the capital gain exclusion on the sale of the home is available as well. This is one of the advantages to using an irrevocable trust instead of a straight life estate deed. Best, Suzanne
Hi… Your article, although I came across it some time after it was written, was, nevertheless, very interesting about irrevocable trusts.
My question is this: If a an irrevocable real estate trust is legally created by a fiduciary of the testator, wherein the trust assets comprise of one real property, and the subsequent distribution of that asset, executed upon the death of the Testator, causes capital gains tax for its beneficiary when sold, would you think that to be an actionable cause for the beneficiary to sue the Fiduciary for causing the capital gain exposure…Thnx…Charles…Oh, the basis into the trust was zero.
Hi Charles, I would need way more facts about the situation to offer a response. Sometimes long-term care planning means that you lose certain tax advantages that you would have otherwise had. Best, Suzanne This response is not intended to provide legal advice or create or imply an attorney-client relationship.
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