An irrevocable trust must be carefully funded, structured and managed to achieve both asset protection and tax planning.
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Editor’s note: This is part four of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.
Revocable trusts and irrevocable trusts are created through contracts in which a person is appointed as “trustee” to hold title to property, with an obligation to use the property for the benefit of another person as the “beneficiary.” Both revocable trusts and irrevocable trusts are excellent estate planning tools, but by giving up additional control over assets in an irrevocable trust, an irrevocable trust can be a much more powerful tool for asset protection and tax planning.
In contrast, revocable trusts can only be used to protect property for the trust maker’s children after the trust maker is dead, but revocable trusts do not protect property for the trust maker.
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Unlike a revocable trust, the trust maker of an irrevocable trust cannot themself amend the irrevocable trust after formation. Nor can an irrevocable trust maker simply transfer the property back out of the irrevocable trust whenever they feel like it. Irrevocable trusts would probably have been better named “non-revocable trusts,” but we are stuck with the sometimes-confusing name irrevocable trust. Just the same, much like a power tool can cause irreversible (irrevocable) changes, so, too, can an irrevocable trust.
A popular, though false, notion about irrevocable trusts is that by transferring property into the irrevocable trust, the property will automatically be protected from creditors and will automatically exempt the trust assets from the federal estate tax (death tax).
Although irrevocable trusts can accomplish both asset protection and tax planning purposes, neither of these often-hoped-for features of irrevocable trusts is automatic, and the irrevocable trust must be carefully funded, structured and managed to achieve both. The trust maker must also give up certain rights and controls, though the amount of controls and rights vary by jurisdiction.
Among the rights and controls that determine the level of asset protection afforded by an irrevocable trust, beneficiary rights are the more important right. All U.S. jurisdictions permit a trust maker to form an irrevocable trust for the benefit of individuals other than the trust maker and achieve asset protection. However, fewer than 20 U.S. jurisdictions permit a trust maker to form an irrevocable trust for themself as beneficiary and achieve asset protection.
An irrevocable trust in which the trust maker is also the beneficiary is often known as a domestic asset protection trust (DAPT), or self-settled asset protection trust. If a trust maker wishes to be the beneficiary of the trust they are forming but does not live in a jurisdiction that permits self-settled asset protection trusts, the trust maker can choose to form a trust under the laws of the almost 20 jurisdictions that do permit a self-settled asset protection trust.
The trust document must name the state jurisdiction being utilized and comply with both the state laws where the trust maker lives as well as the laws of the jurisdiction where the trust is set up. This usually includes compliance with asset transfer laws such as solvency analysis and affidavits, hiring a trustee in the jurisdiction where the trust will be located, as well as possibly relocating trust assets and trust asset management to the state where the trust is formed.
However, it is challenging and uncertain to protect real estate located in a jurisdiction where self-settled asset protection trusts are not permitted because the state in which the real estate is located will claim jurisdictional priority over real estate located in the state’s boundaries.
The strongest way to set up an irrevocable trust for both asset protection and estate tax planning is for the person forming the trust to give up trust beneficiary rights to other people and appoint an independent trustee. However, giving up beneficiary and trustee rights over an irrevocable trust is often impractical and frequently undesirable because it can cause adverse tax consequences.
“Funding” an irrevocable trust — the process of transferring property into a trust — should be the first consideration before drafting and forming an irrevocable trust. Trust makers often go into the trust planning process excited, having many ideas about the estate planning features they want in their irrevocable trust, such as who will get which properties when and subject to which conditions. Irrevocable trusts are simply irresistible thought experiments for many people — they are, in fact, the building blocks of a long-lasting legacy or dynasty.
Example: A prospective irrevocable trust maker goes to an attorney to discuss several potential trust types and features that they learned about from online videos and blogs. The prospective trust maker talks about protecting their assets from creditors. The trust maker discloses to the attorney that they just received a notice of deficiency from the IRS, and another potential creditor has threatened litigation. The prospective irrevocable trust maker is disappointed to learn from the attorney that it is too late to transfer their property into an irrevocable trust at this point because a judge can set aside the transfers into an irrevocable trust under fraudulent transfer laws. The trust maker must first work with advisors and counsel to resolve the tax issues.
The design of an irrevocable trust is pointless if property cannot be lawfully transferred and titled into the irrevocable trust because the property is subject to loans or creditors. Creditors can claw the property back out of the irrevocable trust by invoking fraudulent transfer laws or voidable transaction laws, or through the federal bankruptcy transfer claw-back rules.
Each state in the U.S. (and the federal government) has different rules for lawfully transferring property into irrevocable trusts, though the general rule for transfers into an irrevocable trust is that the transfer cannot leave the trust maker insolvent.
In addition, the trust maker cannot transfer assets into an irrevocable trust if the transfer will hinder, delay or defraud known, pending or threatened creditors. If an irrevocable trust is being formed to either qualify for government benefits or to protect against recovery, we must also add to the general transfer rules an additional layer cake of transfer rules and prohibitions applicable to Medicaid, SSI and VA benefits. It is beyond the scope of this brief discussion to consider those rules.
Irrevocable trust makers must remember that implementation of an irrevocable trust by transferring property into the trust is the magic ingredient to make the trust effective, and unless an irrevocable trust is lawfully and properly loaded up with property, the irrevocable trust can do nothing to protect property that the trust doesn’t own.
Although irrevocable trusts can provide asset protection and tax planning if the irrevocable trust maker properly transfers and funds the trust, the choice of an irrevocable trust maker to keep more power, control, possession and enjoyment over the irrevocable trust and the trust property will reduce both asset protection and change the income tax and estate tax aspects of the irrevocable trust.
The trustee of a trust exercises power and control over the trust and trust property, and the trustee, as a fiduciary, must act in the best interests of the trust beneficiaries. Trustee “control” over an irrevocable trust can be roughly broken down into two primary trustee powers or authorities to 1) manage trust property and 2) distribute assets.
The trustee's power to control management of the irrevocable trust includes diverse duties such as filing trust taxes and investing the trust assets by doing things like renting out real estate, purchasing trust-owned investments, borrowing against trust assets, etc. The distribution trustee has the power to distribute assets to the beneficiaries out of the irrevocable trust, and the distribution trustee can deny distributions to a beneficiary if they would do harm to the beneficiary.
However, the management trustee and distribution trustee powers are regularly combined and held by just one trustee, usually for control and to save on trustee costs. Unfortunately, the control and cost savings that convince a trust maker to retain both management and distribution trustee powers do diminish the asset protection of the trust as shown in this example:
Example. An irrevocable trust maker forms an irrevocable trust and names themself as trustee over the irrevocable trust, with trustee authority to both manage the trust and decide on distributions going out of the trust to the beneficiaries. The trust maker is not the beneficiary of the irrevocable trust, but instead names their minor children as beneficiaries. The trust maker believes that the irrevocable trust property is protected from creditors and later asks an attorney to review the trust. The attorney opines that by virtue of the trust maker retaining management over the trust property, some state courts could (though not for certain) assert that the trust maker still has power and control over the trust and trust property. This dominion over the trust by the trust maker could potentially cause a court to claw the property back into the hands of a creditor for the trust maker — especially since the trust beneficiaries are the minor children of the trust maker. The attorney tells the trust maker that the trust is much “better” than doing nothing to protect, and suggests that the trust maker could strengthen the irrevocable trust’s asset protection and fortify the asset protection by giving up this control over the irrevocable trust by resigning as management trustee.
The question, “Who will be the trustee in charge of managing the trust?” is always one of the most challenging questions that trust makers face when setting up an irrevocable trust. Not only do irrevocable trust makers not typically want to give up control over the trust, but often, they aren’t sure whether they want to hire a professional fiduciary trustee to oversee the responsibility to manage the trust.
Some trust makers want to ask a family member or friend to serve as trustee — which can be a bad idea. It can be a big mistake to choose a friend as a “free” trustee rather than paying full price for what you want/need: trustee competency and insurance. A friend who accommodates a request to serve as a “free” trustee will almost always lack experience in dealing with many complicated and unfamiliar aspects of trustee duties. Plus, a friend or family will have no professional liability insurance. This all adds up to family and friends serving as trustees being more likely to make mistakes with the trust that they cannot afford to make right.
Irrevocable trust makers often set up trusts for members of their family as beneficiaries, and when the beneficiaries are minor children, the trust maker has even more dominion, power and control over the trust. Although making children or family the beneficiaries of a trust can still provide asset protection and even exclude assets from the taxable estate, caution should be exercised. If a trust maker retains trustee power over management and distributions to minor children, the trust is not as strong for asset protection, and the trust can also be included in the trust maker’s gross estate because a trust maker with management rights will be seen by the IRS as possessing or controlling the assets.
Under IRS rules IRC 2036 and IRC 2038, if a trust maker keeps the rights to manage assets, the value of the trust assets will be included in the trust maker’s gross estate — which can be a good thing for capital gains tax savings if the trust maker has enough exemption from estate tax so that no tax is owed anyway.
Another challenging question in setting up an irrevocable trust is, “Who will be the ‘distribution trustee’ in charge of distributions from the trust?” The trust maker often wants to have a say in when and to whom the trust assets are distributed — after all, the trust maker worked hard to earn the assets that will be contributed into the trust. However, by retaining the powers of the distribution trustee of the irrevocable trust, the trust maker is again making it more likely (but not certain) that a court will not afford the irrevocable trust asset protection in case a creditor or the IRS comes after the trust.
To achieve maximum asset protection with an irrevocable trust, the trust maker should consider appointing a different person as trustee over the management and distributions from an irrevocable trust. Fortunately, creative attorneys have developed several helpful mechanisms that a trust maker can use so that they can give up management trustee and distribution trustee powers over their irrevocable trust, but still have some indirect, or in-conjunction, powers over the irrevocable trust.
My next article will detail how domestic asset protection trusts (DAPTs) can protect assets for the trust maker.
