January 4, 2012

Types of Irrevocable Trusts

The majority of trusts that are drafted are known as revocable or living trusts. However, some people write irrevocable trusts as well if the situation dictates the necessity for such. The following are some of the more common irrevocable trusts:

Life Insurance Trust (commonly known as a ILIT)

In this type of trust, parents gift money to their children to pay the life insurance policy premiums, which are taken out for the parent's lives, and the parents then designate the children as the policy's beneficiary. An ILIT provides the benefit of reducing the parent's taxable estate for Estate Tax purposes and provides the children with liquidity to satisfy Estate Tax obligations. For example, the parents might gift $26,000 to their children annually to purchase the largest life insurance policy they can obtain. When the parents pass away, the proceeds from the policy will not be included in his or her gross estate for Estate Tax purposes. In turn, the children will reap sufficient liquidity to pay any Estate Tax liability. Generally speaking, the IRS requires prompt payment of the Estate Tax, hence access to large quantities of cash is needed to pay it. Unfortunately, you cannot barter services with the IRS as a form of payment so money is needed to pay them off not your impressive karaoke skills.  

Crummey Trust 

This type of trust allows a parent to gift the maximum annual exclusion amount, $13,000 in 2012, to their child's trust. The name is derived from the court case which recognized its validity, Crummey v Commissioner (9th Cir 1968) 397 F2d 82. Basically, a parent tells their child that they are gifting their Crummey Trust $13,000 and the child has the right to withdraw said funds within a specified time period if they so desire. Invariably the child will not withdraw the funds whereby the funds become part of the child's trust. If this seems like a big charade to you, then you can think prudently. 

Charitable Trust

Since the Estate Tax allows a charitable deduction, a wealthy individual might write a trust which benefits a recognized charity to offset the Estate Tax. There are two types of these, a charitable remainder trust ("CRT") and a charitable lead annuity trust ("CLAT"). In a CRT, individuals are designated as beneficiaries for a specified period of time, with the remainder interest passing to charity. In a CLAT, the formula is reversed, the charity is the initial beneficiary for a specified period of time, with the remainder interest passing to named individuals. 

Special Needs Trust (commonly known as SNTs)

A SNT is a trust designed for individuals who are disabled with the goal of retaining the individual's public benefits such as Medi-Cal and Supplemental Security Income while simultaneously allowing them to receive property. There are two types of SNTs, a First-Party Specials Needs Trust and a Third-Party Special Needs Trust. In a First-Party SNT, the disabled individual themselves creates the trust. For example, the individual is awarded a substantial judgment for a personal injury claim and creates the First-Party SNT to maintain eligibility for public benefits. Conversely, with a Third-Party SNT, some person other than the disabled individual, almost always the parents, creates the trust for the individual. 

Qualified Domestic Trust (commonly known as a QDOT)

In the case of a couple, the Estate Tax is not an immediate concern should one spouse away. The reason for this is because one spouse is allowed to transfer to the surviving spouse an unlimited amount of property upon their passing. IRC §2523. For example, if Jack and Jill were collectively worth $250M and Jack suddenly passed away in a tragic hot air balloon accident, Jill would have no immediate concern of paying the Estate Tax since Jack could leave his entire to her absent Estate Tax liability. Although Jill's estate would have to pay the Estate Tax once she passes away. Regardless, the major qualification for the unlimited marital deduction is that the surviving spouse be a U.S. citizen. IRC §2056(d).

If the surviving spouse is not a U.S. citizen, the couple can write a QDOT to take advantage of, albeit partially, the marital deduction for Estate Tax purposes. The nuances of a QDOT are beyond the scope of this brief post because the requirements are rather technical and more importantly for you the reader, quite boring. However, a prior post is dedicated to this topic.   

There are many other types of irrevocable trusts. I focused on the above trusts because I see them in use most frequently.