All trusts fall under one of two categories: revocable or irrevocable. These trusts differ in several significant ways, including their purpose, asset ownership and use, tax treatment and annual maintenance requirements. This newsletter will briefly discuss the differences between a revocable and irrevocable trust and then discuss three common scenarios where irrevocable trusts fail.
The Revocable Trust
A revocable trust can be amended or revoked at any time during the trust creator’s (the “grantor”) life and is typically the first step in creating an estate plan. The revocable trust can serve several significant, valuable purposes, including avoiding probate [1], making gifts upon the grantor’s death, protecting inheritances and maximizing the estate tax exemptions of spouses. While serving these purposes, assets continue to be controlled by the grantor (as trustee) and can be bought and sold as the grantor pleases. Any income generated by these assets is included in the grantor’s taxable income.
A common misconception is that placing your assets in any trust provides asset protection—this is not true. When a court or the IRS determines the ownership of an asset, the key factor is control. Since the grantor continues to control the assets in a revocable trust, those assets are not protected from creditors and continue to be treated as if the grantor owned them personally.
The Irrevocable Trust
An irrevocable trust, on the other hand, cannot be amended or revoked by the grantor and is generally considered advanced planning because it serves specific purposes that may not apply to everyone. These purposes include asset protection, reduction of the taxable estate and utilization of the annual gift tax exclusion ($14,000 in 2014) or lifetime exemption ($5.34 million in 2014). Once transferred to the trust, these assets are no longer controlled by the grantor, and therefore, not considered an asset of the grantor. The income of an irrevocable trust can either be included in the grantor’s taxable income or can be taxed to the trust itself, depending on how the trust is drafted.
While assets transferred to an irrevocable trust are intended to be protected from creditors and excluded from the grantor’s taxable estate, there are processes that must be followed in order to maintain the integrity of the irrevocable trust. When these processes are not followed, courts will pierce the asset protection in favor of creditors or include the assets in the grantors taxable estate, defeating the purpose of the trust.[2]
Scenario #1: Failing to Notify Beneficiaries
When an annual exclusion gift is made by the grantor to an irrevocable trust, the trustee must notify the beneficiaries that a gift has been made.[3] This is done in the form of a “Crummey Notice” (named after the case establishing the requirement). The beneficiaries should (a) be given written notice that a gift has been made to the trust, (b) be informed of the amount he or she is entitled to withdraw and (c) be granted a reasonable amount of time to withdraw the gift before the trustee invests it.
If the trustee fails to provide such notice, the IRS does not consider a present interest gift to have been made. This failure can result in the gifted assets reverting back to the grantor’s estate and essentially eliminating the benefits that the grantor intended to achieve by establishing the irrevocable trust.
Scenario #2: Paying Premiums from Your Personal Account
When an asset is owned by an irrevocable trust, any payments towards that asset must be made by the trustee, not the grantor. The most common example of this is an Irrevocable Life Insurance Trust (“ILIT”) that owns a life insurance policy on the life of the grantor. Too often, whether for lack of guidance or attention, the grantor will pay the life insurance premium directly from a personal account to the insurance provider. When this is done, the IRS will likely consider the policy an asset of the grantor and include the death benefit in his or her taxable estate, defeating the purpose of the ILIT.
In order for the IRS to respect the gift of the premium from the grantor to the beneficiaries and the ownership of the policy by the ILIT, the following process must be followed: first, the grantor must make the gift (the amount of premium due) to a bank account established by the trustee of the ILIT; second, as stated above in “Scenario #1”, Crummey Notices must be given to the beneficiaries of the ILIT; and third, after the period of withdrawal has passed, the trustee may pay the premium to the insurance provider. Only by following these steps can the grantor properly make a present interest gift that will be excluded from his taxable estate.
Scenario #3: Treating the Trust as Your Bank Account
In a recent case, a couple had transferred real estate to an irrevocable trust.[4] The IRS imposed a $2 million federal tax lien against the couple and foreclosed on the property. When the dispute went to litigation, the court ruled that couple had “engaged in a legal fiction by placing legal title…in the hands of a third party while actually retaining some or all of the benefits of true ownership.”
The court’s decision was based on the facts surrounding the ownership and use of the property. The couple maintained the property, paid the utility bills, held insurance on the property in their own names for which they paid the premiums personally and used and rented out the property without the trustee’s knowledge. Additionally, payments in connection with the purchase of the property came from a variety of sources, including rents, payments directly from the couple and payments from the taxpayer’s business. Had the couple respected the integrity of the trust, the property would have likely been protected from creditors, which in this case was the IRS. By failing to do so, the couple lost the property and wasted the time and cost of planning.
Conclusion
An irrevocable trust can serve many important purposes. The trust preparer must be aware of the grantor’s goals and intentions and the trust document must be drafted with these goals in mind. However, it is important to understand that in order for the trust to serve its purpose, the integrity of the trust must be respected and the established processes must be adhered to. If you have an irrevocable trust in place and are concerned about whether it is being maintained properly, it is important to contact an experienced estate planning attorney as soon as possible to have the trust reviewed.
1. Please see the April 2013 Newsletter, Probate—What It Is and How to Avoid It.
2. Please see the February 2012 Newsletter, Asset Protection Through Estate Planning.
3. Please see “The Notice Requirement for Gifts in Trust” in the December 2010 Newsletter.
4. US v. Tingey, 716 F. 3d 1295 (2013).