Revocable Trust vs. Irrevocable Trust

A trust: what is it?  You may know you need one but you are not certain what kind you need. Don’t get frustrated. There are really only two types:

  1. Living revocable trust
  2. Irrevocable trust

These are very different legal animals. When someone talks about a “family trust” they are usually referring to a the living revocable trust that they set up for probate avoidance and privacy. It is the most common type. It can be revoked at anytime and is not taxed as a separate entity. This also means that it isn’t going to provide any asset protection. When an attorney is planning to sue you, if he sees the words “family trust” he knows that the assets held in it are almost guaranteed to be available for the taking.

An irrevocable trust gives its owners lots of asset protection. It can never be revoked and has its own tax number. If you are sued they can’t get the property held there. However, when you put property in this type of vehicle, you are giving up ownership and control. Most Americans like to maintain control, so they opt for the living revocable trust.

A living revocable trust can be formed under a number of different names, such as a loving trust, family trust, marital trust, land trust, etc. Often the attorney will include a person’s name as part of the trust’s name.  For instance, the name will read something like, “The John and Mary Doe Family Trust.” That actually tells you nothing about its legal structure, but it tells someone who is looking to find out what you own information that you do not need to give them.

I haven’t used the term “family trust” for years. Today, privacy is a major issue, and I advise clients to use an “odd” name. You can call the document anything you want. It is much more difficult to find you and your property if you call it the JMD Trust instead of using the John and Mary Doe Family Trust format. Including your name in the title provides a potential identity thief with too much information. Using a name like the “Pretty Tree” doesn’t give the identity thief any information about who the grantors or beneficiaries of the document might be. It also doesn’t tip your hand as to what type of vehicle it is.

I expect the term “family trust” to become rarer in the actual title of the document.

HOWEVER, there is a legal meaning for the term “family trust” that you should know. When one of these is established for a couple, and estate taxes are concerned, the document will be designed to create two parts, a “shelter trust” and a “marital trust.” Assets with a value up to the “exemption equivalent” (the amount of property that can be passed to heirs without an estate tax actually being payable) will be isolated in the shelter trust and the remainder of the assets will be held in the other part. The shelter trust is taxed at the death of the first spouse to die, and the rest of the assets are taxed at the death of the surviving spouse. Splitting the estate this way allows the couple to get more money out of the estate, tax free.

How to save on estate taxes is another topic that I cover in my book Protecting Your Financial Future.

Lee Phillips, JD

There are dozens of different types of trusts. Trusts are one of the most flexible tools that an attorney has. They have asset protection value, income tax planning value, estate tax planning value, and asset management value. However, no one trust is a universal solution to all of your needs.

The most popular trust is the living revocable trust. It is the trust that is used to avoid probate, help control estate taxes, and facilitate smooth asset management when the “owner” of the trust becomes incompetent or dies. (Yes, I know, all of the attorneys that are reading this just flipped out, because trusts don’t have “owners.” But, I am not writing this for the attorneys. Although, they might learn something by reading it.) We’re going to detail the establishment and use of the living revocable trust in this section of the website. Let me first overview the different types of trusts and explain the basic functions of trusts.

There are two basic types of trusts – irrevocable trusts and revocable trusts. The two types of trusts have very different purposes. The person who establishes the trust is called by a number of different terms – Grantor, Settlor, or Trustor. The terms are used interchangeably. (Attorneys get paid by the word, so they create lots of different words.) The person who manages the trust property is called the Trustee. The people who receive the benefits of the property put into the trust are called the Beneficiaries. One person can be the grantor, trustee and the beneficiary all at the same time. In fact, a trust that is revocable and has one person (or the same people) acting as grantor, trustee and beneficiary is a special type of trust called a “grantor trust.” The IRS gives grantor trusts special consideration.

Once an irrevocable trust is established, the grantor(s) can’t go back and revoke it or get rid of it. It’s “irrevocable.” They usually can’t change it in any major way. Irrevocable trusts are generally good asset protection tools, because the grantor is actually irrevocably giving up ownership of the property he or she places into the trust. They can’t get it back, so you can’t sue them and get it either. Because ownership is irrevocably given up, the trust becomes its own taxing entity. It has to get a tax ID number and file tax returns. Generally, the property put into the trust is being (for tax purposes) “gifted” to the beneficiaries, and it is removed from the estate of the grantor. Thus, the irrevocable trust can be used to do income tax planning, avoid estate taxes, and place assets out of the reach of the grantor’s creditors. However, when property is put into the trust there is a gift tax issue, because the grantor is “giving” the property to the beneficiaries. Some planner dudes forget about the gift tax consequences. The grantor usually isn’t a beneficiary of the irrevocable trust he or she establishes, because that would ruin the estate tax and income tax advantages of the trust.

The common trusts that are usually irrevocable include insurance trusts, children’s trusts, 2503 trusts, and sometimes land trusts. The common living trust used by most people for estate planning is never irrevocable. (Actually, the living trust changes its nature after the grantor dies, when it switches from a revocable trust to an irrevocable trust.) But, your living trust will be a revocable trust as long as you are alive. Land trusts are usually revocable.

Revocable trusts generally don’t secure any type of asset protection for the grantor(s). Because they are revocable, the grantor can revoke the trust and get the property in the trust back at any time. Thus, the creditors and lawsuiters of the grantor simply have to have the court order the grantor to get the property back and turn it over. Lots of people who are using a land trust think they are getting some asset protection value out of the trust. If it is a revocable trust, it doesn’t matter who the trustee or beneficiary is, the grantor’s creditors can get to it. There is no asset protection achieved by using a revocable land trust. Having said that, I can help a couple get some asset protection value out of the standard living revocable trust, but not the land trust.

The standard living revocable trust has a dozen different names: family trust, A-B trust, C-B trust, loving trust, etc. The attorneys and financial planning dudes all come up with a unique name for their trust, so that clients have to come to them to get the special trust. Yes, the trusts can we written differently, but they are all the same animal. Some are written in the finest of legal prose. Some have plain English. There are lots of bells and whistles (different legal provisions) that can be put into the trust, but they all operate the same and have basically the same results, that is IF the trust is written properly, and it is written with enough specificity to meet the goals of the grantor. It does have to have the basic parts and pieces written the way the courts and IRS want them written. I don’t know what the statistic is, but Fortune Magazine awhile back reported that only 1% of American lawyers know how to draw a good living revocable trust. You don’t want one of the Legal Doom trusts you get off the internet. They are written for the lowest common denominator of society, and I’ll bet you are far enough above the lowest common denominator that those trusts won’t be what you expect or want.

You need to know enough about the trusts to make sure you are getting a good one. You also need to know how to use the trust once you get it. It isn’t just a paper you pay $5,000 for and then stick in a safe deposit box. You have to use it or it will not avoid probate and do the other tricks that you were told it would do. Attorneys never teach you how to use the trust, because if they don’t, then they get the big bucks for setting up the trust and they get to clean up the probates and other messes that occur, because the trust didn’t perform as advertised. A high percentage (like over 80%) of the families that get a living revocable trust go through probate just like everybody else.

There are lots of things the grantors of the living revocable trust have to do to make it sit up and bark as advertised. In my book, Protecting Your Financial Future, I go through all of the things you need to do to make the trust work for you. The procedures aren’t hard to follow, but you do have to change the way you think about your property. For example, you have to have the trust “own” your property that would otherwise be probated at your death. Ownership is a hard concept to deal with. Lots of older people are scared to death to “give up ownership” of their property. The living revocable trust will let you control the property, but you can’t own it.

When you were single, you owned your checking account as a single person with just your name on the signature card down at the bank. When you got married, the first thing your spouse said was, “Let’s put our names on the checking account as joint tenants.” The ownership of the account changed from you as a single to you as a joint tenant. The checks still cashed just the same and they bounced just as high when you ran out of money. To play the trust game, you now need to change the signature card on the account out of your names as joint tenants and make it so that the trust’s name is on the signature card as the owner. You and your spouse will sign as co-trustees on the account. Your signature on the check will be just the same as it has always been. The checks don’t need to be reprinted. They will cash just the same and bounce just as high as they did before the account was owned by the trust.

You have to change your mind set. You are not an individual. You are not a joint owner. You are now a trustee. You own nothing in your name. You don’t own anything any more. You simply control and use property owned by the trust. Your life style doesn’t change at all, but your mind set has to change, otherwise the trust won’t work. In Protecting Your Financial Future I go through how to get all of the stocks, bonds, cars, real estate, and other assets from your ownership into the trust’s ownership. I have seen attorneys make huge mistakes trying to change ownership. The mistakes have costs their victims (clients) tens of thousands of dollars in later years.

Avoiding probate using the living revocable trust is a legal trick. The trick has to be executed exactly right, or it doesn’t work, but when it works it is a beautiful thing. Families that use the trust avoid all of the stress and expense associated with probate. When you’re finished here, click over and read about probate on this site.

The living revocable trust can also help with estate taxes. I suspect that you either don’t have a will or if you do it is what is known as a “John loves Mary will.” In the John loves Mary will, everything has to be probated, and it is an estate tax disaster. Assume you die in the automobile accident. (It’s just an assumption. Don’t get excited.) Your will states that you love your spouse and everything you have goes to them. There isn’t any tax when you transfer property between a husband and wife, so the tax part of the equation is ok. There may or may not be a probate, depending upon how you owned your property. Most couples own the property as joint tenants. If you own everything as joint tenants, there won’t be any probate either, at least no probate until the second spouse dies.

Ok, assume your spouse dies twenty minutes later on the way to the hospital in the ambulance. Look what happened in twenty minutes. All of your property went from you to your spouse. The spouse now has everything. When the spouse dies, just twenty minutes later, everything will be going to the kids. After all, both your wills say all of the property goes to the other spouse, if they are alive, and if they aren’t alive then it goes to the kids. When the property goes to the kids, everything will be probated and it will all be subject to the estate tax. Estate taxes touch many families today, and in the coming years, many many families are going to lose a lot of money to the estate tax man. The amount of property that you can pass is going to be a lot less, so families that didn’t have to worry about the estate tax are going to get killed by the tax. The first dollar where you have to pay tax is taxed at 45%. That’s a heavy tax.

If your living revocable trust is written properly, a couple can get twice as much property down to the kids without an estate tax as they could with the John loves Mary will. The trust can literally give your family over $700,000 more than the John loves Mary will can. That’s a lot of money, and it is real money, not just phantom paper accounting stuff.

It is possible that you can have a trust “built into your will.” That type of trust is called a testamentary trust. It is actually described within your will document. It can get you the extra estate tax protection, just like the living revocable trust. However, it guarantees a nice probate for the lawyer. Lots of people think they have a living revocable trust, but they actually have a testamentary trust. You need to check and see exactly what type of trust you have, if you have one. If you don’t have a trust already, you need to get a living revocable trust. Learn about the trusts so you get a good living revocable trust and you can actually use it. Trusts really are a beautiful thing when they are done right.