REVOCABLE OR IRREVOCABLE? THAT IS THE QUESTION

When it comes to understanding trusts, knowing the difference between revocable and irrevocable trusts is critical to making any estate planning decision.  A Revocable Trust is one that can be changed at any time.  So, for example, if you change your mind about a particular provision or beneficiary, then you can change the terms of the trust with a trust amendment.  Or, if you later decide that you no longer like anything about the trust, you can revoke it entirely.  For all intents and purposes, you (the Grantor) continue to hold all “incidents of ownership” of the revocable trust property, which can have significant tax and other consequences.

An irrevocable living trust is a different animal.  If you transfer some or all of your property to an irrevocable living trust, you are giving up your rights to that property.  That is, by designating the trust as irrevocable, you forfeit the right to amend or revoke the trust because you no longer own the property in any shape or form.

So why would anyone ever want to give up their rights to their hard earned assets?  Simply put, it wouldn’t make much sense – unless of course the stakes are very high.  As you can imagine, this type of trust would not exist unless it served some very important purposes.

One common purpose of an irrevocable trust is to satisfy a property settlement agreement as a result of a divorce or some other court decree.  Many property settlements require that certain property be placed in trust for the benefit of someone else.  For example, the settlement agreement may require the ex-husband to maintain a life insurance policy in an irrevocable life insurance trust for the benefit of the ex-wife.

Another reason to create an irrevocable trust is to protect against creditor actions.  Wealthy individuals often utilize this form of estate planning to protect their assets from the claims of creditors, especially because they are often vulnerable to law suits that could result in high monetary judgments.  The truth is, it’s easy to find yourself owing people money – sometimes unwittingly.  A creditor can be a tax-collecting agency, accident victim, or health-care provider.  An irrevocable trust can serve to insulate your property to effectively keep it from a creditor’s reach.

An irrevocable living trust can be a useful tool when it’s time to consider a nursing home.  In California, the average cost of a nursing home can range form $70,000 to $150,000.  The idea of draining your last bit of savings to pay for a nursing home is certainly an unwelcome proposition.  Medi-Cal may help to offset this burden.  Medi-Cal is the sole payer for certain types of long term care, such as nursing homes and certain at-home services through In-Home Supportive Services (IHSS).  However, you have to qualify for Medi-Cal, which is why many elderly persons choose to transfer their property to an irrevocable trust before applying.

In order to qualify for Medi-Cal, an individual is permitted a $2000 cap in countable assets, plus certain exempt assets.  By transferring assets into an irrevocable trust, it may be possible to qualify for Medi-Cal while ensuring that property will be left to loved ones.  However, it’s important to keep in mind that in order to qualify for Medi-Cal following a transfer of property into an irrevocable trust, the property must have been transferred to the trust at least 5 years prior to filing.  So it’s always a good idea to plan far in advance.  Of note, this particular form of planning tends to highlight some ethical concerns which I cannot attempt to address in this forum.

Perhaps one of the most common uses for an irrevocable living trust is the avoidance of federal estate taxes.  In past years, individuals with large estates were subject to federal estate taxes as high as 55%.  The 2011 through 2012 federal estate tax exemption is $5 million and the estate tax rate for estates valued higher that this amount is 35%.  Since few people have over $5,000,000 in assets, this may seem like a largely irrelevant issue.  However, the estate tax exemption is predicted to fall back to $1 million beginning in 2013.  Ones home can easily be valued at $1 million alone, so there is room for concern.  Also, it’s important to note that even if a home has a mortgage, the estate tax is based on the appraised value regardless of the equity.

I should mention, however, that the federal government treats a transfer of property to an irrevocable trust as a gift for federal gift tax purposes.  The federal gift tax rates are substantially the same as the estate tax rates.  Initially, it would seem that there is little to be gained by transferring property to an irrevocable trust.  But, that is not necessarily true.  For example, property that is appreciating in value could be a good  candidate for this type of transfer because the appreciation in value from the date of transfer to the date of death will be exempt from both the federal gift tax and estate tax.

Finally, there is another very important asset that is often placed into an irrevocable trust – the life insurance policy on the grantor’s life.  If the policy is in your name (the insured), the death benefits payable upon death are subject to federal estate taxes.  The tax rules say you own a life insurance policy if you possess so-called “incidents of ownership,” meaning the power to change policy beneficiaries, change coverage amounts, or cancel the policy.  So if the estate exceeds $5 million (for 2011 or 2012), which is very possible with plenty of life insurance coverage, then your heirs will stand second in line behind Uncle Sam.

A viable approach to avoid paying estate tax on life insurance proceeds could include transferring ownership of the policy to the irrevocable life insurance trust.  The trust would pay the premiums and the death benefits would go directly go to the named beneficiaries.  You as the Grantor continue to transfer funds to the Trustee of the trust, who makes payments on the premiums.  However it should be noted that the premiums payments may be counted against the gift tax exemption, so careful planning is crucial.

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