An irrevocable living trust is a legal arrangement in which the grantor, who creates the trust, transfers property into the trust during their lifetime.
The trust is managed by a trustee, a separate person from the grantor, and cannot be altered or terminated by the grantor once it is established.
This type of trust is designed to do the following:
- Go into effect while the grantor is still alive.
- Be irrevocable, meaning it cannot be changed or terminated after being signed by the grantor.
Irrevocable living trusts serve various purposes, such as avoiding probate, reducing estate taxes, and providing asset protection.
Some specific types of irrevocable living trusts designed for tax planning purposes include:
- Bypass Trusts
- Qualified Terminable Interest Property (QTIP) Trusts
- Qualified Domestic Trusts (QDOT)
- Charitable Trusts
- Generation Skipping Trusts
- Life Insurance Trusts
- Grantor-Retained Interest Trusts.
Bypass Trusts
Also known as a credit shelter trust or an A-B trust, a bypass trust is commonly used by married couples to minimize estate taxes upon the first spouse’s death.
When the first spouse passes away, a portion or all of their estate is transferred into the bypass trust. The surviving spouse can access the income generated by the trust and, in some cases, the principal for specific purposes, like health or education expenses. However, the assets in the trust are not considered part of the surviving spouse’s estate, thereby reducing the taxable estate upon their death.
Example: John and Jane are married with a combined estate worth $20 million. They create a bypass trust to minimize estate taxes. When John dies, $10 million of his estate is transferred to the bypass trust. Jane can access the trust’s income but not the principal. Upon Jane’s death, the trust assets are distributed to their children, free of estate taxes.
Qualified Terminable Interest Property (QTIP) Trusts
A QTIP trust allows a grantor to provide a lifetime income for their surviving spouse while controlling the ultimate distribution of the trust assets. The surviving spouse receives income from the trust during their lifetime, but they don’t have an ownership interest in the trust’s principal. When the surviving spouse dies, the trust assets are distributed to the beneficiaries specified by the grantor.
Example: Mike has children from a previous marriage and wants to provide for his current spouse, Susan, while ensuring that his children ultimately inherit his assets. Mike creates a QTIP trust, which provides Susan with income for life. Upon Susan’s death, the trust assets are distributed to Mike’s children.
Qualified Domestic Trusts (QDOT)
A QDOT is similar to a QTIP trust but is specifically designed for situations where the surviving spouse is not a U.S. citizen. It allows the non-citizen spouse to receive income from the trust without incurring immediate estate taxes. However, the principal is subject to estate taxes when distributed to the final beneficiaries.
Example: Robert, a U.S. citizen, is married to Maria, a non-U.S. citizen. They create a QDOT to provide Maria with a lifetime income while deferring estate taxes until the trust assets are distributed to their children after Maria’s death.
Charitable Trusts
A charitable trust is established for philanthropic purposes, such as donating to a charity or supporting a charitable cause. These trusts offer income and estate tax benefits by allowing the grantor to make tax-deductible donations to qualified charitable organizations.
Charitable Remainder Trusts (CRT) and Charitable Lead Trusts (CLT) are two common types of charitable trusts.
Example: Sarah creates a Charitable Remainder Trust, transferring a valuable art collection into the trust. She receives income from the trust for her lifetime. Upon her death, the art collection is donated to a museum, and her estate receives a charitable deduction.
Generation Skipping Trusts
A Generation Skipping Trust (GST) is designed to transfer assets directly to the grantor’s grandchildren or more remote descendants, skipping the grantor’s children. The trust helps avoid the estate taxes that would apply if the assets were first passed to the grantor’s children.
Example: Linda creates a GST, placing assets worth $5 million in the trust. The trust provides income to her children for their lifetimes, but upon their deaths, the trust assets are distributed to Linda’s grandchildren, bypassing estate taxes at the children’s level.
Life Insurance Trusts
A life insurance trust holds a life insurance policy, ensuring that the policy’s proceeds are not considered part of the grantor’s taxable estate. The grantor cannot have control over the policy, and the trust must be in place for at least three years before the grantor’s death for the proceeds to avoid estate taxes.
Example: David creates a life insurance trust and transfers ownership of his $2 million life insurance policy to the trust. Upon his death, the policy’s proceeds are distributed to the trust beneficiaries without being subject to estate taxes.
Grantor-Retained Interest Trusts
A grantor-retained interest trust allows the grantor to transfer assets into the trust while retaining interest for a specified period. This type of trust can be structured as a Grantor Retained Annuity Trust (GRAT) or a Grantor Retained Unitrust (GRUT).
In a GRAT, the grantor receives a fixed annuity payment, while in a GRUT, the grantor receives a variable payment based on a percentage of the trust’s assets. The remaining trust assets pass to the beneficiaries when the specified period ends.
Example: Karen creates a GRAT and transfers $1 million worth of stocks into the trust. She retains an annuity interest in the trust for ten years, receiving a fixed amount annually. After ten years, the remaining trust assets are distributed to her children.
If the stocks’ value has appreciated significantly during the ten-year period, her children receive the appreciation free of gift or estate taxes. However, Karen must outlive the trust term for this strategy’s effectiveness.
