What is an Irrevocable Trust?

Irrevocable Trusts for Asset Protection and Tax Planning

The legal arrangement known as an Irrevocable Trust is one of the most important tools for  business asset protection and protecting wealth.   An Irrevocable Trust can produce significant business, tax and asset protection advantages in addition to traditional estate planning benefits.

Differences from Revocable Trusts

Before we discuss the particular planning opportunities of an irrevocable trust lets briefly review what the term “trust” means. Remember that a trust is an arrangement where one person, (the trustor) transfers money or other property to another  (the trustee) who agrees to hold the property according to the terms specified in the agreement. The trust agreement specifies what the trustee is required or permitted to do with the property – how he or she is to hold it, for how long and who is to receive any benefits. Those who are entitled to receive the benefits of the trust are called the beneficiaries.

A trust which is revocable, such as a typical living trust used in estate planning, is one that can be cancelled or changed in any way, during the trustor’s lifetime.  A revocable trust is often used to avoid a probate of the trustor’s estate and to provide a structure for holding and distributing assets upon the death of the trustor. Because of these unrestricted powers over trust property, during lifetime, the assets of a revocable trust are generally treated as owned by the trustor, for all legal and tax purposes.

Purposes of Irrevocable Trusts

An irrevocable trust is generally designed to accomplish a specific business, tax or estate planning purpose which involves removing particular assets from the trustor’s “balance sheet.”  Depending on the particular goal and what is intended to be achieved, an irrevocable trust provides appropriate restrictions on the powers of the trustor and trustee so that relevant legal and tax rules are properly accounted for.

Tax Trusts

For example, an individual may wish to shift taxable business or investment income to lower bracket family members to achieve  tax savings. A typical revocable trust, with unrestricted powers retained by the trustor will not be effective in shifting income to another taxpayer.  The trustor will still be considered the owner of trust property for tax purposes.

By contrast, an irrevocable trust, for these purposes, is one which sufficiently restricts the trustor’s powers over the trust, in a manner consistent with the specific rules of IRC Sections 671-679. If the rules are followed, the trustor is not treated as the owner of trust property for income tax purposes and the tax planning goal can be achieved.

Similarly, if one is attempting to reduce the size of an estate, to reduce or eliminate estate taxes, assets are often transferred to an irrevocable trust. The powers which can be maintained by the trustor are narrowly drawn and the limitations on the trustor’s powers must be strictly adhered to if property is to be successfully removed from the estate to avoid estate taxes

Asset Protection

An irrevocable trust is the key strategy for protecting assets from legal judgments. It is distinguished from a revocable trust which provides estate planning benefits but not asset protection or tax advantages.

Irrevocable trusts can be used to minimize potential liability from a property or to protect the assets in the trust from the claims of a trustor’s or beneficiary’s future creditors. To protect trust assets from a future creditor claim, state laws and sometimes federal bankruptcy law must be properly applied. Some states allow a trustor to maintain strong powers to manage trust assets and to control the timing and direction of the trust fund and even to receive current income distributions.

Irrevocable trusts are the most popular strategy to protect assets from judgments.  Trust law allows great flexibility in the design and operation of the trust, creating significant asset protection and tax planning opportunities.

A major advantage of the irrevocable trust over other legal entities such as LLC’s and Family Limited partnerships is that it is extremely flexible in legal form. Unlike other entities, the creation of a trust is not required to be registered publicly so a greater degree of financial privacy concerning management and beneficial ownership can be achieved. Additionally the trust can incorporate provisions which combine the best features of domestic and even offshore arrangements within the language of the plan documents.

All of your assets can be held within the trust—but be governed by special terms appropriate for that specific asset ( Family Savings Trust).  For example, the family residence, personal savings, life insurance, business property and real estate assets can be protected within an irrevocable trust structure with different terms providing protection for each asset ( Asset Protection and Estate Planning with Family Savings Trusts).

The choice of laws to be applied to the irrevocable trust also creates a wide variety of planning opportunities to take advantage of domestic or foreign laws which fully protect assets in the trust. For example, some states offer excellent asset protection for a residence but not for retirement plans. Or it may be the other way around with savings protected but homes less so. Based on the type of assets involved and the client’s goals, an irrevocable trust takes advantage of the asset protection laws in those jurisdictions which are most favorable for the clients needs. ( New State Laws Allow Residents to Shield Assets From Creditors)

Additional flexibility is provided when the irrevocable trust is designed to shift situs during its term to optimize available asset protection and tax benefits.  The type and value of assets held by the trust may change over time. Often an asset sale is anticipated at some point in the future which may generate a large tax liability.  Proper drafting of the trust document should permit the migration of the trust to the jurisdiction which provides not only asset protection but also the most favorable tax treatment of income.

Irrevocable Trusts Under 2018 Tax Law

The 2018 tax law (Tax Cuts and Jobs Act ) creates opportunities for substantial tax savings by using irrevocable trusts to shift income and assets to tax favored entities or lower bracket family members.

The most significant feature of the 2018 tax law is reduced rates for corporations and pass-through entities such as LLC’s, partnerships and S-Corps. The corporate rate was reduced from 35% to 21% and some pass-through entities are now entitled to a deduction of up to 20% of income.  Tax planning with an irrevocable trust attempts to shift income or assets to lower bracket entities or family members to take advantage of these favorable tax rates. ( Family Savings Trusts – Income Tax Planning)

The 2018 tax law also advantages business income over income derived from salary.  Business income can be routed through one of the lower bracket entities while salary is subject to the highest individual tax rates.  These provisions in the new tax law make the source of the income- as business or wages- the most important determinant of the rate at which it will be taxed. Often an irrevocable trust attempts to convert wage income into business income to take maximum advantage of beneficial tax rates.

The new limitations on deductions for state and local taxes as well as mortgage interest make the shifting of income and assets through an irrevocable trust even more valuable. By shifting income and asset ownership the impact of deduction limitations may be mitigated by dividing state and local taxes and mortgage expenses among different taxpayers through an irrevocable trust.

Irrevocable trusts can be used to protect the assets in the trust for the benefit of the trust or other beneficiaries.  To achieve asset protection goals and effective tax planning under the 2018 tax law, state and federal laws must be properly applied. Make sure to discuss your asset protection planning with your attorney and tax advisors so that your particular planning needs are considered in adequate detail.