When discussing estate planning options, we tend to group whole plans in terms of “will” plans or “trust” plans.
Will-based planning is the most commonly used estate planning mechanism, most likely because of the simplicity of execution during the testator’s lifetime. However, the term “trust” can be quite misleading. Trusts vary widely in provisions, applications and consequences.
Irrevocable trusts provide a way to protect assets from future creditors, including potential long-term care costs, if the document includes the appropriate provisions and they are timely funded. Because of the asset protection intent of irrevocable trusts, we create them for the purpose of distancing the grantor from his or her own property. The inability of the grantor to exert control over the property allows for greater asset protection.
One of the most significant consequences of the trust plan depends on whether the irrevocable trust uses a completed gift or allows the grantor to create an incomplete gift.
A completed gift trust requires the grantor to retain no taxable interest in the assets within the trust. In many cases, trusts paid for with completed gifts are created for the purpose of tax mitigation.
Completed gifts provide great tools for life insurance trusts in particular, especially for those with large amounts of life insurance and larger estates. The completed gift removes the life insurance proceeds from the individual’s taxable estate at death, potentially preventing the taxation of other property.
Completed gift plans also are a good option for grantors who do not want to retain any legal ties to income-producing property. Grantors who want to ensure income-producing property will pay directly to children instead can complete the gift so the income is no longer taxed to the grantor.
Trusts paid for with completed gifts are not a good option for those who intend to accumulate income within the trust because trust tax brackets are significantly higher for completed gift trusts. Similarly, because gifts of appreciated assets retain the donor’s tax basis, transferring appreciated assets likely will cause capital gains taxes to beneficiaries.
On the other hand, irrevocable trusts paid for with incomplete gifts are more common for simple asset protection and in order to preserve the stepped-up tax basis for beneficiaries. These trusts, often referred to as Intentionally Defective Grantor Trusts, still require gifting property into trust, and need a trustee who is separate from the grantor. However, the grantor retains the property in his or her taxable estate.
Retaining property in the taxable estate means the grantor, whether or not he or she actually receives income from the trust, will be taxed on income to the trust. This may sound daunting, but it actually allows income to accumulate in an Intentionally Defective Grantor Trusts without triggering the high trust tax rates. This also means that upon the grantor’s death, beneficiaries receive property at a “stepped up” tax basis of fair market value, resulting in significant capital gains tax savings.
The determination of whether to use an irrevocable trust funded with a completed gift or an incomplete gift should be carefully and individually considered based on the type of property and the goal of the individual.
Irrevocable trusts are powerful tools used primarily for estate preservation. When used properly, they also can offer substantial tax savings.