What Is an Irrevocable Trust?
An irrevocable trust is a trust that cannot be amended. Once you put assets into an irrevocable trust, you can’t take them back out for yourself. An irrevocable trust allows you to protect your assets from creditors and reduce estate tax liability.
Understanding Irrevocable Trusts
In contrast, a revocable trust, often called a living trust, can be altered or terminated by the grantor during their lifetime. However, it doesn’t offer the same asset protection or tax benefits as an irrevocable trust.
Florida irrevocable trust laws are found in Chapter 736, Florida Statutes, and in common law and court decisions interpreting trust law. Florida law provides that property held in an irrevocable trust is protected from the creditors of the trust beneficiaries. The most important legal principles that provide asset protection to trust beneficiaries are:
- The spendthrift protection
- The discretionary distribution protection.
How Does an Irrevocable Trust Work?
An irrevocable trust legally transfers assets from an individual’s ownership (the grantor) into the trust’s ownership. Once this transfer occurs, the assets are typically beyond the reach of both the grantor and their creditors. The trust, while created by the grantor, operates according to predetermined terms and is managed by a trustee for the benefit of its designated beneficiaries.
Here’s a step-by-step breakdown of how an irrevocable trust works:
- Creation of the Trust:
- The grantor works with an attorney to draft the trust document. This document specifies the terms of the trust, including the beneficiaries, the trustee, how distributions should be made, and other essential details.
- Funding the Trust:
- The grantor transfers assets into the trust. This could include real estate, stocks, bonds, life insurance policies, cash, or other valuables.
- This transfer typically involves changing the title of ownership from the grantor’s name to the trust’s name.
- Management by the Trustee:
- The trustee manages the assets in the trust according to the terms specified in the trust document.
- The trustee has a fiduciary duty, which means they must act in the best interest of the beneficiaries and according to the trust’s stipulations.
- Asset Protection:
- Once assets are inside an irrevocable trust, they are generally protected from the grantor’s creditors.
- Since the grantor no longer owns these assets, they’re typically not included in the grantor’s estate for tax purposes.
- Distributions to Beneficiaries:
- The trust document will specify how and when distributions should be made to beneficiaries.
- Some trusts might distribute assets after a certain event (like the grantor’s death), while others might specify age milestones or other criteria.
- Tax Considerations:
- Unlike a revocable trust, an irrevocable trust can be a separate taxable entity. This means it may need its own tax identification number and might need to file its own tax returns.
- Assets within the trust, and the income they generate, might be subject to taxation. How they’re taxed depends on the trust’s structure and the nature of the assets.
- Termination of the Trust:
- An irrevocable trust will have terms indicating when and how it should terminate. This could be upon a specific date, after a certain event, or once its assets have been fully distributed.
- Upon termination, remaining assets are distributed to beneficiaries as the trust document dictates, and the trust ceases to exist.
- Limited Changes:
- While “irrevocable” suggests that no changes can be made, there are limited circumstances under which modifications can occur. Some jurisdictions, such as Florida, allow for changes with the unanimous consent of all involved parties, or through legal methods like “decanting,” where assets from one trust are effectively poured into a new trust with different terms.
In summary, an irrevocable trust operates as a separate entity that holds and manages assets for beneficiaries. The terms are set by the grantor, but once established, control over the assets typically rests with the trustee, and the grantor loses direct control over them. Irrevocable trusts can provide benefits like asset protection, tax advantages, and specific provisions for beneficiary distributions.
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Spendthrift Provisions for an Irrevocable Trust
A beneficiary’s interest in an irrevocable trust established for their benefit by another person is protected from that beneficiary’s creditors if the trust agreement includes a spendthrift clause.
A spendthrift clause states that a beneficiary may not assign or convey their beneficial interest. This trust clause is a “spendthrift” clause because the provision was initially designed to prevent an imprudent beneficiary from voluntarily squandering their inheritance by assigning their trust interest to another person. Spendthrift protection is based on the idea that a beneficiary’s creditors cannot force a beneficiary to do involuntarily what the beneficiary cannot do voluntarily under the trust document. So, when the trustmaker prohibits the beneficiary from assigning their trust interest voluntarily to a third party, the beneficiary’s creditors cannot force an involuntary assignment to pay the beneficiary’s debts.
Florida courts have consistently applied asset protection to irrevocable trusts. Florida law provides that a spendthrift provision must expressly restrain voluntary and involuntary transfers of a beneficiary’s trust interest to protect the beneficiary’s interest from creditors. After a trustee makes a distribution from a spendthrift trust to a beneficiary, the money in the beneficiary’s hands is no longer protected from the beneficiary’s creditors by the trust spendthrift clause.
Florida law makes two exceptions to the spendthrift protection. First, the law prohibits a trustee of an irrevocable trust from withholding a distribution required under the trust agreement solely to protect the distribution from the beneficiary’s creditors. Overdue mandatory distributions can be garnished from a spendthrift trust.
The second exception from spendthrift trust protection applies to “special creditors” or “creditors of last resort.” These special creditors include claims by a beneficiary’s child, claims of a former spouse for support and maintenance, and claims by creditors (such as an attorney) who have provided services for the protection of a beneficiary’s interest. The special creditor may garnish a beneficiary’s interest and distributions from an otherwise protected spendthrift trust.
What Are the Key Features of an Irrevocable Trust?
An irrevocable trust is a distinct estate planning tool with several key features that differentiate it from other types of trusts. Here are the primary features of an irrevocable trust:
- Loss of Control: Once assets are transferred to an irrevocable trust, the grantor typically cannot modify, amend, or terminate the trust without the permission of the trust’s beneficiaries. This means the grantor gives up a degree of control over the assets.
- Trustee Management: The trust is managed by a trustee, who has a fiduciary duty to manage the trust assets in the best interest of the beneficiaries. The trustee follows the guidelines and instructions provided in the trust agreement.
- Tax Implications: Assets in an irrevocable trust are generally not considered part of the grantor’s taxable estate. This means that, upon the grantor’s death, the trust’s assets are not subject to estate taxes at the federal level (and in states that have estate taxes). Additionally, certain types of irrevocable trusts can help reduce or defer income taxes.
- Protection from Creditors: Since assets transferred to an irrevocable trust are no longer owned by the grantor, they are typically shielded from the grantor’s creditors. However, this can vary by jurisdiction and the trust’s specific terms.
- Types of Irrevocable Trusts: There are various types of irrevocable trusts, each designed for specific purposes. Some examples include:
- Life Insurance Trusts: Designed to hold a life insurance policy, removing the proceeds from the taxable estate.
- Charitable Trusts: Created to benefit a charitable organization while providing income or other benefits to the grantor or other beneficiaries.
- Special Needs Trusts: Set up to provide for a beneficiary with special needs without jeopardizing their eligibility for government benefits.
- Bypass or Credit Shelter Trusts: These are established to utilize the estate tax exemption and ensure that wealth is transferred to heirs with minimal tax liability.
- Finality of Decision: Before establishing an irrevocable trust, it’s crucial to be certain about the decision, given the permanence and loss of control associated with these trusts. They are powerful tools for estate planning but require careful consideration.
Irrevocable Trust Discretionary Distributions
There is another basis of protection of a beneficiary’s interest in an irrevocable trust agreement that gives the trustee discretion over the amount and timing of distributions to beneficiaries. These trusts are referred to as “discretionary trusts.”
Section 736.0504(1) of Florida law states that a beneficiary’s creditor cannot compel a trustee to make a discretionary distribution of income or principal to a trust beneficiary when the distribution would become vulnerable to the beneficiary’s creditors. This protection against forced distributions is valid regardless of whether the trustee’s discretion is subject to an express standard and regardless of whether the trustee may have abused their discretion.
Most spendthrift trusts include discretionary distributions. However, the legal protection from creditor judgments of discretionary distributions is separate and distinct from the protection provided by spendthrift provisions.
The asset protection of an irrevocable discretionary trust applies even when the beneficiary is also the trustee, provided that the trustee’s discretion to distribute property to themselves is subject to an ascertainable standard. A typical ascertainable standard for discretionary distributions is the beneficiary’s health, education, maintenance, and support (referred to as “HEMS” discretion). If the trust agreement’s provisions include an appropriate HEMS standard, a debtor who is both a trust beneficiary and the appointed trustee over their own trust share can withhold distributions to protect the trust property from their creditors.
Florida Trust Execution Requirements
An irrevocable trust must be executed properly to be valid.
Under section 736.0403 of Florida law, if a revocable trust has any testamentary provisions, then the trust must be executed with the same formalities of a will. That means the trust must be signed in the presence of two witnesses and a notary. Typically, the trust will have a self-proving affidavit as well.
Contributions to an irrevocable trust are current gifts, not testamentary gifts, so irrevocable trusts do not have the same requirement for will formalities.
Self-Settled Florida Irrevocable Trusts: No Protection
A self-settled trust is a trust where the trustmaker is also a beneficiary. In other words, a self-settled trust is created by a trustmaker for their own benefit.
A revocable living trust is an example of a self-settled trust. An irrevocable self-settled trust provides no asset protection benefits. Florida trust law expressly states that regardless of whether a self-settled trust agreement includes a spendthrift provision, the trustmaker’s property transferred to the trustmaker’s trust is subject to the trustmaker’s creditors’ claims. Florida courts have denied creditor protection to self-settled trusts for reasons of public policy.
How to Modify an Irrevocable Trust
The terms of an irrevocable trust agreement expressly state that the trust agreement may not be amended, and the trust itself may not be revoked. Still, there are situations when a family may want to change an irrevocable trust. Changes may be warranted because of changes in family financial condition, changes in tax laws, revisions in the trustmaker’s personal goals, beliefs, or any number of other circumstances. Florida laws allow families to alter irrevocable trust when all the affected parties to the trust agree that modification is appropriate.
The Florida statutes permit an interested person to ask a court to “reform” a trust agreement when they can prove by clear and convincing evidence that the terms of the trust do not accomplish the trustmaker’s intent because of mistake of fact or law. A court may consider evidence of the trustmaker’s intent that contradicts the clear terms of their intent stated in the trust agreement.
A court may also modify an irrevocable trust’s terms to provide a tax benefit to the trustmaker, provided the modification is not contrary to the trustmaker’s overall intent. Some irrevocable trusts are created to achieve tax reduction, and changes to tax law make the trust ineffective or counter-productive.
Often the trust beneficiaries do not know about an irrevocable trust or trust terms until after the trustmaker’s death. Then, all the beneficiaries can decide that the terms of the trust are not beneficial. The Florida Statutes provide that an irrevocable trust may be amended after the trustmaker’s death with the unanimous agreement of all trust beneficiaries and the trustee.
Another procedure to indirectly change an irrevocable trust is what is known as “decanting” a trust. Under Florida Statute 736.0117, a trustee with the power to use trust principal for the benefit of one or more beneficiaries may exercise this power by transferring the trust principal to the trustee of a second trust for the current benefit of one or more of the same beneficiaries. The decanting process effectively replaces the terms of the irrevocable trust agreement with a new agreement applicable to the second trust. Decanting, properly done, does not have a tax effect.
Florida Statute 736.1401 provides for appointments of trust directors, commonly referred to as “trust protectors.” An irrevocable trust agreement may nominate a trust protector and grant the protector specific powers. Those powers may include the power to add or remove trust beneficiaries, change the trustee, decant a trust, terminate a trust, or many other powers that implement the trustmaker’s intent and serve the interests of the beneficiaries. Trust protectors historically have been employed mostly in asset protection trusts, but they are becoming more common to increase flexibility to deal with changing tax laws and changing needs of beneficiaries. The trust protector should be an independent professional person who understands legal and tax issues of trust administration
Exception Permitting ILIT Changes
There is an IRS exception for a trustmaker to modify an otherwise irrevocable ILIT. The IRS allows people to modify an insurance trust by creating a new trust with different trust provisions and assigning the life insurance policy to the newly formed trust. The IRS does not consider the assignment of the life insurance to the new trust to constitute a taxable event so long as the trustmaker is the same and the trustmaker is liable for income tax on all trust income.
How to Terminate an Irrevocable Trust
An irrevocable trust terminates upon a certain date or upon conditions expressed in the trust agreement. If a trust does not include a termination provision, the trust will endure for a long time, and the trust parties will be burdened with trust administration, including, for example, tax returns and trustee fees.
Florida law provides a way to terminate an uneconomical irrevocable trust. The law states that a trustee may terminate an irrevocable trust with less than $50,000 of assets if the trustee concludes that the amount of assets does not justify the cost of continued trust administration.
There are other ways to terminate an irrevocable trust through judicial proceedings or by including provisions in the trust agreement that provide flexibility to the trustee or an appointed trust protector.
Dissolving an Irrevocable Trust
An irrevocable trust can be dissolved pursuant to the terms in the trust document.
A typical trust document will allow the trustee to dissolve the irrevocable trust if it is no longer economically feasible to maintain the trust for the beneficiaries. In other words, if the trust assets diminish where there is not much left in the trust estate, the trust document will usually allow the trustee to dissolve the trust.
What Happens to an Irrevocable Trust When the Grantor Dies?
An irrevocable trust is a type of trust that cannot be modified or terminated without the permission of the beneficiary or beneficiaries. The grantor, having transferred assets into the trust, effectively removes all of their rights of ownership to the assets and the trust.
When the grantor of an irrevocable trust dies, what happens to the trust depends on the terms outlined in the trust agreement. However, here are a few general scenarios:
- Continued Trust Operation: If the trust was set up to continue for the benefit of certain beneficiaries (like children or grandchildren), the trust will continue to operate according to its terms. The trustee will continue to manage the trust assets and distribute them to the beneficiaries as specified in the trust agreement.
- Trust Termination and Asset Distribution: In some cases, the trust may be set up to terminate upon the death of the grantor. In this case, the trustee will distribute the remaining trust assets to the beneficiaries as outlined in the trust agreement. After the assets have been distributed, the trust will cease to exist.
- Trustee Succession: If the grantor was serving as trustee and passes away, a successor trustee named in the trust agreement will take over management of the trust.
- Tax Implications: Upon the death of the grantor, the trust assets generally aren’t considered part of the grantor’s estate for estate tax purposes, as they were removed from the grantor’s taxable estate when placed into the irrevocable trust. However, the trust itself may have tax obligations, and distributions to beneficiaries might have income tax implications.
The specifics of how an irrevocable trust is handled after the death of the grantor largely depend on the terms set forth in the trust agreement.
Irrevocable Insurance Trusts
Irrevocable trusts in Florida are used for reasons other than asset protection. A common example is ownership of life insurance policies. An irrevocable life insurance trust, also known as an ILIT, is an irrevocable trust created to own a life insurance policy. Like other irrevocable trusts, the insurance trust cannot be rescinded, amended, or modified with narrow exceptions (discussed below). Once the trustmaker contributes a life insurance policy to the trust, they cannot later reclaim ownership of the policy or change the terms of either the policy or the trust.
An irrevocable insurance trust is sometimes used for estate tax planning. If an ILIT is properly structured, the death benefits paid to the trust will be free from inclusion in the taxable estate of the insured trustmaker for estate tax purposes. In addition, the ILIT can also be structured so that the trust can distribute money to the insured’s surviving spouse without inclusion in the surviving spouse’s taxable estate. An ILIT that includes a spendthrift provision or discretionary distributions to ultimate beneficiaries protects death benefits retained in trust from future creditors or divorced spouses of the named beneficiaries.
How to Create a Life Insurance Trust
Creating a Florida insurance trust involves coordination between the financial adviser who recommends and sells the policy, an attorney who drafts the legal trust documents, and the person named as trustee of the trust. We suggest the following procedures for establishing a life insurance trust for the purchase and ownership of a life insurance policy:
- Professional legal and tax advisors should recommend an insurance trust and explain its advantages.
- The trustmaker decides the terms of the trust (including the establishment of beneficiaries and the choosing of both initial and successor trustees).
- Medical examination procedures should be commenced. There is no need to draft a trust if the trustmaker is not insurable.
- The attorney drafts the insurance trust.
- The trustmaker and trustee sign the insurance trust.
- The trustee applies for an employer identification number (IRS Form SS-4).
- The trustee applies for life insurance and signs the application as insurance owner. If the insurance company requires a check with the application, the application should not be commenced until the trustmaker makes an initial gift to the insurance trust to cover the initial premium and the trustee notifies the beneficiaries that a gift is being made to the trust for their benefit.
- The trustee completes the application and pays the initial premium.
FAQs about Irrevocable Trusts
Why would someone want an irrevocable trust?
You should consider forming an irrevocable trust if (1) you want to protect the trust assets from creditors of yourself or the trust beneficiaries, (2) you want to reduce estate taxes, particularly with life insurance (3) you want to provide for a beneficiary without jeopardizing government benefits.
Who owns the assets in an irrevocable trust?
Assets in an irrevocable trust are owned by the trust itself. Because the trust is irrevocable, the grantor cannot take back the trust for their own benefit.
Which is better, a revocable or irrevocable trust?
A revocable trust is better for typical estate planning needs, such as providing for children and avoiding probate. An irrevocable trust is better for asset protection during the grantor’s lifetime or for avoiding estate taxes on insurance proceeds.
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About the Author
Jon Alper is an expert in Florida estate planning for individuals and small businesses. He helped hundreds of clients with wills and trusts and has practiced law for over 35 years.
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