What Are the Disadvantages of an Irrevocable Trust?
An irrevocable trust, also called an income trust, is a legal entity created to own and control assets on behalf of third parties. The assets of the trust come from a grantor, sometimes called a settlor, and are managed by a trustee. Irrevocable trusts do not necessarily produce a distinct tax advantage for a grantor, and can be far more complex than revocable trusts.
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Features
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As with any trust, the grantor (or settlor) of an irrevocable trust gives certain assets over to a trustee, who manages them for a beneficiary. The unique feature of an irrevocable trust is that the grantor fully surrenders ownership of the assets and has them re-titled in either the name of the trust or the trustee. This feature distinguishes irrevocable trusts from living trusts and others, where the grantor typically retains ownership. This loss of ownership (and the costs associated) is one of the disadvantages of an irrevocable trust, at least for a grantor seeking to retain control during their lifetime.
Significance
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This distinction of ownership is crucial to the IRS for income tax purpose. Income generated by estates held in revocable trust (called grantor trusts) flows through to the grantor and is taxed at their individual rate. Not so for an irrevocable trust, which is taxed as a separate entity at a brisk 35 percent on taxable income above $10,000.
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Effects
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The high tax rate on income associated with an irrevocable trust leads trustees to distribute all income (or at least enough to get below the tax threshold) to beneficiaries annually, where it is taxed at the individual rate of the beneficiary. If the grantor is a beneficiary, they receive no particular tax benefit of the assets' income unless their share of the income is not enough to lift them to a higher tax bracket, but the total income would have if they had remained the sole owner. This feature of irrevocable trusts is the reason they usually contain high income generating assets and are often called income trusts.
Considerations
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Another disadvantage of an irrevocable trust is that, because it is a separate taxpaying entity, it must file its own annual tax returns. This is not the case will all other forms of trusts, which are considered grantor trusts by the IRS, and are taxed through the grantor or beneficiaries. This can significantly increase the cost of maintaining the trust in terms of time, effort and accounting fees.
Warning
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Because the grantor surrenders title to assets transferred to an irrevocable trust, and the trust is considered a separate tax entity, the trust property cannot just be given over for free. When a grantor transfers property to an irrevocable trust, they must count the full market value of the property towards their gift exclusion, which is $11,000 per beneficiary annually. If the value of the property exceeds this exclusion, the grantor is subject to a gift tax on the value in excess of the allowance. The grantor must also give the beneficiary the right to withdraw the asset from the trust in order for it to count as a gift, though the beneficiary generally does not do so.
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