Could you please explain the difference between an Irrevocable Trust and a Revocable Trust?

A trust established during the lifetime of the grantor or settlor is either revocable or irrevocable. A revocable trust permits the grantor or settlor to revoke the trust, alter the terms of the trust, or withdraw some or all of the assets from the trust. A revocable trust becomes irrevocable at the death of the grantor or settlor.

Since the grantor or settlor of a living trust retains control of assets through his or her power to revoke or alter the trust, there are no gift, income, and estate tax consequences when assets are conveyed to a revocable trust. The grantor or settlor continues to report the earnings of the trust assets on his or her personal income tax return if the grantor or settlor is the trustee.

The living trust is an excellent instrument by which a person can plan for the administration of assets in the event of a disability. A successor trustee can be named to administer the trust assets in such an event. The trust instrument normally states that when the written opinions of licensed physicians (the grantors and another physician) certify that the grantor is physically or mentally incapable of managing his or her property, the grantors right to continue to serve as the trustee during that period of incapacity is suspended. The trust document normally reserves the right of the person creating the trust to request the court to determine the question of incapacity or capacity to manage the trust assets. The successor trustee will manage the trust assets during the period of the trustee’s incapacity.

The need for a living trust is based on many factors, including the amount of the assets, the ability of the spouse to continue to manage assets acquired during the marriage, and the health of the husband and wife. Though it is best to consider a living trust as soon as the circumstances justify, the need for a living trust should especially be evaluated upon the death of the spouse. Special consideration should be given to the availability of a child to serve as successor trustee. If the child is not available to serve as the successor trustee, serious consideration should be given to the appointment of a bank or trust company as the successor or perhaps the initial trustee.

The assets placed in a living trust are not subject to a probate proceeding. However, these assets must be administered after the death of the settlor or grantor. The successor trustee must collect the trust assets, pay the final bills, be responsible for the federal estate tax apportioned to the trust, and make distribution of the remaining assets according to the trusts instructions. Creditors in a probate proceeding must file claims against probate assets within three months of the first publication of a notice to creditors in the newspaper. Since there is no similar publication procedure to shorten the claim period for a trust, a successor trustee cannot distribute the trust assets to beneficiaries free of potential creditor claims for two years from the date of the grantors death. This is because the statute of limitations period within which creditor claims must be asserted extends for two years from the date of the settlor’s death. A summary probate administration can be useful, since this procedure permits publication of a notice requiring that creditors file claims within three months of the date of first publication.

Another kind of trust is an irrevocable trust, one that cannot be amended or altered. The assets conveyed to an irrevocable trust cannot be withdrawn or returned to the grantor or settlor. An irrevocable trust is normally created for estate tax purposes. A person will transfer assets to an irrevocable trust to avoid having to include the fair market value of these assets in his or her taxable estate at death. It is important to remember that a transfer of an asset to an irrevocable trust constitutes a gift. Accordingly, the fair market value of the asset on the date of the transfer to the trust must be reported to the Internal Revenue Service as a gift by April 15 after the year of the transfer. The taxpayers estate or gift tax exemption equivalent (presently $2,000,000) will be applied to the gift taxes due as a result of this transfer. The advantage of transferring assets to an irrevocable trust is that the appreciation in the value of these assets will not be subject to federal estate taxes upon the taxpayer’s death.

Another use of the irrevocable trust is for the purchase of life insurance to provide the beneficiaries of the trust with the money to pay the estate taxes of the grantor. Since the life insurance policy is owned by the trustee and not the taxpayer, the proceeds paid on the taxpayer’s death are not included in his or her gross estate. The payment of the premium for the life insurance during the taxpayer’s life is normally made from annual contributions by the taxpayer to the trustee of the irrevocable trust. Since there is presently a $12,000 per donee annual exclusion for federal gift tax purposes, there is no gift tax owed when these annual contributions to the irrevocable trust are made if the beneficiaries of the trust are granted the unrestricted right to withdraw these contributions during the year in which they are paid to the trustee. The withdrawal right for each beneficiary is usually limited to the amount of annual gift tax exclusion, which is presently $12,000 per donee.

The proceeds of an existing life insurance policy transferred to an irrevocable trust will be included in the estate of the grantor if he or she fails to survive for three years after the date of the transfer.

Also, there is a gift tax on the value of the life insurance policy on the date of the transfer to the irrevocable trust.