Irrevocable Trusts

Irrevocable trusts (ITs), which come in many forms, are normally used to give away property during your lifetime, so that the gifted property is not included in your estate when you die.  Unlike a living trust, an irrevocable trust is one which, once it is created, normally cannot be canceled or amended by you, the “settlor.”

What are the basic rules for giving away your property using an IT?

You are entitled to give away $13,000 a year to someone without incurring any gift tax.  If you hand someone $13,000 in cash, you pay no tax.

Likewise, you can put that $13,000 into an IT leaving it to your son upon your death, and still avoid paying any gift tax, provided that your trustee gives your son a one-time opportunity to take the $13,000 right away. 

What are the advantages of having an IT?

First, you avoid or decrease your estate tax liability.  Estate taxes are based on the value of property you have when you die.

Once you irrevocably give away property to an IT, it is no longer considered “yours,” and, when you die, that property is not be included in your “taxable estate.” Your beneficiaries take the property tax-free.  When you transfer property into a revocable (or “living”) trust, since it remains under your control, it is included in your taxable estate when you die, and may be subject to estate tax.

And, because you no longer control the property held by the IT, your creditors normally cannot go after that  property to satisfy your debts.

What are the disadvantages of having an IT?

First, you lose control over the property; the trust document and the trustee control the property, not you.  Even if you need the property back in an emergency, you normally cannot get it.

Second, if the property you transfer to an IT is a life insurance policy, and you die less than three years after the transfer, the life insurance proceeds will still be included in your taxable estate.

Third, if you transfer property to an IT, and need to apply for Medicaid nursing home benefits within five years of the transfer, you may be ineligible for Medicaid for a period of time.  The length of the disqualification period is based on the value of the property you transferred to the IT.

Finally, unlike a revocable (or “living”) trust, where you can act as your own trustee, an IT normally is more costly to set up, and the trust likely will need to pay a trustee to manage the trust assets.   Because an IT is an entity separate from you, it must have its own tax identification number and file its own income tax return.

What are the advantages of a Life Insurance Irrevocable Trust (ILIT)?

First, if you die owning a life insurance policy, that policy becomes part of your probate and taxable estates, and your estate may end up paying estate tax on the money paid out on that policy.  With an ILIT, you either purchase a life insurance policy and give it to the trust, or gift an amount of money to the trust to purchase a life insurance policy on your life.  When you die with an ILIT, the insurance proceeds go to the estate to be paid out to the beneficiaries you designated, and your estate owes no estate tax on those proceeds.

Second, ILITs are also less risky for you than if you transfer money to an IT.  If you need that monet later, you are out of luck. But if you own a life insurance policy and transfer it to an ILIT, you do not really lose control of a very valuable asset, since the policy becomes valuable only when you die – and you won’t need the money then!

Third, another advantage to ILITs is that your estate gets a pretty quick infusion of cash from the insurance company.  If your estate owes estate tax on other property in your estate, the IRS wants it paid fairly quickly, usually within months of your death.

When your estate receives the “quick cash” from the insurance policy, it can pay its bills – including any estate tax on your other property – without liquidating other estate property to pay the bills.  This is important where you have left specific property – such as a house – to your beneficiaries, and you don’t want the house sold.

Fourth, another benefit of an ILIT is that you get a lot of bang for your buck.  If you give $13,000 to an IT, and then die, your beneficiaries only get the $13,000.  If you give that same $13,000 to an ILIT, and the ILIT buys a $500,000 life insurance policy, you have leveraged the gift and earned value on it.  When you die, your beneficiaries will get $500,000, and none of that will be subject to estate tax.

Fifth, if you own a life insurance policy and transfer it to an ILIT, you must survive at least 3 years.  If you do not survive the three years, the policy is included in your taxable estate, as if you had never transferred it at all.

But there is an important loophole to this 3-year rule.  If you transfer cash to the ILIT, and the ILIT purchases the policy, you can die the next day and the policy will not be included in your taxable estate.

Finally, ILITs may be particularly suited to married couples.  The ILIT can buy a “second to die” policy, which pays out only upon the death of the second spouse.

Because of the marital deduction, no estate taxes are usually due on the death of the first spouse, but only upon the death of the second spouse.   It is at this point that the “second to die” policy will pay out, giving the cash infusion needed to pay the estate tax bill.

What are the disadvantages of an ILIT?

Once you create an ILIT, you must give up all control over the life insurance policy.

You will not be able to change beneficiaries or to cancel the policy.  Only your trustee can make these independent decisions.

If you exercise too much control, the IRS likely will disregard the ILIT and the policy will be pulled back into your taxable estate, and taxed.

If you think you could benefit by estate planning with an IT or ILIT, don’t delay, and please call us today at 508-316-3853.