An Overview of an Irrevocable Trust in Texas
In the state of Texas, an irrevocable trust is simply a trust agreement where the terms cannot be modified after the trust has been created. The initial terms are set by the granter and those terms cannot later be changed, except as is necessary to achieve the stated purpose of the trust, or as necessary for the uniformity of the trust. Once assets are transferred to an irrevocable trust, the granter no longer owns those assets. Since the granter no longer owns the assets the assets are not subject to Texas estate taxes and are not subject to claims by future creditors and litigants. While the granter will no longer receive the benefit of the assets, those assets can be distributed to a named beneficiary at the death of the granter .
Texas law does allow for some changes to be made during the lifetime of the granter and thereafter. For example, the trustee who is managing the estate may decide to terminate the trust in instances where the value of the estate is worth less than $50,000. Furthermore, an irrevocable trust may be revoked by the granter only with the consent of all the beneficiaries or if permitted by the court. It is important to note that once the grantor dies, the trust can never be modified or terminated by any person. However, to facilitate the purpose of the trust at the direction and under the supervision of the court, the trust may be terminated with the consent of all the beneficiaries or for other good cause shown. A Texas court is free to modify an irrevocable trust to prevent the possible waste of the trust property.
Legal Basis for a Texas Irrevocable Trust
Texas law regarding irrevocable trusts is found primarily in the Texas Trust Code (TTC), which is located at Sections 111 of the Texas Property Code. This code contains the fundamental rules under which all trusts in Texas will operate, including how a trust is to be created, who can be a trustee, how a trustee can be removed, and what remedies are available to beneficiaries in the event a trustee breaches his/her fiduciary duties.
The TTC also sets out how a trust can be modified, how long a trust can last, how a trust may terminate, and more. Importantly—it also addresses the unique Texas irrevocable trust.
The default rule for all trusts in Texas is that they are revocable by the Settlor unless the governing document—including the declaration of trust—expressly prohibits revocation. See TTC at § 112.051.
The key point here is that if a Texas irrevocable trust prohibits revocation, then it is a true "irrevocable trust," and the Settlor cannot go back and add or change terms of the document. See id.
However, the prohibition rule is not without exceptions. The first is found in the case of Kliebert v. Martin, which has been interpreted to allow a corporation to sever property from a trust and transfer it to a different trust.
In Kliebert, the Court held that a clause stating a joint venture could sever its interest in an existing trust and transfer it to a new investment trust prevented the existing trust from asserting that assets subject to a joint venture agreement were improperly distributed to a competing business entity. See Kliebert v. Martin, 996 S.W.2d 464, 466, 468-70 (Tex. App.—Texarkana 1999, no pet.).
Kliebert is still good law in Texas and is the only case found that addresses this specific issue. In Kliebert, the Court would only decide whether the creation of a new trust was improper under Section 112.051. It did not rule on the merits of any action for breach of fiduciary duty. Like all things litigation-related, red flags exist but conversely, so do huge opportunities.
The rules for irrevocable trusts are found in Chapters 111 and 113 of the Texas Property Code, which include:
Ultimately, the answer to whether a trust is irrevocable lies in the facts of each individual case. The starting point for understanding irrevocable trusts in Texas begins with the Texas Trust Code.
Advantages of Creating an Irrevocable Trust in Texas
The potential benefits of creating an irrevocable trust in Texas can be significant. Some of these benefits include:
Asset Protection – One of the primary advantages of creating an irrevocable trust in Texas is that the grantor would be relinquishing all ownership and control over the trust assets. As a result, if a properly drafted asset protection trust is established and the assets are transferred to it, lawsuits, creditors and divorce proceedings would be unable to reach any of the principal and interest of the trust’s holdings.
An irrevocable trust can also protect the beneficiary’s assets from future divorce actions. For example, if the original title to a bank account is transferred from a married person to an irrevocable trust and the funds are then placed into that trust, those assets will not be subject to any divorce legal claims as the assets are no longer considered part of the estate.
Not only does transferring your bank account and investments into a trust protect them from divorce actions, but it also protects these assets from lawsuits. If a creditor files a lawsuit against you and gets a judgment from the court, the creditor will be unable to access the funds in the trust as the assets are not under your name, so the funds can’t be garnished by the creditor.
Tax Advantages – Establishing an irrevocable trust can bring you not only a level of asset protection, but it can also provide tax benefits as well. There are some tax benefits that are specific to certain types of trusts, such as charitable remainder trusts. In some cases, an irrevocable trust is entitled to the marital deduction, which allows a surviving spouse not to pay taxes on the appreciation of the trust’s assets upon the spouse’s death.
If the irrevocable trust has children or other beneficiaries who are less likely to be subject to tax laws, the trust will also create additional tax benefits.
A recent Texas case provides an example of how an irrevocable trust can protect assets: In 2009, Wilma Gage created a living trust that named her husband and then her daughter as contingent beneficiaries. Twenty-six days later, Wilma transferred 15 acres of farmland valued at over $275,000 into the trust, signing a deed (but Wilma did not place her signature on a corresponding affidavit of the trust). Though Wilma’s husband died in 2010, the trust was self-funded, and Wilma did not make any further efforts to ensure it was funded or administered properly. She continued to pay taxes on the land and 50 percent of its crops, and attempted to sell the property in 2014.
Wilma failed to update her will to address the trust and enter into a joint agreement with the beneficiary, and in 2015, Wilma’s sister unsuccessfully attempted to block the sale of the property or obtain damages. Wilma then entered into a joint agreement with Wilma’s son-in-law that transferred the property into real estate notes. In 2017, Wilma’s sister filed another suit that requested the trust be dissolved on the grounds that the property transfer invalidated the trust and that the notes had a market value of zero. Wilma’s daughter (the beneficiary of the trust) subsequently elected to exercise the fourth-party defense, which disallowed Wilma’s sister from continuing her suit. The appellate court affirmed the lower court’s ruling.
How to Establish an Irrevocable Trust in Texas
Starting an irrevocable trust in Texas involves the preparation of a number of documents that are usually separate, but in this context can be grouped into three stages: 1) establishing an irrevocable trust agreement, 2) creating a pour-over will, and 3) signing a fund transfer document.
Irrevocable Trust Agreement
The irrevocable trust document states the terms of the trust and the rights of each person. It names current and future beneficiaries, provides for alternate beneficiaries in the event the current beneficiary dies, and will generally describe the trustee’s powers. In addition, the irrevocable trust document names a guardian for minor children and specifies how income and principal may be distributed (or prohibited from distribution, as the case may be).
Pour-Over Will
The pour-over document is similar to a will but allows the trustee to manage the assets while the initial beneficiary is still alive. The pour-over document names the trustee who will take over from the initial beneficiary to the beneficiary’s death. At that time, the assets in the trust will be managed the same way as any asset named in the pour-over document. These assets will avoid probate as well as any estate tax liability, for those beneficiaries who can afford costlier estate planning.
Fund Transfer Document
The last document that must be signed by the initial beneficiary is the fund transfer document, which is essential to allow the trustee to manage all types of assets. For example, if the initial beneficiary is a retirement plan participant, a copy of the plan document, along with the pour-over document, should also be signed by the plan custodian.
Case Examples Involving an Irrevocable Trust in Texas
To illustrate the effectiveness of irrevocable trusts in estate planning, consider the following case studies:
Case Study 1: Estate Tax Mitigation for High Net Worth Individuals
In 2021, Mr. Smith, a successful Texas business owner with a net worth exceeding $12 million, sought ways to minimize his estate tax liability. After discussing his options, his attorney recommended the creation of an irrevocable life insurance trust (ILIT).
Mr. Smith’s ILIT was structured to own and be the beneficiary of a $2 million life insurance policy on his life. By transferring ownership of the policy to the ILIT, the death benefit, which would otherwise have been included in his taxable estate at his death, would pass to the trust free of estate taxes. The ILIT was also structured to provide Mr. Smith’s wife with lifetime discretionary distributions should she require financial assistance , making it a flexible and beneficial estate planning tool.
Case Study 2: Asset Protection for a Physician
Dr. Johnson, a respected physician in Texas, faced a potential malpractice lawsuit that could put his personal and business assets at risk. In consultation with his attorney, he created an irrevocable asset protection trust to safeguard his assets from potential creditors and malpractice claims.
Dr. Johnson transferred ownership of his medical practice, as well as his personal residence, to the trust. In doing so, he effectively separated his personal assets from the practice, protecting them from any potential legal claims related to his medical practice. Furthermore, he nominated a trusted individual as the trustee to manage the assets and ensure their proper administration.
Challenges Related To Texas Irrevocable Trusts
Despite the many benefits of an irrevocable trust, a Texas irrevocable trust can often be difficult to set up and administer. In most cases, the biggest issue that arises is the loss of control over the assets you place into the trust.
First, an irrevocable trust takes complete control of the asset once you place it into the hands of the trust. While there are some exceptions (such as the Texas Income-Only Trust), most irrevocable trusts are meant to be managed by an independent trustee. So long as a person acts as the trustee – even if that person owns a significant slice of the trust assets – the trustmakers (or grantors) will be prevented from accessing the funds or otherwise controlling the property.
Second, if the IRS suspects that you attempted to circumvent the tax code via use of the irrevocable trust, or that you did not structure the trust correctly, it may attempt to "pierce" or "bust" the trust. This means that the IRS might consider the asset to be part of your estate (rather than the trust’s), which in turn could increase your tax liability for the tax year in question.
Sometimes a third party – such as a child or a former spouse – might also attempt to pierce the trust. Right of creditors are complicated in the state of Texas, as they are in all states, so a Texas attorney should be able to help in setting the trust up in such a way that the assets cannot easily be accessed by creditors, children, or spouses.
When irrevocable trusts do not work out as you intended, it may be possible to bring a lawsuit against the trustee. This situation can arise if the independent third party trustee fails to operate in the best interest of the trustmaker – though it can only occur if the trustee was negligent in their actions.
Amending or Dissolving an Irrevocable Trust in Texas
The Texas Trust Code provides that an irrevocable trust may be amended by the settlor to the extent the modification is not prohibited by the terms of the trust. Tex. Prop. Code § 111.054. As discussed below, Texas law permits trust modification or termination with court approval in certain circumstances. Tex. Prop. Code §§ 111.004 et seq.
The Texas Trust Code governs modification and termination of trusts. If a trust does not specify a method for modification or termination, then Court permission is required. The burden of proof is on the party desiring modification or termination of an irrevocable trust. Tex. Prop. Code § 112.054.
A trust can be modified and terminated without the necessity of Court involvement in the following circumstances:
- (1) The settlor and all beneficiaries agree to the modification. Tex. Prop. Code § 112.054(a)(1).
- (2) The modification is not inconsistent with a material purpose of the trust, and all beneficiaries consent. Tex. Prop. Code § 112.054(a)(2).
- (3) The trust terms provide the power to direct invasion of principal or administrative powers. Tex. Prop. Code § 112.054(a)(3).
- (4) The purpose of the trust has been fulfilled or become illegal or impossible to fulfill. Tex. Prop. Code § 112.054(a)(4).
- (5) A material purpose has been achieved. Tex. Prop. Code § 112.054(a)(5).
In situations where the trustee’s incompetence has caused a failure of the purpose of the trust, distribution of the trust property to the settlor may be compelled. Tex. Prop. Code § 112.052(b). Also, when the entire beneficial interest of the trust has been relinquished, the Court may order the trust terminated. Tex. Prop. Code Section 112.052(a).
In those instances where the Court must be involved in the modification of a trust, modification can be achieved in the following ways: (1) by the Court if the Court determines that the modification is consistent with the settlor’s intent; or (2) by consent of the Court if the modification is not inconsistent with the settlor’s intent. Tex. Prop. Code §§ 112.054, 112.055. Also, the trust may be modified with the consent of the beneficiaries if not inconsistent with a material purpose of the trust. Tex. Prop. Code § 112.054.
Moreover, ineffective trust provisions may be modified or eliminated by a Court in any situation where the Court finds that the purpose of the trust has been undermined because of a failure of the provision as drafted. Tex. Prop. Code § 112.054. In such a situation, the Court may replace the ineffective provision with a similar provision that is most likely to further the purposes of the trust. Tex. Prop. Code § 112.054(c).
Court action is not required when, in the case where the settlor is dead, the beneficiary requests modification of the trust and no other beneficiary of the trust objects to the modification. Tex. Prop. Code § 112.053. Also, trust property may be distributed to the settlor without the necessity of a Court proceeding where the trust terminates and the settlor is the sole beneficiary of the trust. Tex. Prop. Code § 112.058.
Expert Recommendations for Texas Irrevocable Trusts
An irrevocable trust is a legal entity that is permanent. A person (Settlor) sets a trust up for the benefit of one or more persons (Trust beneficiaries). The Trustee or Trustees oversees the content of the trust for the benefit of the Trust beneficiaries.
Most of the advice on how to manage a Texas irrevocable trust is for the person who is going to administer the trust. So, if you are the Accountant or Lawyer of a Trustee, here are some tips you should know for proper administration:
- Observe the Trust Document. While Texas has the "Uniform Trust Code," it is not the "Uniform Trust Code in spades." I mean it is not (another thing) like finding an exact replica of your trust document in the Texas "Trust Code." So, if the trust document is different or more stringent than the Texas trust code, follow the trust document.
- Follow minimum distribution provisions . You don’t really have any "discretion" if the trust requires distributions must be made no less than once a year, as the Trustee must follow the trust.
- Follow discretionary provisions. If the trust gives the Trustee discretion you have some leeway, but you have to follow the trust agreement.
- Maintain Trust Records. Even if you are a lay Trustee, you must maintain records and accounts for the Trust. You should be able to explain the decisions and actions taken on behalf of the Trust, and why you made the decisions you made.
- Be Mindful of Trust Languages vesting in Trust beneficiaries. Some trusts have language vesting in Trust beneficiaries after the statute of limitations (4 years) has run.
- Take your fees. Don’t be shy about taking your fee. This is what the trust agreement required you to do. However, it will be a taxable event.