What is a Trust?
To understand an irrevocable trust, it helps to understand what a trust is in general. A trust is a legal arrangement where a person (the grantor) transfers property to another (the trustee) for the benefit of a third party (the beneficiary).
There are many different classifications of trusts, depending on when it was created, how it was created, and the purpose of the trust.
A trust created during a grantor’s lifetime is called an inter vivos trust, which is also known as a living trust. By contrast, a testamentary trust is a trust created by the grantor’s will, and comes into being after the grantor’s death.
Two main classifications of living trusts is whether the trust is revocable or irrevocable. In a revocable trust, the grantor creates a trust but retains the power to amend or revoke it. When an irrevocable trust is created, the grantor generally gives up the right to amend or revoke it.
In this article I discuss the purpose and uses of an irrevocable trust. You can learn more about revocable trusts in my article here.
How Does an Irrevocable Trust Work?
An irrevocable trust is formed in the same way a revocable trust is created:
- the grantor appoints a trustee to manage trust assets according to the grantor’s wishes
- the grantor designates beneficiaries
- the grantor funds the trust with trust assets
Although the nuts and bolts of revocable and irrevocable trusts are the same, with an irrevocable trust the grantor retains limited powers in order to achieve certain tax shelters, asset protection, or management advantages.
Irrevocable Trust Taxes
Although a grantor loses the right to amend or revoke an irrevocable trust once it is created, a grantor may choose to do this in exchange for certain tax benefits.
One of the main tax benefits is the grantor’s ability to forgo paying federal income tax during the grantor’s lifetime by transferring the tax liability to the trust itself. Rather than trust income being claimed on the grantor’s tax return which would increase the amount of the grantor’s taxable estate on Form 1040, the trust will file its own taxes with the IRS on Form 1041.
When a grantor transfers assets into an irrevocable trust, since she generally gives up the right to amend or revoke the trust as well as to obtain any enjoyment or benefit of the trust assets, an irrevocable trust will help protect the trust assets from the grantor’s creditors.
In California, there may be some exceptions where the law will allow a creditor to access trust assets, such as for alimony, child support, or past tax liability.
An irrevocable trust will also help protect the asset from the beneficiaries’ creditors (subject to the same exceptions above). A creditor’s ability to access a debtor’s assets is normally tied to the amount of control the debtor retains over the asset. Since a beneficiary under an irrevocable trust normally has very little influence or control over trust assets (the burden resting with the trustee to manage the assets), this serves as credit protection for the beneficiaries.
Irrevocable Trust Disadvantages
One of the main disadvantages of an irrevocable trust is that it is less flexible than a revocable trust. As its name implies, once the irrevocable trust is created, it can not later be amended or revoked (generally speaking).
Not Ideal for Active Investors
The irrevocability of a trust can have grave implications for a grantor who wants to personally maintain active management over his assets. For example, real estate investors often highly value the ability to actively manage a real estate portfolio. Germane to real estate investing is the ability to hold real estate when it is increasing in value or producing income, while at the same time retaining the freedom to liquidate it when the market turns or when cash flow is needed for personal income or to invest in other properties.
Real estate investors can still transfer their real estate assets into a trust via a trust transfer deed, but a revocable trust may be more suitable for a real estate portfolio under active management by a grantor.
Self-Settled Trusts Not Permitted in California
A “self-settled” trust is a trust where the grantor is also the beneficiary. Self-settled trusts are prohibited by California law. So if a grantor desires to shelter an asset for which she is also the beneficiary, the remedy is to transfer assets to an offshore trust or to a domestic asset protection trust (allowed in states such as Delaware or Nevada) which tolerate the creation of self-settled trusts.
An exception to the ability to revoke an irrevocable trust lies in California’s Uniform Trust Decanting Act (CUTA), effective January 1, 2019.
Under CUTA, an authorized fiduciary can amend or modify an irrevocable trust, provided no beneficiary objects to the modification, and as long as the modification preserves the grantor’s intent.
Can a Trustee Withdraw Money from an Irrevocable Trust?
As the trustee’s name implies, a trustee only holds title to assets on behalf of the grantor for the benefit of the beneficiaries. Although the trustee holds legal title to trust assets, the beneficiaries have an equitable interest in the property. This is known as a bifurcation of property rights.
Thus, a trustee owes a fiduciary duty to beneficiaries and can only withdraw money from the trust if it is allowed or required by the trust instructions, such as to make income or principal payments to beneficiaries, or in the case where it is required by law, such as to pay trust taxes.
What Happens to an Irrevocable Trust When the Grantor Dies?
When the grantor dies, this normally will not have an effect on an irrevocable trust, because normally the grantor is not going to be the trustee of an irrevocable trust.
This is because one of the primary purposes of the irrevocable trust is exclude taxes from the grantor’s estate, and when the grantor retains control over trust assets (as trustee), the grantor is at risk of the IRS considering trust assets as part of the grantor’s taxable estate.
Most irrevocable trusts are set up with longevity in mind, where the beneficiaries can take advantage of the principal and income of the trust assets for years to come.
So when the grantor dies, this normally will have no effect over an irrevocable trust, assuming the trust has established an independent trustee and successor trustees to manage trust assets.
Irrevocable Trust Medicaid
Medicaid is a joint federal and state government program that allows medical assistance for those who are financially in need.
In 2021, Medicaid is available in California to those earning (if single) $16,395 per year, or (if married) $22,108 per year.
If over the age of 65, Medicaid is available in California to an individual earning less than $2,382 per month.
Generally, whether an asset is placed in a revocable or irrevocable trust, if the grantor receives a benefit from the principal or income of that asset, it can be counted toward the grantor’s income. The law governing trusts for the purpose of reducing income for the purpose of obtaining Medicaid is complex, and you should consult with your attorney.