Irrevocable Living Trusts
A trust is an arrangement for the ownership of property. The person who creates a trust is called a grantor or settlor. Irrevocable living trusts are one category of trusts that can be useful in financial and estate planning. Trusts are formed under state laws, but a separate body of IRS rules determines how trusts are taxed at the federal level.
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Living Trusts
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A living trust, also called an inter vivos trust, is one made during the lifetime of the grantor, as opposed to a testamentary trust, which is formed by operation of a will after the grantor's death. The main benefit of a living trust is that the assets owned in trust bypass probate and can be transferred to the beneficiaries without court order and without being subject to the decedent's creditors. Because a grantor typically wants to retain final control or use over the assets in trust, many living trusts are revocable. All revocable trusts are classified as "grantor trusts" and treated as disregarded entities, which means there is usually little, if any, tax benefit. Assets in a grantor trust are included in the gross estate for estate tax purposes, even though they are not included in the probate estate.
Irrevocable Trusts
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An irrevocable trust, under state law definitions, is simply one that cannot be amended or revoked by the grantor once it goes into effect. An irrevocable trust may be modified with the unanimous consent of the beneficiaries or by some other mechanism stipulated in the trust document. Even where the trust is irrevocable, however, the grantor can still exercise a considerable amount of control over the trust, such as choosing the trustee and the beneficiaries. If the grantor reserves control over or use of the assets of an irrevocable trust, it is taxed as a grantor trust and included in the gross estate. Only if the grantor truly has no control or benefit of the trust is it taxed as a separate entity.
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Defective Grantor Trusts
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Financial planners have long use intentionally defective grantor trusts to remove assets from the grantor's gross estate for estate tax purposes while preventing the beneficiaries from having to pay tax on the appreciation of the assets. An intentionally defective grantor trust is an irrevocable living trust in which the grantor reserves no powers that would trigger the assets to be included in the gross estate. But because the grantor reserves the right to reacquire the trust assets by substituting other assets of equal value, the trust is not a grantor trust. Because the grantor trust is a disregarded entity, there is no gift tax on the transfer and the trust's tax basis in the assets is the same as the grantor's.
Life Insurance Trust
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Another, less complicated, use of the irrevocable living trust is the irrevocable life insurance trust, or ILIT. Here, an irrevocable trust is created in which the sole asset is an outstanding life insurance policy on the grantor. The beneficiaries are typically a spouse or children. The grantor has relatively little incentive to retain any control on the trust whatsoever. When he dies, the life insurance settlement is paid to the trust and is not counted in the grantor's gross estate and does not pass through probate.
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