Ep. 12: Irrevocable Trusts 101: Understanding the Basics and Beyond

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Theres often a lot of confusion between the different types of irrevocable trusts, even as more and more people are forming them today.

A trust is a relationship between a trust-maker and a trustee, and there are specific terms that the trustee is expected to follow. As a general rule, a trust can either be revocable or irrevocable.

A revocable trust is one in which the trust can be revoked within the lifetime of the trust-maker. An irrevocable trust is one that cannot be revoked, which means the trust-maker cannot directly take back the assets that they placed in the trust.

In this episode of Repair the Roof, Attorney Ted Gudorf explores the three types of irrevocable trusts: estate tax irrevocable trusts, asset protection trusts, and Medicaid asset protection trusts.

Key Topics:

  • What is a “trust”? (0:29)
  • Similarities between revocable trusts and irrevocable trusts (2:19)
  • Differences between revocable trusts and irrevocable trusts (4:17)
  • Grantor trusts (04:43)
  • Type 1: Estate tax irrevocable trust (06:37)
  • Type 2: Asset protection trust (08:21)
  • Type 3: Medicaid asset protection trust (11:32)
  • Removing trustees through a trust protector/advisor (15:37)


Transcript: Prefer to Read — Click to Open

This is episode 12. Three types of irrevocable trusts. More and more of our clients are forming irrevocable trust. There seems to be a lot of confusion over the different types of irrevocable trusts. We are going to explore that today.

First of all, let us first understand what is a trust. A trust really is a relationship between a trust maker and a trustee, where we specify specific terms that the trustee is to follow. Now, as a general rule, trust can either be revocable or irrevocable, two main categories. Revocable simply means that during the lifetime of the trust maker, the trust can be revoked, and if it is irrevocable, it simply means that it cannot be revoked. That is that the trust maker cannot directly be able to take back the assets that they placed in the trust. That is a critical distinction. Most of our clients are familiar with a revocable trust. It is typically used to avoid the probate court process in the event of incapacity or death, and furthermore, oftentimes it will contain continuing trust that lasts beyond the lifetime of the trust maker. To avoid probate with a revocable trust, assets have to be aligned with the revocable trust. In other words, they have to be funded into the trust. The same is true with respect to a near revocable trust. There are a lot of similarities between a revocable trust and a near revocable trust, let us explore the similarities first.

In each type of trust, there necessarily must be a trust maker. Oftentimes, the legal community will call the trust maker, a grantor or a settler, it all means the same thing. It is the person who makes the trust. Every time you have a trust, there must be a trustee. In some instances where we have a revocable trust, the initial trust makers are commonly also the trustees. Now the trust always has to have beneficiaries. Typically, we will divide the beneficiaries up between lifetime beneficiaries and remainder beneficiaries. Typically, the remainder beneficiaries are those who will take once the trust makers pass away. In a revocable trust, oftentimes, the trust makers are the initial trustees as well as the initial beneficiaries. So, if I have a revocable trust for myself, I can be the trust maker, I can be the trustee, and I can also be the lifetime beneficiary, and perhaps my spouse or descendants are the successor or remainder beneficiaries. With an irrevocable trust, again, we are going to have a trust maker, a trustee, but the trustee oftentimes is going to be somebody different than the trust maker. Also with respect to the lifetime beneficiaries, this is where we see a significant difference between the revocable and irrevocable trust. Oftentimes, the lifetime beneficiaries are going to be for instance, our children, or perhaps our grandchildren, and the lifetime beneficiaries may also end up being the remainder beneficiaries.

The revocable and irrevocable trusts can be created to be what are called grantor trusts. Each of them can have the trust maker place assets in the trust, and then any income earned on those trusts can be reported upon the trust makers individual tax return. All too often, I see where our CPA colleagues immediately come to the conclusion that within irrevocable trust, it automatically is a non-grantor trust, and therefore they do a 1041 return. It is very rare for estate planning lawyers who create irrevocable trust to make them non-grantor trust during the lifetime of the trust maker; 99% of the time, they are going to be grantor trust, and all of the income is going to be reported on the individual return of the trust maker. Now, when it comes to irrevocable trusts, we have to note the similarities between revocable trust as well as where there is a difference, and also we have to remember, there are many types of irrevocable trust. Today, I am only going to cover three types of irrevocable trust. There are more, there are other types, but I am not going to cover them today. We will cover them in a separate podcast.

The three that I want to talk about will depend upon when a client comes in to our office, they have to articulate what are their goals? What are they trying to accomplish? The first type of irrevocable trusts that I confronted in my early career was called an estate tax irrevocable trust, oftentimes, it took the form of an irrevocable life insurance trust. The key to that trust was is that the trust maker, or trust makers, if it was a joint trust, would create a trust and could never directly take back any of the assets that they placed into that trust. The trust makers were never the trustees. They were never the lifetime beneficiaries, and they were never the remainder beneficiaries. They gave up all control, and that makes some sense. If you are going to be able to take an asset and transfer it into a trust and not have it be subject to the federal estate tax or state estate tax in those jurisdictions that still have a state estate tax, you are going to want or the government is going to want you to give up all control over those assets.

When most people think about an irrevocable trust, they are thinking about an estate tax trust, where the trust maker has to give up total control, cannot be a trustee, cannot be a lifetime beneficiary, cannot be a remainder beneficiary. In fact, has to give up almost all control or all powers over the trust. But that is only one type of irrevocable trust. Let us compare that to a newer type of irrevocable trust that we do on a regular basis. It is called an asset protection trust in Ohio, is called an Ohio Legacy Trust. Think about this scenario, with a Legacy Trust or asset protection trust, more often than not, the assets that we place in the trust are still going to be part of our taxable estate. That is they are going to be subject to the estate tax, and they are going to get a step up in tax basis at our death. One of the unusual things about the asset protection trust is that the trust maker is allowed to be a beneficiary of the trust, significantly different than the estate tax trust that we have been creating all these years. The asset protection trust, the key to it, the key to the legacy trust is that the trust maker is allowed to be a lifetime beneficiary of the trust and yet all of the assets that are placed in this so-called irrevocable trust, are totally protected from creditors. Furthermore, there are no issues with respect to the trust maker’s spouse, and/or children serving as trustee over that trust. While the trust maker cannot serve as trustee, the spouse or children can.

These asset protection trusts, these Ohio Legacy Trusts, I would like to refer to them almost as revocable irrevocable trust. Why? Because the trustee who is a related party has full authority to be able to sell the asset in the trust, and distribute that asset back out, or the proceeds of the sale of that asset back out to the trust maker. But while the assets are held inside of the asset protection trust, creditors have no access to those assets, a really significant different type of irrevocable trust than the estate tax trust. Again, when clients come in, we have to know, what are they trying to accomplish? Are they trying to avoid the federal estate tax? Or are they simply trying to protect assets from a potential lawsuit? A big difference in the design of those trusts, both of those trusts are a form of an irrevocable trust, but treated far differently under the law.

Now there is a middle ground trust as well, that we routinely create, and the goal of these trusts is to protect assets from the nursing home, we call them Medicaid Asset Protection Trust. The Medicaid asset protection trust that we create are not as stringent as the estate tax trust that I alluded to first, but they are also not as flexible as an asset protection trust, that we create to protect assets from creditors. You see, under Ohio law, Medicaid does not consider themselves to be a creditor of your estate. They have special statutory rights, and to the extent that you create a trust, an irrevocable trust and retain any rights to either the income or principal of that trust, then Medicaid will claim to have a right as to those assets. Oftentimes, when we create a Medicaid asset protection trust, we are going to name the children as the trustees, that is permissible. We do not name the spouse as a trustee like we do with an asset protection trust. We also do not have to name an independent trustee like oftentimes we do with an estate tax trust, but we do name family members, and typically we are going to name children as the initial trustees of a Medicaid asset protection trust. Once again, in terms of the lifetime beneficiaries of the Medicaid trust, oftentimes, we are going to name the children as the beneficiary of both the income as well as the principal the trust in the event, we ever need to transfer the assets out of the trust, we will transfer them out to one of the kids who then under the law are permitted to gift them back to the parents if the parents need the assets. There are a few occasions where we will name the trust makers, as the beneficiaries of income of the trust assets, oftentimes we will do this with respect to farm planning. We will have a farmer come in, they are going to want to protect the land from the nursing home, we will place the land inside of the irrevocable trust. Perhaps we will first put it inside of a limited liability company and then put the limited liability company inside the Medicaid asset protection trust, but the farmer is going to retain the right to the income, just no right to the principle of the trust. That is permissible under Ohio law. While there is some controversy concerning that approach, for the most part, that has been regularly or routinely accepted by Medicaid as an appropriate way to structure the trust.

So, under the Medicaid asset protection trust, the trust makers create the trust, their descendants can be the trustees of the trust. Typically, the descendants are going to be the beneficiaries of income in principle, occasionally, the trust makers will be the beneficiary of income. The trust makers, oftentimes with a Medicaid asset protection trust, are going to retain the power to be able to change the beneficiaries of the trust during their lifetime. We call that, keep the kids coming home for Sunday dinner provision. So, the trust makers can alter or change the beneficiaries at any time. So, they have a degree of control. In addition, oftentimes, to give the trust makers greater input or control, will also allow them to be able to remove the trustee through a mechanism we call a trust protector or trust advisor. So, the grantors or the trust makers of the trust may have income, may not, may be able to change the beneficiaries of the trust, and may be able to change the trustees of the trust. Typically, those are not the kind of powers that are utilized when we are creating an estate tax trust, they are oftentimes permissible in an Ohio legacy trust where we are trying to protect assets from creditors.

So, you can see, an irrevocable trust is nothing to be feared of. It is nothing to be worried about, it will depend upon the type of your irrevocable trust in terms of what control or powers the trust makers will have. All too often I hear a CPA or a financial adviser express concern that the trust maker is going to have to give up total control, and the assets of the trust are going to be subject to the higher trust tax rates. Just remember, most of the time, that is not the case. It will depend in part upon the design and the type of irrevocable trust that we are going to create for the client. It is best to make an inquiry of the designing attorney, so we make sure we understand what the specific provisions of the trust are, and that will dictate our ability to have access and control over any of the assets that were placed inside of an irrevocable trust.

Well, hopefully, you found that this conversation, this discussion on the three different types of irrevocable trusts that we regularly create can create some clarity and some confidence that will allow you to proceed. Most of our clients will have both a revocable as well as one type or another of an irrevocable trust.

Thank you for being with us today. Enjoy your day. This is Ted Gudorf for the Repair The Roof Podcast. Thank you.

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