Irrevocable Trusts - California Estate Planning | Bohm Wildish & Matsen LLP (2024)

Irrevocable trusts are created by the maker of the trust, who is called the trustor, grantor or settlor. There has to be a trustee appointed and there must be assets in the trust. The essential requirements for a trust are the trustor, the trustee, and the trust assets. An irrevocable trust is just that, irrevocable. It cannot be changed and what is originally documented in the trust has to stay the same. However, there are ways to get around that. Most states have passed laws that allow the courts to make changes in an irrevocable trust if there is an overriding and compelling reason. For example, if the tax laws have changed since the trust was written and the main purpose of the trust was to take advantage of the tax laws during the original time that the trust was set up.

The court may allow a change in the trust to give effect to the obvious intent of the trustors. This kind of action generally must be approved by the beneficiaries. If they object, then the court may not agree to change it. If the terms are going to be changed, then everything as set forth in an irrevocable trust can perhaps, only be modified by a protector, which is a fourth party who has the right to substitute the trustee and to change the situs of the trust. Changing the situs could mean changing it from one state or country to another. The protector may be able to change the beneficiaries, or the forms of distribution. The protector has long been a part of international trusts and it’s only within the last decade that it has become more utilized in US trusts.

An intentionally defective grantor trust is a trust that is set up in such a way that even though it is irrevocable and the asset is outside of the ownership of the grantor, the grantor is still the income beneficiary of the trust. Many years ago, taxpayers set up trusts because the income tax rate for a trust was much lower than an individual’s income tax rate. The IRS didn’t like that. They said these trusts were defective because the trustors retained some power over them. Therefore, the IRS taxed the money in the trust to the trustor rather than to the trust.

However, to make the trust intentionally defective may be to the advantage of the settlor or trustor of the trust of the purposely retained power of the trust so as to have the trustor taxed for any income rather than the trust or any beneficiaries, while at the same time removing the asset from the estate of the trustor for estate or death tax purposes. If the decedent is the one who has the money and is the one who is trying to reduce the estate for estate tax purposes, then he/she doesn’t want a tax on the transfer of the assets that has appreciated in value causing a taxable gain. A decedent wants to eliminate that. It’s a very complicated setup. It has to be done using a lot of care and you have to spend the time to figure out if it’s worth it to save the estate taxes in order to eliminate the gift tax, or if it’s better to eliminate the gift tax (usually at a discount), even though the capital gain tax will have to be paid by the beneficiaries for the difference in value at the time of the gift to the trust instead of the stepped-up tax basis (value) at death.

An irrevocable life insurance trust (ILIT) pays the premiums to keep life insurance in force, collects the death benefits upon the insured’s death, and distributes the money according to the terms of the trust where the insured does not own the insurance of the deceased (the trust) and life insurance proceeds are not included in the insured’s estate. The insured determines that the trust terms are set up but since the trust is irrevocable, it cannot be amended. The ILIT is an excellent way of providing for heirs and avoiding estate taxes. Each year, a parent can make a gift to the ILIT in the amount of the annual exclusion, for each beneficiary, without having to pay gift taxes or use any of the gift tax credit. This excluded gift amount can be utilized to reduce the gift tax on the premium payments on the insurance policies.

The process for establishing the ILIT is as follows: a trust is drafted and it’s executed by the trustor. The next step is to fund the trust with the insurance policy and have the trustee, obtain a federal tax identification number for the trust. After the insurance policy and premiums on the policy have been determined, the trustee needs to open up a bank account in the name of the trust. The trustee is selected when the trustor makes up the trust. Usually, a close friend or a professional is appointed to be the trustee.

The trustee needs to provide the bank with a copy of the trust and the trust taxpayer identification number. The trustor then writes a check to the trust and the trustee deposits it into the trust account. Then, the trustee sends a notice to the beneficiaries of the contribution and has it signed by all the trust beneficiaries. This notice is called a Crummey Letter because that is the name of the tax case that allows this procedure to be followed for the purposes of utilizing the gift tax exemption. The Crummey Letter is extremely important and has to be executed each time the premium is paid. In effect, it gives the beneficiaries the right to take the money out instead of leaving it for a certain period of time, usually about 60 days.

Once the Crummey Letter has been sent out, the trustee writes a check to the insurance company to pay the premiums on the insurance. The trustee has the responsibility of filing a very brief tax return for the trust. There will normally be no income taxes paid but the return may be filed for information purposes only. A trustee keeps the original policy, along with the original executed trust document and the original notice to the beneficiaries for each year, in a safe place. Each year, the trustee will receive notice from the insurance company of the amount of the premium and the trustee then coordinates with the trustor, with respect to the trustor’s deposits in the trust’s bank accounts for the annual premium amount.

Upon the death of the trustor, the trustee should obtain a certified death certificate of the decedent trustor and then contact the insurance company to obtain the necessary forms with respect to the death payments of the insurance policies. These insurance proceeds are deposited into the trust account and distributed according to the terms of the trust. There will be no estate or income tax, except for income tax on any interest on any of the insurance proceeds. An ILIT can be a very useful way of keeping life insurance separate for asset protection purposes and also for the administration of the estate.

A retirement trust is an irrevocable trust that sets up a format for the retirement IRA or pension plan designated beneficiary. The IRA beneficiaries are usually the children or the heirs and if the children are named directly as beneficiaries of the IRA, they may not necessarily obtain the income tax stretch out after many more years of potentially spending hundreds of thousands of dollars in taxes. This can only happen because beneficiaries are not aware of the tax and the consequences that are involved and their alternatives regarding distribution. All too often, the beneficiaries want immediate access to all of the cash.

In many cases, beneficiaries cash out the entire account immediately and foolishly spend it all. Unfortunately, they do this before they consult with a family member or a professional. They have to report the entire amount of the distribution as income tax in the year in which they took the money out. The solution for these problems is to create a trust to be the beneficiary of the IRA. Not only does it provide for the tax stretch out benefits, it also provides for asset protection benefits and the creditors then will not be able to attack the trust. Otherwise, if it’s just taken out, a creditor could get to the money.

An effective IRA trust can contain a lot more flexible provisions that the normal revocable living trust doesn’t provide. Many times, it’s a better vehicle if it’s a separate trust. The required IRA trust sets forth provisions that would otherwise not be in a traditional family trust. The IRA trust can be carefully drafted to comply with the complex income tax regulations that qualify the trust as a qualified designated beneficiary. Hence, it’s often called the designated beneficiary or stand-alone IRA trust. It also provides for asset protection for the benefit of the beneficiaries.

A Qualified Personal Residence Trust (QPRT) is often called the “Senator’s Trust” because the law allowing for it was passed back in the 1950s by some wealthy senators and it allows for the transfer of a personal residence by the transferor to their trust with the right to stay in their house rent-free. The house then is outside the estate for estate tax purposes. There has to be a gift tax paid; however, the amount of the gift is greatly reduced by the right of the transferor to stay in the house. This can be a good estate planning technique, when appropriate. You set the trust up so that the property is transferred into the name of the trust and then the grantors have the right to stay in the house for a certain period of years, as long as they stay alive, and then it stops for that period and the trust is terminated. If they die prematurely, then the benefits of the trust are extinguished. If the period expires and the trustor outlives it, then the trustor will have to start to pay fair market rent to the trustee in order to stay in the house.

Another benefit of the QPRT is that it is exempt from creditors, if it is set up before the claim originates, because the trustor or the transferor doesn’t own the property. The trust owns the property and upon the death of the transferor, the property is distributed to the heirs. Or, at the time of the expiration of the terms of the QPRT, rent is paid by the trustor resident of the house. The house can be sold but the sale proceeds still have to be put back into the trust.

As we have already discussed, the unlimited marital deduction does not generally apply to property passing to a surviving spouse who is not a citizen of the United States. However, transfers to a special Qualified Domestic Trust or QDOT enables a deceased US citizen to set aside property for their surviving non-citizen spouse without incurring immediate estate tax liability.

In an effort to avoid the possibility of transfers to non-citizen spouses being free of the federal estate tax system and then transferring the other assets to a jurisdiction that does not have gift and estate tax in the United States, the traditional marital deduction is not permitted. The QDOT provides a system that may defer the estate tax otherwise due at the decedent’s death had the property been distributed through the trust. The QDOT has to be in existence at the time of the US citizen spouse’s death and requires several requirements in order to be classified as a proper QDOT trust.

First, there must be at least one trustee who is a citizen of the United States or a domestic corporation as the US trustee. Second, the US citizen deceased spouse’s property in the QDOT must be irrevocably treated as marital deduction property on the deceased spouse’s federal and estate tax return. Third, no distribution of any cash or property from the QDOT is allowed unless the US Trustee is entitled to the estate tax attributed to the principal distribution. Fourth, if the fair market value of the assets distributed to the QDOT exceed $2 million, the trust has to comply with certain requirements designed to provide adequate security to make sure payment of the estate tax liability is imposed on the transfer of property.

Let me give you an example of how the QDOT would be relevant and utilized. Patricia Browning owns a large amount of separate property. She is married to Thomas Marsh, a non US citizen. If Patricia takes advantage of the marital deduction and transfers the property to Thomas, it would be taxed at death (with a very small credit) unless the QDOT is the recipient. Accordingly, in her estate planning documents, Patricia would set up a QDOT by means of provisions in the trust that dictate the QDOT process and its requirements. The set up and establishment of the QDOT would be much different than having a normal US estate plan for a married couple which usually provides for distributions to a marital deduction trust or outright to the spouse or to a QTIP Trust.

All of these issues need to be examined and analyzed. Once this analysis process is completed then the estate can move forward. If the process is neglected, then serious and expensive ramifications may occur.

BDIT means a Beneficiary Defective Inter-Vivos Trust or some people call it a Beneficiary Defective Inheritor’s Trust. The basic idea behind a BDIT is that the trust is not established by the client. It is set up by a trusted third party such as the client’s parents for the benefit of the client. The client is unable to be the beneficiary and the Trustee. The parents must contribute a nominal amount of money which gives the client the ability to withdraw that amount using an annual withdrawal power. If the client refuses to exercise the right to withdraw, the client becomes the owner of the trust for income tax purposes but not for estate tax purposes. The client as a beneficiary could sell valuable assets to the BDIT in exchange for a promissory note for the fair market value without any capital gain applicability.

The beneficiary controlled trust strategy has been developed over the last several years to provide future beneficiaries with assets, for both inheritance and protection from future creditors and to eliminate the gain on the asset from the client’s estate. The BDIT usually works by having the parents make up the trust for the benefit of the child or children. The Trustee has the responsibility to manage and invest the principal of the trust. A third party is named and given authority over trust distributions. The parent has to contribute a nominal amount of money to the trust. The child as the beneficiary can then sell valuable assets to the BDIT in exchange for a promissory note at full fair market value.

Discounting may be available which makes the BDIT even more attractive. By selling the assets to the BDIT, the asset is protected from creditors. Since the trust is not created by the beneficiary, transfers to the trust are not subject to the normal statute of limitations on fraudulent transfers.

The BDIT is an outstanding strategy but has to be done with great care and professional expertise. The IRS closely monitors this process and, therefore, the structure has to be devised and governed by various rules and regulations with which only a professional planner would be familiar.

The BDIT uses freeze, squeeze and burn techniques as part of the estate provision process. However, the client can control using and enjoy the transfer of assets and determine the disposition. In addition, the assets in the BDIT are transferred tax death free in that the growth of the asset in the trust is shifted from the transferor rather than to increase his/her estate. The “freeze” occurs because the appreciation of the value of the assets transferred to the BDIT is limited for estate tax purposes. The “squeeze” refers to the valuation discount by exchanging assets that can be discounted for assets not subject to full valuation. The discount is passed tax free into the BDIT outside of the estate of transferor for death tax purposes. The “burn” occurs as a result of the trust beneficiary paying income tax on the income earned by the trust. The income tax payments accordingly reduce the estate assets which in turn reduces the estate tax. Finally, the assets should be creditor protected.

Specific techniques and issues involved in setting up a BDIT are beyond the scope of this book. However, many of these can be satisfied by using this strategy with the assistance of professionals who understand and can employ it in the proper manner.

Briefly, the benefits of the BDITs are as follows:

1. Estate “freezing”
2. Estate “squeezing” and Estate “burn”
3. Control and access for the beneficiary
4. Asset protection
5. Keeps assets in the family
6. Reduces or eliminated federal Gift and Estate Tax
7. Retention of flexibility if circ*mstances or goals change

For more information on Irrevocable Trusts In The State Of California, an initial consultation is your next best step. Get the information and legal answers you are seeking by calling (714) 384-6500 today.