An Introduction to Irrevocable Trusts
An irrevocable trust is a trust that, by its very definition, is not reversible. Once assets go into an irrevocable trust, the person who establishes the trust (the "grantor") cannot take assets out of the trust for any reason. Grantors cannot enjoy or control the trust assets in any way once the trust is created. The only way to alter or terminate an irrevocable trust is by the consent of the grantor, trustee, and all of the beneficiaries, as stated in the trust agreement.
The primary use of irrevocable trusts is to remove assets from an estate so that the trust assets are not subject to estate tax upon the death of the trust grantor. There are many other uses for irrevocable trusts as well, such as protecting beneficiaries’ inheritance from their creditors, providing for beneficiaries with special needs, providing for minor beneficiaries until they become of age, or providing for a beneficiary’s lifetime of support.
In Massachusetts and other jurisdictions, the core differences between irrevocable and revocable trusts are as follows. When a trust is established, the grantor may be a beneficiary during his or her lifetime and may receive distributions pursuant to the terms of the trust. However, the extent of the grantor’s control and rights cannot reach the level that would cause the trust assets to be considered as part of the grantor’s estate for estate tax purposes. The grantor of an irrevocable trust cannot amend the trust or demand that trust assets be distributed to him or her. In contrast , the rights of a grantor of a revocable trust are virtually unlimited. A revocable trust established by the grantor may be altered or terminated at any time during the grantor’s lifetime. In fact, a revocable trust is often used as a vehicle for managing assets for the benefit of the grantor so long as he or she is able to manage his or her own affairs. Upon the grantor’s incapacity, a successor trustee assumes management of the revocable trust assets for the benefit of the grantor.
Funding an irrevocable trust constitutes a gift by the grantor to the beneficiaries of the trust. The trustee will then hold the assets in trust for the benefit of the named beneficiaries. The trust assets will not be part of the grantor’s estate when the grantor dies. Because an irrevocable trust constitutes a gift, the grantor must also consider the federal gift tax implications of such gifts, including potential annual gift tax returns. For purposes of determining estate taxes, the value of the grantor’s estate will be reduced by the assets transferred to the irrevocable trust. However, the gift tax exclusion amount and federal estate tax exclusion amount often result in little or no federal estate tax upon the grantor’s death.
Massachusetts Laws on Irrevocable Trusts
Massachusetts irrevocable trust laws have some specific rules that establish the rights of irrevocable beneficiaries and the powers of the trustee. Massachusetts follows the Uniform Trust Code, a model distrubution law that other states can choose to enact into their own state laws. Massachusetts has enacated most provisions of the Uniform Trust Code, and it is included in Chapter 203E of the Massachusetts General Laws. The UTC addresses common topics related to trust administration including the rights of the trust beneficiaries, the powers of the trustee, duties of the trustees, matters regarding the construction and validity of the trust, distribution provisions, decanting rules, and trust modification.
As the Uniform Trust Code establishes rules for the administration of irrevocable trusts, certain provisions from the UTC are specific to the circumstances of Massachusetts resident’s trusts. For example, Section 105 of Chapter 203E defines which states’ law will be used for the proper administration of the trust. Massachksetts follows the "most significant relationship" rule, which allows Massachusetts law to be used for the administration of a Massachusetts trust with its principal place of administration in Massachusetts. If the principal place of administration is located in another state, that state’s law applies to the administration and construction of the trust, unless the trust states otherwise. The purpose of this section of the law is to make clear which state’s law applies when the trust has multiple locations of administration.
The Uniform Trust Code also removes and supersedes several other laws that are no longer relevant in its rules. For example, the law abolishes the affect of the Massachusetts Rule Against Perpetuities, which limited trusts to a maximum duration of 90 years, in the event the trust was silent on terms to endure for more than 90 years. This means a Trustee can administer the trust for an indefinite period of time as specified by the terms of the trust instrument. In addition, Massachusetts law replaced the concept of cy pres, which previously limited the duration of a trust to twenty years after the death of the settlor, with the new UTC cy pres doctrine. The new law allows the income and principal of the trust to be used for a designated charitable purpose or multiple charitable purposes of the trust instrument.
The law also imposes fiduciary duties on trustees, and identifies any violation of those duties by a trustee as grounds for court review of the trust. Trustees are liable for the breach of trust, as well as personal and economic losses resulting from the breach of duty. In addition, the duties of a trustee also encompasses duties relating to maintenance and treatment of property, the requirement to be impartial between or among beneficiaries, the duty to preserve trust property, the duty to act with care, skill, prudence and diligence, and the duty to deal impartially with income and principal beneficiaries having uneven interests. Finally, the UTC reduces the number of required signatures on trust documents for any action requiring the consent of a trust settlor and all beneficiaries. Massachusetts trust law requires the signature of the trustee, the trust settlor and all beneficiaries in order to modify or terminate a trust. With the new law, however, the signature of all beneficiaries is no longer required. The court will not consider the modification of the trust until at least one beneficiary consents to the proposed modification.
The Benefits of an Irrevocable Trust
An irrevocable trust can be an advantageous tool in several circumstances. Massachusetts residents may find benefits in establishing an irrevocable trust for asset protection, tax planning, or estate planning purposes.
Asset Protection
One of the primary reasons people pursue establishing an irrevocable trust is asset protection. For instance, someone with significant assets may want to establish an irrevocable trust to protect those assets from creditors or lawsuits. Another use for an irrevocable trust may be to ensure that assets remain in trust for the benefit of a disabled beneficiary. In the past, medical and government programs would establish a lien on assets of individuals that exceed a certain value; this lien would attach as soon as the individual qualified for state assistance, meaning they could not receive inheritance or gifts until the debt was paid off. Now, in order to keep assets protected from liens and creditors, some people establish irrevocable trusts to hold assets for individuals with disabilities.
Income Tax Planning
It might seem counterintuitive to plan for income tax purposes with an irrevocable trust, but it actually works well in some cases. For example, an irrevocable trust is a useful tool for tax-free appreciation of assets that are expected to appreciate substantially over time. Since the trust itself will not have control over the assets placed into it, and the beneficiaries cannot simply receive the asset directly, the appreciation is not considered income for income tax purposes, and the assets are not taxed. This is especially popular for life insurance policies, which can have a value of $1 million or more by the time the policy payer passes away. Additionally, some irrevocable trusts can avoid being taxed in Massachusetts as Grantor Trusts if they are set up creatively and properly.
Estate Tax Planning
There are three common uses for irrevocable trusts in Massachusetts for estate tax purposes. First, a spouse can create an irrevocable trust for their husband or wife to allow them to qualify for Mass Health, as stated above, without releasing the Massachusetts’ state lien that may be imposed on their assets. A second use is for estate tax planning: irrevocable trusts can help people transfer wealth while excluding the value of the transferred property from their Massachusetts taxable estate. Finally, a common use of irrevocable trusts in Massachusetts is to take advantage of the federal estate tax exemption, which allows an individual to transfer a specific amount out of their estate tax-free each year. Once the recipient of the funds has the money, they can keep, spend, or otherwise use that money as they wish. There is no penalty for using the money, but transferring it to a trust gives the transferring individual more assurance that the money will go to their intended beneficiary.
Drawbacks and Challenges
While irrevocable trusts offer several benefits, there are shortcomings and risks that one must be aware of before creating one. The first and most significant problem is the loss of control over your assets. Once you have created an irrevocable trust, you cannot simply reverse it because you change your mind. Since you are no longer the trustee for your trust and you cannot be the current beneficiary, you may not have any access to trust assets once the trust is created. Your trustee has full control and discretion over all aspects of the trust, including distributions. The sole power of amending and revoking the trust is vested in the settlor and this power cannot be transferred to any other person. The irrevocable nature of an irrevocable trust can also involve certain tax risks. First, the Internal Revenue Service ("IRS") is slow to respond to new trust arrangements that may have negative tax consequences or may be used to reduce or avoid federal taxes. Therefore, with an irrevocable trust, a beneficiary may have to wait several years to find out if the IRS approved of the arrangements described in the trust documents. Moreover, if by the time the IRS makes a ruling it disapproves of the new trust arrangements, the IRS may assess penalties for gift and other taxes. Therefore, since an irrevocable trust cannot be changed once it is created, the settlor cannot amend his or her intentions once the trust is created. This could result in a beneficiary being subject to significant tax liabilities as the settlor’s vision for how the trust should function may never come to fruition. As stated above, it is very difficult to change an irrevocable trust. This does not mean, however, that it is impossible to change an irrevocable trust. A settlor can request to have the will or trust modified or revoked by a competent court for several reasons, such as the following: Although a settlor may request a modification or revocation of an irrevocable trust, it is important to note that even if the modifications are permitted by the court, these changes may still be deemed a tax avoidance scheme. Therefore, it is important to consult with your attorneys to ensure that the change to the irrevocable trust is permissible with respect to Massachusetts and federal income tax laws. It is important to remember that the best way to avoid unexpected tax liabilities and issues with your trust is to consult with a qualified estate planning attorney before making the decision to create an irrevocable trust. An attorney will be able to fully explain all of the advantages and disadvantages your revocable trust may have before it is created, and will be able to guide you toward trusted advisors such as bankers, financial planners and accountants.
Establishing and Managing Irrevocable Trusts
Setting up an irrevocable trust in Massachusetts is relatively simple but requires an experienced Massachusetts estate planning attorney to draft and execute the trust as there are many ways that it can be set up to your benefit. The first step in the process is to decide who you would want as the Trustee of the trust. The Trustee’s role is to manage the assets within the trust, including investments, distributions and any transactions associated with the administration of the trust.
After the Trustee has been identified, the next step is the drafting of the irrevocable trust itself, which is a complicated and legally binding document. This document should include detailed instructions and provisions for the Trustee to follow when administering the trust. It must include any powers that the beneficiary may retain after the creation of the trust, otherwise known as "powers of appointment". It must also include any instructions for distributions out of the trust for the beneficiary’s needs . It may further include any tax planning strategies that the beneficiary wishes to incorporate into the trust.
In addition, the trust must also include any special instructions for the distribution of trust property upon the death of the beneficiary. It must encompass any tax planning that the beneficiary would like to use in conjunction with the irrevocable trust. This document must also include the legal names of the parties to the trust, the Trust’s name, address of the trustee and any alternate and successor trustees that will follow in the future.
The final steps in the process are determining the funding of the trust and the proper handling and collection of any of the trust assets. Depending upon the types of assets that the beneficiary wishes to place into the trust, the funding may sometimes be more complicated. We have had experience with all types of funding and collection of any and all types of assets and would be able to guide the beneficiary through those steps as well.
Tax and Legal Considerations
Massachusetts irrevocable trusts not only serve as an asset protection mechanism for the person transferring property to the trust from Massachusetts estate tax, but they also have a number of other unique legal and tax implications.
Depending on the terms of the trust agreement, irrevocable trusts may provide income to the beneficiary over time or allow the trust principal or corpus to be distributed to the beneficiary. Distributions or payments from the trust to the beneficiary may or may not be taxable to the beneficiary and, regardless of the designated beneficiary, the trust itself may still be subject to U.S. federal income tax if the corpus generates income for the trust.
U.S. Citizens are subject to income tax, regardless of whether it is generated from Massachusetts or from any other state or country. Massachusetts income tax applies to Massachusetts and to U.S. source income. If one or more of the trustees or the beneficiary is a Massachusetts resident, the Massachusetts income tax laws will apply to the trust.
If the trust is a Complex Trust that is not required to make distributions to the beneficiary, the trustee reports and pays taxes on the undistributed income of the trust. This is because the beneficiary does not receive the income from the trust. The income of a Complex Trust may be payable to the trustee of a Green Trust for the benefit of any beneficiaries under the age of 21 years, and paid by the fiduciary to the beneficiary, at the trustee’s discretion, for the benefit of any other beneficiaries under the age of 21 years. A fiduciary return must be filed annually for the trust during the life of the decedent and outside of the decedent’s estate.
Common Myths
Common misconceptions about irrevocable trusts in Massachusetts lead people to make decisions that ultimately do not suit their needs. While you should always consult a Massachusetts estate planning attorney to obtain advice specific to your situation, there are a few common myths that I can dispel for you.
First and foremost, an irrevocable trust is not necessarily an "irrevocable" trust. Although the name seems misleading, it is not a term of art. Instead, it simply means that the trust terms cannot be unilaterally changed by the person who creates the trust (the "grantor"). This does not mean it cannot be changed if the grantor, a beneficiary, trustee or other person with rights under the trust has the ability to modify the trust. Even so, the process to amend an irrevocable trust is not as simple as you might think. It may involve several Court hearings and significant costs to obtain approval.
Another myth popular among non-sophisticated estate planning clients in Massachusetts is that assets will be protected in a Massachusetts irrevocable trust from all lawsuit creditors. The reality is that Massachusetts laws regarding creditor protection of trusts are quite particular. If the trustee has unfettered discretion, the assets in the trust are generally protected. However, if the beneficiary has a right to compel the trustee to distribute money from the trust in his/her favor, the Court may allow an unsecured creditor access to the trust assets. It is therefore important to carefully evaluate how the trustee’s discretion will operate under the Massachusetts irrevocable trust in order to ensure maximum creditor protection.
Massachusetts law also allows for a Bankruptcy trustee to reach trust assets in certain circumstances. For instance, if a beneficiary has a right to receive the net income of a trust in Massachusetts, the income is subject to the claims of a Bankruptcy trustee. This, however, is not true in every state.
It is also important to understand that Massachusetts irrevocable trusts often have special tax implications. An irrevocable trust is considered a separate entity for income tax purposes and files its own income tax return (IRS Form 1041). The income tax bracket for trusts is very compressed, so high rates kick in with relatively little income. This means that irrevocable trusts are often taxed at 37% on income over $12,500, whereas a single individual is not taxed at that rate until she earns more than $500,000. What your Massachusetts estate planning attorney may do to avoid this double taxation is allocate amounts to beneficiaries who may be better able to handle the tax consequences. This may be done, for example, by having the trustee make distributions to the beneficiary equal to the trust income in any given year. That way, the beneficiary reports the income on his/her own tax return and pays taxes on income at the beneficiary’s individual tax rate, if lower than the highest trust rate. A Massachusetts estate planning attorney should discuss with the trustee what distribution policy would be best.
Choosing Legal Help
It is important, if you are considering setting up an irrevocable trust, that you consult with an attorney who has experience in this area of the law. He or she will explain the legal implications to you and help you make a decision as to whether this type of trust is appropriate for your circumstances. Often, there is a misconception that the drafting of a trust is all that is necessary . Although that is certainly the essential first step, if the property planned to be placed in trust is not titled in the name of the trustee or if it is not funded into the trust, then the best laid plans can go awry. An experienced estate planning attorney will address these details with you to ensure that the irrevocable trust plan is successful.