What Physicians Should Know About Irrevocable Trusts

Trusts are one of the least understood items in both financial planning and estate planning. In a prior column we shared some guidance on revocable living trusts. Here, we will discuss how they differ from irrevocable trusts.

Key differences
Every trust has a trustee (or trustees), who is/are empowered by the trust document to follow the instructions on how to use the assets inside. There are also trust beneficiaries, those who are intended to benefit from the assets managed by the trustee.

The major difference between a living trust and an irrevocable trust is the very important fact that the grantor, (the person who created the trust and placed assets inside of it), does not have any control as a trustee of an irrevocable trust.

Once it has been created, the grantor cannot revoke it. This can be either because the grantor has given away the assets inside the trust during life or because he has died and can no longer serve as the trustee of what was once a “living trust.”

In this scenario, the trustee would be the person designated as the grantor's successor when he created the trust. In either case, the trust assets are now totally controlled by the trust document and the trustee(s) that administer it.

Key uses
An irrevocable trust provides for some interesting features. First, since the grantor does not technically own or control it, the trust is not considered part of his estate (and therefore it is not subject to estate tax). This feature is crucial to one of the most common uses of irrevocable trusts: the ILIT (Irrevocable Life Insurance Trust). Those individuals and families lucky enough to be subject to estate taxes at death can own life insurance inside an ILIT. At their death, the trust is funded with the insurance death benefit and governed by the document and trustee. There will be no estate tax or income tax applied to the funds.

If the insurance had been paid to the estate, it would have been subject to estate taxes (if the estate was large enough). Given the current $5.2 million estate tax exemption, the ILIT is now used only by the wealthiest families. Other than an ILIT, there are very few reasons to create an irrevocable trust during life.

More commonly, an irrevocable trust results when an individual dies with a living trust in place. The living trust may have been funded during life or by the will at death. Now the trust is irrevocable and governed by the trust document and trustee. This feature provides both control and excellent asset protection in most cases.

The trust document spells out the terms and conditions under which trust assets are dispensed to beneficiaries (control). The use of an independent or co-trustee allows the trust to protect the beneficiaries from creditors (asset protection). In most cases, it is not advisable for the trustee and beneficiary to be the same and only person.

It is very important to understand the difference between a revocable living trust and an irrevocable trust. Many believe the former type of trust carries the same asset protection that the irrevocable trust does, but this is a big error.