Sophisticated Planning With Flexible Irrevocable Trusts

Sophisticated tax planning involves using trusts and entities to better protect your assets and to minimize estate tax, income tax and taxes on capital gains. This planning often involves the use of irrevocable trusts.

Irrevocable trusts are widely used for other types of specialized planning, such as special needs trusts or qualifying for Medicaid or veterans’ benefits. However, this article focuses on planning to minimize taxes on capital gains, ordinary income, estate tax and property tax.

The term “irrevocable trust” can be troubling for successful clients who are accustomed to maintaining control over their business and financial lives. The term “irrevocable” alone creates concerns. None of us knows what the future will bring, what our financial needs will be or even what tax laws will be. However, careful drafting permits you to retain influence or indirect control over assets, income and business, while providing significant flexibility to respond to changed circumstances.

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How irrevocable trusts work

Assets are typically not transferred directly to the irrevocable trust. Instead, they are transferred to an entity such as a limited liability company (LLC), S corporation or family limited partnership (FLP) that you control. Then, an interest in that entity is transferred to the irrevocable trust so you retain control of the entity and the assets. This can be done by transferring nonvoting interests in the entity to the trust.

Selecting the trustee

You can designate the initial trustee to oversee trust transactions and activities. While clients often seek to appoint themselves as trustee while they’re alive, you actually have more control if you're not the initial trustee. If you're the initial trustee of a trust for your children, distributions are limited to health, education, maintenance and support (HEMS) if assets are to be excluded from your estate for tax purposes.

HEMS distribution provisions can also impede beneficiary protection from creditors. A creditor could assert that the beneficiary has a right to the HEMS distribution and seek to take that amount from the trust.

If you're not the trustee, however, the trustee may have complete discretion to make distributions, providing better asset protection for your beneficiaries. The key is having a trustee who will act according to your wishes.

In selecting a trustee, clients typically have two goals: During their lifetime, they want a trustee to show absolute loyalty, and after death, they want someone whose judgment they trust. You may designate a trusted adult child, though you should be careful to consider factors such as family dynamics and history in this decision.

Removing or replacing the trustee

More importantly, you retain the right to remove the trustee and designate a new one without cause. If any trustee fails to act properly, or you simply change your mind, you can remove them and designate another. This is a far stronger means of maintaining control than designating the initial trustee.

When selecting a new trustee, you cannot select someone related or subordinate to you. "Related" means a lineal descendant or sibling of your parents, while "subordinate" refers to an employee of any business in which you own a significant share. However, related or subordinate persons can be included in the trust's succession provisions.

How to create a flexible irrevocable trust

Trustees have fiduciary duties to beneficiaries and potentially to creditors including tax authorities. A trustee must follow the declaration of a trust’s provisions.

Appointing a trust protector

A trust protector is a position defined in the trust agreement with the power to take designated actions, including those that may harm the beneficiaries. To be effective, the trust protector should be specifically identified as not being a fiduciary or holding a fiduciary relation to beneficiaries or other interested parties. I sometimes describe the trust protector as being the Lone Ranger. He does not wear a badge but rides in to save the day and then rides off into the sunset.

You can define a trust protector’s powers, including:

• Removing and replacing a trustee
• Appointing a related or subordinate trustees
• Remove beneficiaries and changing allocation
• Adding beneficiaries
• Change distribution timing and methods

However, if the irrevocable trust is being used to minimize income tax, including the tax on capital gains, the only power that you can give the trust protector is removing or replacing the trustee. Otherwise, the trust is characterized as a grantor trust for income tax purposes, with all trust income reported on your individual return.

This means that the trust essentially does not exist for income tax purposes. All trust income is reported on your individual tax return as the “grantor” or creator of the trust. While this doesn't minimize income tax, it can help minimize estate tax. Income-producing assets held outside your estate still generate income tax that you pay, essentially creating tax-free gifts to beneficiaries.

Due to irrevocable trusts' long-term nature, you don’t name a trust protector when drafting the trust. Instead, the trust provides a process to appoint a trust protector if or when needed, often through your law firm or CPA. The trust protector typically handles a specific action and resigns after completion.

Decanting

Decanting is another process that can be used to modify an irrevocable trust. State laws vary greatly, so be sure to check your state's law on decanting. Some states, such as California, have a restrictive decanting statute that allows very limited change to an irrevocable trust. Others, including Nevada, have a very broad decanting statute permitting a wide range of modifications. However, all decanting statutes require the consent of all the beneficiaries. The requirement for consent does not provide the control or influence desired by most clients at the outset of the plan.

A flexible alternative

An irrevocable trust in an uncertain world can be very worrisome over time. We don’t know your financial needs, income, asset values or even the tax rates in the future. However, careful drafting can provide necessary flexibility and control. Instead, a “flexible irrevocable trust” is what is needed in today’s uncertainty.

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