“I need to amend my irrevocable trust,” John said.
“You can’t amend something that’s irrevocable,” I answered. “Are you sure that the trust you’re talking about isn’t revocable?”
“Yes, maybe it’s revocable,” John replied, nodding his head.
It is easy for laypeople to become confused over terminology. In most situations, clients have revocable trusts. Otherwise known as a “grantor” or “living trust,” revocable trusts are used, among other things, to keep your financial and legal affairs private, avoid guardianship in the event of your incapacity, and avoid a public probate court process when you die.
A revocable trust is also referred to as a grantor trust, which is a term defined under our federal income tax laws. For federal income tax purposes, a grantor trust is indistinguishable from the person who established it (often referred to as the “Settlor” of the trust). It uses the settlor’s social security number as the tax identification number, so no separate income tax return Form 1040 is filed annually.
When John Doe changes title on his investment accounts and real property to “John Doe, Trustee for the John Doe Trust dated May 1, 2021” all those accounts still use his social security number as the account’s tax identification number. During John’s lifetime, the trust income and expenses appear on his own Form 1040. A revocable trust is tax neutral. It neither helps nor hinders the settlor’s federal income tax situation.
A trust is revocable in the sense that the settlor may always change the terms of the trust. The settlor can, by a properly signed trust amendment, change the trustee, trust beneficiaries, the terms under which the trustee can invest and distribute trust assets, and the terms under which beneficiaries will inherit the assets, so long as she has “testamentary capacity.” This is defined as the mental capability to understand the extent and value of her property, the persons who are beneficiaries, the disposition she is making, and the how these elements relate to form an orderly plan of distribution.
Just because someone is old does not mean that they lack testamentary capacity. Even a person afflicted with the early stages of dementia can have lucid moments enabling her to legally amend a revocable trust.
For federal transfer (gift, estate and generation skipping) tax purposes the value of assets held in the revocable trust is included in the estate of the settlor.
Are all revocable trusts grantor trusts? Yes. Are all grantor trusts revocable? No. Some irrevocable trusts are grantor trust for federal income tax purposes. Generally speaking, settlors cannot revoke or amend irrevocable trusts. Most irrevocable trusts are used to remove assets from the settlor’s estate for federal estate tax purposes. The federal estate (transfer) tax system is separate and apart from the federal income tax system.
Examples of irrevocable trusts include Irrevocable Life Insurance Trusts (ILIT), Grantor Retained Annuity Trusts (GRAT), Qualified Personal Residence Trusts (QPRT), Spousal Lifetime Access Trusts (SLAT), Charitable Remainder Trusts (CRT), Inheritor’s Protected Trusts and Intentionally Defective Grantor Trusts (IDGT).
Many of these trusts may remain grantor trusts for federal income tax purposes, but for gift and estate tax purposes the transfer of the assets to the trust removes them from the settlor’s estate.
Once the trusts are established and assets transferred to them, there settlor cannot easily change his mind and reverse the transaction without incurring adverse tax or legal consequences. That is why it is vitally important to understand the drafts of these trusts before signing and funding them.
Irrevocable trusts that are not grantor trusts typically have an independent trustee from the settlor (who might be his spouse or children who are also beneficiaries) and use a separate taxpayer identification number which requires the filing of a Form 1041 annually for income tax purposes. When transfers are made to the trust a Federal Gift Tax Return Form 709 is often filed. I wrote about gift tax returns in a recent column that you can find here.
Even though an irrevocable trust cannot be amended by its settlor, that does not mean that they are all inflexible. When warranted, I usually draft flexibility into my clients’ irrevocable trusts by allowing a beneficiary/trustee to control investment, distribution, and remainder decisions, or by granting powers of appointment, and/or using trust protectors. When using these types of provisions properly, the attorney must have extensive knowledge of the interaction between federal income and transfer tax laws, as well as how state law fits into the plan.
The federal income and transfer tax systems are built largely independent of one another. That is good and bad. From one viewpoint it is confusing to the client. From another, an estate planner with extensive knowledge can legally manipulate these differences using tax saving strategies for the client and her family.
Bernie Sanders’ recent legislation attempts to prohibit or severely limit the use of some of these strategies that bridge the difference between the federal income and transfer tax systems. Consequently, if you have a larger estate, it is time to consider implementing these strategies before Congress prohibits their use.
The use of irrevocable trusts will become more common with upcoming changes to the gift and estate tax laws. Here, I hope I provided a frame of reference which helps when speaking to your attorney.
© 2021 Craig R. Hersch. Learn more at floridaestateplanning.com