When it comes to understanding trusts, knowing the difference between revocable and irrevocable trusts is crucial. If you mistakenly request a revocable trust rather than an irrevocable one in certain situations, or vice versa, the legal and tax consequences will be significant. Below I will discuss the similarities as well as differences between the two options.
I. Similarities
Before I discuss the difference between a Revocable and Irrevocable Trusts I believe it would be prudent to mention the benefits derived from both. Both are valuable tools to:
- To plan for mental disability - Assets held in the name of a Revocable Living Trust at the time a person becomes mentally incapacitated can be managed by their Disability Trustee instead of by a court-supervised guardian or conservator.
- To avoid probate - Assets held in the name of a Revocable Living Trust at the time of a person’s death will pass directly to the beneficiaries named in the trust agreement and outside of the probate process.
- To protect the privacy of your property and beneficiaries after you die - By avoiding probate with a Revocable Living Trust, your trust agreement won't become a public record for all the world to see and read. This will keep the details about your assets and who you've decided to leave your estate to a private family matter. Contrast this with a Last Will and Testament that's been admitted to probate - it becomes a public court record that anyone can read.
II. Revocable Living Trusts
A Revocable Living Trust in Michigan, also called a Revocable Trust or Living Trust, is simply a type of trust that can be changed at any time. In other words, if you have second thoughts about a provision in the trust or change your mind about a trust beneficiary or fiduciary, then you can modify the terms of the trust through what's called a trust amendment. Or, if you decide that you don’t like anything about the trust at all, then you can either revoke the entire agreement or change the entire contents through an amendment and restatement.
With the typical Revocable Living Trust, it will become irrevocable when the Trustor dies and can be designed to break into separate irrevocable trusts for the benefit of a surviving spouse, such as with the use of AB Trusts, or into multiple irrevocable lifetime trusts for the benefit of children or other beneficiaries.
With the typical Revocable Living Trust, it will become irrevocable when the Trustor dies and can be designed to break into separate irrevocable trusts for the benefit of a surviving spouse, such as with the use of AB Trusts, or into multiple irrevocable lifetime trusts for the benefit of children or other beneficiaries.
Since Revocable Living Trusts are so flexible, why aren’t all trusts revocable? The down side to a revocable trust is that assets funded into the trust will still be considered your own personal assets for creditor and estate tax purposes. This means that a revocable trust offers no creditor protection if you're sued and all assets held in the name of the trust at the time of your death will be subject to both state and federal estate taxes.
III. Irrevocable Trusts
An irrevocable trust is simply a type of trust that can't be changed after the agreement has been signed, or a revocable trust that by its design becomes irrevocable after the Trustor (person establishing the Trust) dies. Generally, an inter vivos (established during one's life) irrevocable trust is funded by the Trustor by means of "gifting" to the trust a portion of his/her estate; as discussed below, there are tax incentives to this funding method.
Irrevocable trusts can take on many forms and be used to accomplish a variety of estate planning goals:
A. Estate Tax Reduction
(i) Use of "Gifts"
The estate of the deceased, under current the current tax code, will be subjected to a 35% tax rate for the value of the estate in excess of the $5,000,000 (5 million) Estate Tax Exemption. However, in 2013 this exemption will be reduced to $1,000,000 with an excess tax rate of 55%.
- Hypo: Peter has an estate valued at $4,000,000. Upon his death, he wishes to devise to his children a portion of his estate valued at $1,500,000; giving the remaining amount away to charity. If Peter dies in 2012 his estate will be subjected to ZERO tax liability. However, if Peter dies after 2012 the portion of his estate that he wishes to devise to his children will be subjected to $275,000 in tax liability. [(1,500,000-1,000,000) * 55%]
The solution to this conundrum would be to create an irrevocable trust by means of gifts for the benefit of his children. If Peter plans his estate in 2011 and "gifts" $1,500,000 of his estate to an irrevocable trust, that gift will be subjected to Gift Tax rather than Estate Tax. In 2011 there will be a $5,000,000 Gift Tax Exemption therefore this gift/transfer will not be subjected to any tax.
(ii) Irrevocable Life Insurance Trusts
Irrevocable trusts, such as Irrevocable Life Insurance Trusts, are commonly used to remove the value of property from a person’s estate so that the property can't be taxed when the person dies. In other words, the person who transfers assets into an irrevocable trust is giving over those assets to the trustee and beneficiaries of the trust so that the person no longer owns the assets. Thus, if the person no longer owns the assets, then they can't be taxed when the person later dies.
(iii) Bankruptcy
As mentioned above, AB Trusts that are created for the benefit of a surviving spouse are irrevocable and, thus, can make full use of the deceased spouse's exemption from estate taxes through the funding of the B Trust with property valued at or below the estate tax exemption. Then, if the value of the deceased spouse's estate exceeds the estate tax exemption, the A Trust will be funded for the benefit of the surviving spouse and payment of estate taxes will be deferred until after the surviving spouse dies.
B. Asset Protection
Another common use for an irrevocable trust is to provide asset protection for the Trustor and the Trustor's family. This works in the same way that an irrevocable trust can be used to reduce estate taxes - by placing assets into an irrevocable trust, the Trustor is giving up complete control over, and access to, the trust assets and, therefore, the trust assets can't be reached by a creditor of the Trustor. However, the Trustor's family can be the beneficiaries of the irrevocable trust, thereby still providing the family with financial support, but outside of the reach of creditor.
