Irrevocable Trust Benefits
Estate planning is an important concern for many people. Because doing it right means navigating complex IRS rules, most find it very beneficial to hire a professional estate planner or attorney when creating an irrevocable trust. Though an irrevocable trust is more complicated and more expensive to create than a revocable trust, it offers unique properties and advantages.
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Identification
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An irrevocable trust is one in which the creator of the trust (settlor) cannot revoke or alter the terms of the trust. Usually, the trust is designed so the settlor surrenders all claim of ownership in the trust property. But depending on the terms of the trust, it might or might not be treated as a grantor trust by the IRS, which affects whether income in the trust is taxed through the creator of the trust or as a separate entity. Irrevocable trusts are funded with after-tax donations, usually linked to a specific beneficiary and deducted under the gift tax exclusion.
Asset Protection
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The most obvious benefit of an irrevocable trust is that it shields assets from probate. A common use of this benefit is through an irrevocable life insurance trust (ILIT), in which the life insurance policy of the settlor is irrevocably placed in a trust for the benefit of named beneficiaries without recourse to probate or creditors. Life insurance is a perfect asset for an irrevocable trust because it is of little use to the settlor during their life.
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Eliminate Estate Taxes
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The irrevocable trust can shield assets from the estate tax if it meets certain conditions contained in §§2306 to 2308 of the Internal Revenue Code (IRC). These relate to the extent to which the settlor can control the assets in the irrevocable trust. If the conditions are met, the assets of the trust do not count towards the estate of the deceased settlor and therefore do not contribute to estate tax liability, if any.
Defer/Reduce Capital Gains Tax
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The assets of an irrevocable trust can, however, be included in the gross estate of a deceased settlor if the trust does not meet the requirements of the IRC mentioned above. If the assets pass to a beneficiary upon the settlor's death, they can be received with a stepped up, or fresh start, tax basis, which means the beneficiary receives them without any capital gains tax liability. If a carryover basis is maintained, the trust can be structured so the tax is deferred until the sale by the beneficiary.
Income Tax Considerations
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In most cases, an irrevocable trust is designed to be taxed as a separate entity. But, because the tax rate on such trusts is higher than most individual tax rates, any income produced is generally distributed to beneficiaries annually and written off by the trust. This can help reduce overall income tax liability if the income is sufficient to raise the settlor or any single beneficiary into a higher tax bracket. But, by making the trust intentionally defective for income tax purposes (by giving the settlor certain controls over the trust) the income of the trust will be taxable at the settlor's individual rate. A skilled lawyer can devise a trust that avoids income tax in this way while still avoiding probate and estate tax.
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