Trusts are created for a variety of reasons. They may be created to manage assets for children or young people who are not capable of taking on full financial responsibility until they reach an appropriate age. Trusts may also be created to provide funds for a specific purpose, such as the care of an elderly parent or disabled family member. There are a number of types of trusts, and each is created for a specific purpose and is governed by specific laws concerning the treatment of the assets under tax law and other regulations.
The Irrevocable Trust
An irrevocable trust is a special type of trust that cannot be undone once it is created. It generally concerns three important entities: the grantor, the beneficiary, and the trustee. The grantor is the person who supplies the assets that will fund the trust. The beneficiary is the person or company that will benefit from or receive the trust assets. The trustee is the person or business entity that will manage the trust and make the appropriate distributions to the beneficiary.
Beneficiaries can receive trust assets in a variety of ways, all of which are determined in advance by the grantor. For example, if the trust is made for the benefit of a small child, the grantor may assign the trustee permission to determine how much of the trust assets to distribute on behalf of the child until the child reaches a certain age, or the grantor may specify certain amounts from the trust to be distributed to the child as he or she reaches certain ages. The grantor may also allow the trust to distribute all of the assets of the trust at once, for example when the child reaches the age of 25.
An irrevocable trust exists as a separate legal entity for taxation purposes, so the trust is required to pay taxes on its own assets and file its own tax return. This can be a complicated process and is often best done by a professional accountant or attorney. If the trustee is a business such as a bank, the trustee may also handle this obligation.
What are the advantages of an irrevocable trust?
One advantage of an irrevocable trust is that it insulates the assets of the grantor and the beneficiary from creditors. Creditors cannot pursue claims against the grantor by attaching assets that are in an irrevocable trust, because once the grantor has signed those assets over, they no longer belong to him or her. Similarly, creditors of the beneficiary cannot attach assets of the trust until they are handed over to the beneficiary. However, there are strict laws governing assets transferred into a trust; for example, assets which are mortgaged or have liens on them generally cannot be transferred directly into the trust without some type of guarantee of payment of the debt. This prevents people from creating an irrevocable trust as a way of avoiding paying legitimate bills.
Another advantage of the irrevocable trust is that any assets passed into the trust prior to the grantor’s death are not part of the grantor’s estate and do not pass through probate. As a result, the grantor can significantly reduce his or her estate tax liability by making timely deposits of assets into an irrevocable trust. Once those assets have been assigned to the trust, the grantor loses control of them, but they must be treated according to the terms of the trust. By carefully outlining the way the trust assets are to be handled, the grantor can ensure that his or her assets are treated in the desired manner and still avoid significant estate or inheritance taxes.
What is the disadvantage of an irrevocable trust?
One disadvantage of irrevocable trusts is that they are subject to gift taxes. Gift tax limits change from time to time, but are currently $13,000 per calendar year. If you transfer more than this amount to the trust in one calendar year, you will pay applicable gift tax on the amount over $13,000. You can increase this limit by having your spouse also donate up to $13,000 to the trust, for a total of $26,000 from each of you. You can also make a gift of up to $13,000 to any single individual, so it may be wise to transfer some assets directly to your heirs and some to the trust. Gift taxes are progressively assessed on any amounts over $13,000 per calendar year per individual.
Setting up a trust requires the advice of a specialized trust lawyer and tax attorney. These are very complicated financial tools but prepared the correct way they can have significant asset protection and tax savings.