The following description of the role of irrevocable trusts in estate planning is for general information purposes only. It should not be relied upon in making estate planning decisions. It is intended only to give a general understanding of how irrevocable trusts work so that the reader can have a more informed conversation with his or her estate planning attorney. The reader should consult with his or her estate planning attorney regarding his or her particular circumstances.
Leaving Property in Trust
It is common for parents to leave property to a child or other beneficiary in trust rather than outright. Parents often leave property to a child in trust, even if the child is an adult. When they do so, the property passes not to the child directly, but instead to an irrevocable trust of which the child is the beneficiary. As discussed below, the child is often trustee of his or her own trust.
Reasons to Create an Irrevocable Trust
There are at least three reasons why a parent might create an irrevocable trust to hold a child’s inheritance. The most basic reason is to control the timing and the circumstances under which the child receives the money. Another potentially important reason to create an irrevocable trust is to protect the assets from the child’s creditors. The third reason is that leaving the property to the child in trust may reduce estate taxes when the child dies.
Control Distributions over Time
A survey conducted a few years ago showed that a large number of lottery winners file for bankruptcy just a few years after winning the lottery. On reflection, the reason seems clear. The lottery winners were unprepared for sudden wealth. Either they were unprepared as consumers (i.e. they spent it all) or they were unprepared as investors (i.e. they mismanaged it), or a combination of both.
Many parents do not feel comfortable leaving large amounts of money to their children all at once. They prefer to leave the money to the children gradually so that they learn how to handle it as they mature. Placing the money in an irrevocable trust, rather than leaving it to the child outright, is a convenient way to do this.
If property is left to a child outright, it can be reached by the child’s creditors. In some cases, it can also be reached by former spouses. However, if the property is placed in a properly-designed irrevocable trust for the child’s benefit, it will generally not be available to creditors or former spouses (although it may be available to pay child support or overdue taxes). For this reason, many parents choose to leave their children property in trust rather than outright.
Estate Tax Savings
If property is left to a child outright, the property will be included in the child’s estate for federal estate tax purposes, if the child still owns the property at the time of his or her death. However, if the property is left to a properly-designed irrevocable trust for the child’s benefit, the property will, in some circumstances, escape taxation at the child’s death. (See the discussion of "The Generation-skipping Transfer Tax" under "Advanced Estate Planning Information" on this website.
What is an Irrevocable Trust?
An irrevocable trust is an arrangement between the creator of the trust, the trustee and the beneficiaries. The creator of the trust signs the trust document and transfers property to the trust. Where the trust is created for a child in the parent’s estate plan upon the parent’s death, the creator of the trust is, of course, out of the picture by the time the trust comes into existence.
The trustee’s job is to manage the trust assets. This means keeping the trust assets prudently invested, filing the appropriate tax returns, keeping the beneficiaries informed about the trust’s activities, and making distributions to the beneficiaries.
A trust may have one trustee or multiple trustees. A trustee can be a person, such as a family member or a trusted family advisor, or it can be an institution, such as a bank or trust company. For a discussion of trustee fees that are customarily charged by trust companies doing business in Utah, see “Utah Trustee Fee Survey Results” that appears on this web-site under “Other Trust & Estate Resources.”
Often the primary beneficiary of the trust will also serve as trustee of the trust. For example, if a parent creates a trust for an adult child, and if the parent believes that the child has the maturity and experience to manage wealth properly, the parent may name the child
to serve as his or her own trustee. If the parent does not believe the child should serve as sole trustee, the parent might name another person to serve as a co-trustee with the child. Alternatively, the parent might designate another person or institution to serve as sole trustee.
A traditional-style trust has one income beneficiary and one or more remainder beneficiaries. The vast majority of irrevocable trusts are of this type.
In this traditional income/remainder style trust, the income beneficiary receives the net income from the trust at least annually. Thus, if the trust holds stocks, the income beneficiary would be paid the stock dividends. If the trust holds bonds, the income beneficiary would be paid the bond interest. If the trust holds investment real estate, the income beneficiary would be paid the rental income. All of these payments are made to the income beneficiary on a net basis, after payment of trust administrative expenses, such as trustee fees and legal and accounting costs.
In addition to distributions of net income, a trust will usually direct the trustee to make distributions of principal to the income beneficiary if necessary for the beneficiary’s support or health needs.
On the death of the income beneficiary, the balance remaining in the trust is distributed to the remainder beneficiary or beneficiaries who are identified in the trust instrument.
While most trusts are of the income/remainder beneficiary type, there is absolutely no requirement that a trust fit this mold. For example, a trust could have multiple income beneficiaries or no income beneficiary at all. Indeed, there is no requirement that a trust define the beneficiaries in terms of income and principal.
A Typical Irrevocable Trust
Suppose a married couple has three adult daughters. After the death of the first spouse, they want all of their assets to be available to the surviving spouse for the balance of her lifetime. On the death of the surviving spouse, they want to leave their assets to their daughters in equal shares. They decide to leave each daughter’s share in trust, rather than leave it to the daughter outright. The trust for each daughter might look like the following:
The daughter would be the sole trustee of her trust. If the parents are not confident that the daughter will be able to serve as trustee responsibly, they can designate another person to serve as co-trustee with the daughter.
All of the trust’s net income will be distributed to the daughter at least quarterly. In addition, principal of the trust can be distributed to the daughter if needed for her medical needs, educational expenses or financial support.
On the daughter’s death, the assets remaining in the trust will be distributed to her children, outright in equal shares. However, the daughter will have the ability to alter this distribution, if she chooses to do so. She will have a “power of appointment” that will enable her to leave more to one of her children than another, or to disinherit a child of hers entirely. She will also have the power to direct that any share passing to a child of hers will be held in trust for the child rather than be distributed outright.