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Trusts - The Difference Between Revocable and Irrevocable. Which is right for you?

Trusts - The Difference Between Revocable and Irrevocable. Which is right for you?

In order to effectively develop a comprehensive estate plan, an estate planner must have a thorough knowledge of the client’s estate, sophistication, and objectives regarding wealth and family dynamics, as well as the prevalent applicable state and federal laws and rules. Yet, sometimes estate planners overlook the most essential element: developing a trusting relationship with the client.  Only after the estate planner has attained this rapport and performed the necessary due diligence can the estate planning process proceed.  Revocable trusts are often part of an appropriate estate plan, especially if the client is married, has a taxable estate, wants to avoid the probate process, and wishes to avoid probate in multiple jurisdictions.  For estates with values above the federal and state estate tax exemptions, trusts offer opportunities to avoid taxes, yet still allow the client (and heirs) to enjoy use of the assets they transfer to such trusts. Though there are many types of trusts, for the purposes of this chapter they fall into two general categories: revocable and irrevocable.

Revocable Trusts 

Revocable trusts allow the maker (generally referred to as a “grantor” or “settlor”) or another authorized person to amend or terminate the trust. While the maker is alive, the Internal Revenue Service (IRS) will not treat the revocable trust as a separate taxable entity from the maker. Therefore, all income, gain, deductions, credits, and expenditures inure to the maker. The maker’s social security number may act as the tax identification number for the trust. Upon the maker’s death, the trust becomes a separate taxable entity. At such time, the trust must obtain an employer identification number (EIN) or Tax Identification Number (TIN) by using IRS Form SS-4. The government taxes trust income at the highest income tax rate, unless the trustee passes out the trust income tax to the beneficiaries through a K-1 form. Revocable trusts are also called “living trusts,” since people create them during life. “Testamentary trusts” are created at death, generally according to the decedent’s last will and testament.

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Irrevocable Trusts 

A maker cannot materially alter or terminate an irrevocable trust. The government may tax such a trust as a separate entity or tax it within the maker’s estate, according to the trust’s purpose, how an estate planner has drafted the trust, and the grantor trust rules of the Internal Revenue Code (IRC), §§ 672-679. The government created these grantor trust rules when income tax rates were higher than estate tax rates. Taxpayers attempted to escape the higher income tax rates by transferring income-producing assets to trusts for the benefit of their heirs who had lower marginal income tax rates, thus shifting the income tax to such beneficiaries’ lower tax rates. Although income tax rates may soon be higher than estate and gift tax rates, they have been consistently higher than, or equal to, the highest marginal income tax rate (presently 35 percent). Estate planners now tend to draft irrevocable trusts to shelter assets outside the maker’s gross taxable estate, yet utilize the grantor trust rules so that the maker is responsible for the income taxes on trust income. Having the maker pay the trust’s income taxes further reduces the maker’s gross taxable estate value, while simultaneously preserving the wealth in the irrevocable trust for the benefit of the maker’s heirs.[1] The grantor trust rules are quite technical, so drafting trusts to purposely use these rules is not for the novice drafter. Nevertheless, such trusts can be quite an effective tool, particularly for wealthier clients in today’s tax climate.

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[1] Among the many proposals for tax change, one aims at limiting one’s ability to use the Grantor Trust rules in this fashion.

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