Why You Don't Need to Be Afraid of Irrevocable Trusts in Estate Tax and Asset Protection Planning

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You probably know that trusts can be a great tool for avoiding probate, minimizing estate tax, and protecting assets. What you may not know is which type of trust is best for your purposes. In this blog post, we'll take a look at irrevocable grantor trusts, and discuss their advantages in tax and asset protection planning

What is a Grantor Trust?

According to the definition given by the IRS, a grantor trust is a trust "over which the grantor or other owner retains the power to control or direct the trust's income or assets." The grantor of a trust is the creator of the trust. It is not necessarily a bad thing for a trust to be a grantor trust; in fact, most trusts are intentionally designed to be grantor trusts,  Why? Because the grantor wants to pay the income taxes on the income earned by the trust assets. Because the grantor pays the income taxes, the grantor trust does not need to file its own tax return.

A common example of a grantor trust is a revocable living trust, in which the grantor creates the trust, funds it with assets, and acts as both trustee and beneficiary during his or her lifetime. After the grantor's death, a successor trustee takes over and distributes trust assets to the grantor's intended beneficiaries. This avoids probate and streamlines the transfer of assets, but a trust like this is not the best option if you are looking to avoid estate taxation or protect assets from creditors or from needing to be spent on long-term care.

An irrevocable trust, is, as the name suggests, a trust that cannot be revoked or amended by the grantor after it is made without the beneficiary's permission. Once the grantor creates the trust and transfers his or her assets into it, the grantor has no further control over the trust or the assets.  Yet, when certain grantor trust provisions are inserted into the trust document, the irrevocable trust becomes a grantor trust and the grantor pays the income taxes on any trust income and no trust tax return has to be filed.

For estate tax planning and asset protection planning, an irrevocable trust is a better choice than a revocable trust. However, unless great care is taken, an irrevocable trust may be treated like a nongrantor trust by the IRS. In that case, you would lose the tax advantages that comes with an irrevocable trust.

Irrevocable Trusts in Estate Tax and Asset Protection Planning

Irrevocable trusts offer a number of advantages, but they can be scary to grantors because of the loss of control. It is that very loss of control on the part of the grantor that provides the protection: because the grantor cannot directly access the assets, neither can his or her creditors.

When might you want to create an irrevocable trust? When you have assets that you want to use for the benefit of loved ones and keep out of the hands of creditors. Because the trust owns the assets, not you, and you have no power to change that, your creditors cannot reach those assets. (This is true as it pertains to bankruptcy only to the extent that federal bankruptcy or state insolvency laws do not permit a "clawback" of assets to satisfy a creditor you were trying to evade.) When properly drafted, an irrevocable trust is highly effective in protecting assets from creditors.

Estate tax planning is another reason to consider an irrevocable trust. Because you no longer own the assets in an irrevocable trust, they do not count toward your estate's value for taxation purposes. Because of the amount of assets that are exempt from estate and gift tax (for 2019, $5.7 million per individual, or $11.4 million for a married couple), estate tax is not an issue for most people. If it is a concern for you, given that the top estate tax rate is 40%, an irrevocable trust can be an excellent way to reduce the value of your estate.

For many more people, Medicaid planning is a reason to consider an irrevocable trust. Most people who have worked hard throughout their lives want to use the wealth they have accumulated to benefit their families. Unfortunately, many people will also need long-term care in a nursing home, which can rapidly deplete a lifetime of savings. Medicaid will pay for nursing home care, but only after the nursing home resident's assets have been "spent down" to pay for care. Timely placing assets in an irrevocable trust can remove them from "countable assets" and preserve them for your loved ones.

Last but not least, an irrevocable trust can be structured to protect your intended beneficiaries from themselves by giving the trustee discretion as to the timing and amount of distributions. If the beneficiaries cannot compel distributions, assets in the trust may be beyond the reach of their creditors.

If You Are Considering an Irrevocable Trust

If an irrevocable trust sounds like it would meet your needs, remember that it's not something to jump into impulsively. To be sure you are weighing all relevant considerations before committing to an irrevocable trust, work with an estate planning attorney who has extensive experience in asset protection and Medicaid planning issues and who has drafted many irrevocable trusts. If you think an irrevocable trust might be right for you, we invite you to contact our law office to schedule a consultation.

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