Editor’s note: This is part three of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. Part one is To Avoid Probate, Use Trusts for Estate Planning. Part two is How Quitclaim Deeds Can Cause Estate Planning Catastrophes.
Revocable trusts are much more common than irrevocable trusts because they provide many important estate planning benefits.
Revocable trusts are more flexible than irrevocable trusts — the revocable trust maker can change the revocable trust at any time, or transfer the property out of the revocable trust at any time without getting permission from anyone. Additionally, revocable trusts will typically have no impact on the trust maker’s income taxes, which is usually desirable, and the trust maker will continue to claim the income taxes from the trust on their individual return, which is usually less costly.
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Trust makers form and transfer assets into revocable trusts most commonly because revocable trusts can:
- Avoid probate
- Allow for a step-up in basis on assets to reduce or eliminate capital gains taxes
- Allow both of the revocable trust makers to use their combined exemptions from estate tax
- Provide instructions for the disposition of assets
- Be structured to protect assets for the trust maker’s beneficiaries after the trust maker dies
There are some limitations
Even though revocable trusts provide powerful estate planning benefits, revocable trusts have some limitations. Only an irrevocable trust can protect assets for the trust maker themself. As an example of how a revocable trust would fail to protect assets following a catastrophic lawsuit, imagine this scenario:
Example. The trust maker sets up a revocable trust and later loses a lawsuit, resulting in the lawsuit winner (the judgment creditor) trying to recover against the trust maker’s assets. The revocable trust maker claims that they had protected their property by placing it in the revocable trust, so the judge demands to review a copy of the trust. The trust maker would be forced to turn over the revocable trust for review by the judge and the judgment creditor. If the trust maker were to refuse to comply with the order, they could be thrown in jail for contempt of court. Once the judge and the judgment creditor read the revocable trust and see that the trust maker has control and rights to revoke the trust or remove the property from the trust, the trust maker will be forced by the judge to turn the revocable trust property over to the judgment creditor — or again face contempt of court.
The less common irrevocable trust is not only used for estate and succession planning, much like the revocable trust, but the irrevocable trust can also provide asset protection and estate tax or other transfer tax planning benefits.
However, the advantages of irrevocable trusts to provide these powerful asset protection and estate tax planning advantages come with a tradeoff of giving up control over the trust and trust assets by the trust maker. Giving up that control can be a very challenging decision for a would-be trust maker of an irrevocable trust.
No asset protection with revocable trusts
On the other hand, revocable trusts provide maximum control to the trust maker, but they provide no asset protection and less tax planning potential than irrevocable trusts, although revocable trusts can be quite income tax and capital gains tax efficient.
While a revocable trust can be an excellent tool to plan for estates and avoid basic tax planning mistakes for people who have modest net worth, only an irrevocable trust will also protect assets and potentially shield them from taxes. In other words, a revocable trust will do nothing to protect assets for the trust maker, although the revocable trust can protect assets for the trust maker’s successor beneficiaries. But a revocable trust maker is not protected from creditors by a revocable trust.
So which trust should you set up, revocable or irrevocable?
Both revocable and irrevocable trusts should be utilized. Most people set up both revocable and irrevocable trusts so that they can get the unique advantages of both types of trusts. Everyone who forms an irrevocable trust should also form a revocable trust.
By using both revocable and irrevocable trusts, a person can achieve some of the advantages of both types of trusts. This is why trust makers almost universally form both revocable trusts and irrevocable trusts to work together in a comprehensive estate plan.
My next article will explain how irrevocable trusts can provide asset protection against personal liability.
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