Question

Suppose you are a CPA, and your client has requested advice regarding establishing an irrecovable trust for his two (2) grandchildern. He wants the income from the trust paid to the childern for 20 years and the principal distributed to the childern at the end of the 20 years. Based on the above scenario, write one to two (1-2) page client letter analyzing: 1) The effect of an irrevocable trust on the gift tax and future estate taxes for your client. 2) Suggest other significant alternatives that your client could use both to reduce estate tax and to maximize potential advantages of the payment of gift taxse on transfers of property. 3) provide recommendation for your client.

Answer 1

What is an Irrevocable Trust?
An irrevocable trust is a trust created by an individual that cannot be revoked, altered, or amended.
Gifting Issues
Each individual is allowed to give $14,000 each year to whomever they choose without incurring a gift tax, as long as it is a present interest gift.
Present interest gifts: A present interest gift is a gift of property where the recipient has the power to immediately receive the money.
Example 1: You give your daughter $14,000, and she can use it however she wants. Congratulations, you’ve just made a present interest gift.
Example 2: You give $14,000 to an irrevocable trust. The irrevocable trust says your daughter gets the money when you die (that would be the future). Oops, you did not make a present interest gift! It’s only a present interest gift if the recipient can use the money in the present.
“Crummey” Powers: The IRS, based on the Crummey v. Commissioner case, allows the present interest requirement to be satisfied as long as the beneficiary has a present interest right to withdraw the gift, even if the beneficiary refuses to do so. That’s why you’ve probably heard of “Crummey” letters or “Crummey” powers.
How it works: You give $14,000 to an irrevocable trust. The irrevocable trust says your daughter gets the money when you die. The trustee of the irrevocable trust sends your daughter a letter (a “Crummey” letter) informing her that you’ve given $14,000 to the trust and that she has 30 days (this can vary) to withdraw the money if she chooses. Even if your daughter doesn’t take the money, the fact that she could have if she wanted to is enough to constitute a present interest gift. If the 30 days lapses and she hasn’t taken the money, she forever loses access to the money (until you’re dead anyway). Because of the withdrawal right, the gift is not subject to tax. Hooray!
What are the advantages of an Irrevocable Trust?
Estate tax savings: Assets held in an irrevocable trust are not included in the grantor’s (the person who set it up and funded it) estate, thus escaping estate taxes (more on this under “ILITs”).
Creditor protection: Because the grantor no longer controls the assets held in the irrevocable trust, creditors cannot reach it (there are exceptions).
What are the disadvantages of an Irrevocable Trust?
Loss of control: You lose control over any asset you place in an irrevocable trust. The only way to revoke an irrevocable life insurance trust is to stop gifting the money to the trust. Without the annual gift, the trustee will not be able to pay the premium, and the policy will lapse. Other assets are not so easy (often impossible) to make “go away”.
The 3 Year Rule: If you gift life insurance to an irrevocable trust and die within 3 years, the proceeds will be brought back into your estate and taxed (more on this later).
The 5 Year Rule: If you gift assets to an irrevocable trust and need Medicaid within 5 years because your assets have dropped below the Medicaid asset limit ($2,000 in most states), you have to re-pay all transfers to the trust over the last 5 years – dollar for dollar – by paying for nursing home costs privately. Once you have “paid back” all of your gifted assets from the last 5 years, you become eligible for Medicaid.
Cost: In addition to the initial fee to set up the trust, there may be an ongoing fee owed to the trustee for managing the assets. There may also be accounting costs associated with tax returns, etc.
How do most people use Irrevocable Trusts?
Any type of property can be put in an irrevocable trust. However, many individuals like to transfer insurance into an irrevocable trust or purchase insurance using an irrevocable trust.
How are Irrevocable Trusts used to shelter life insurance?
The ILIT: The sheltering of life insurance through the use of irrevocable trusts has become so common that this type of trust has acquired its own name, the “ILIT” (irrevocable life insurance trust). It’s the same thing as an irrevocable trust; the term ILIT is just used to characterize an irrevocable trust established to shelter life insurance death benefits from estate taxes.
Taxes: It is commonly known that insurance proceeds are not subject to income tax. However, most people do not realize that insurance proceeds are subject to estate tax.
Tax avoidance: If life insurance is transferred to or purchased by an irrevocable trust, the proceeds will not be subject to estate tax.
Example: Dilbert is in the 45% estate tax bracket and owns a $1,000,000 term life insurance policy. On Dilbert’s death, his estate will owe $450,000 of the $1,000,000 of insurance to estate taxes. If Dilbert had set up an irrevocable trust, he could have either transferred the insurance to the trust or the trust could have purchased the insurance. Either way, the life insurance would have gone to the beneficiaries estate tax free on his death, saving his heirs $450,000.
Control issues: When you transfer an asset to an irrevocable trust, you no longer own or control that asset. This can be bad.
Example: Let’s say you have $300,000 and a $250,000 life insurance policy, and you transfer $100,000 (of real money) to the irrevocable trust. You go on a spending spree, and then the stock market crashes, which is where you have most of your money. You want to get to the $100,000 that you put in your irrevocable trust because you’re broke and need the money. Too bad. It’s not yours; it’s owned by the trust and will be distributed according to the rules of the trust (most of the time this means your kids will get the money when you die). Now, let’s say you had transferred the life insurance to the irrevocable trust instead of the $100,000 of real money. Even if you go broke with your “real money,” the life insurance policy is of little value to you, so you really don’t care if you can’t access it (with the exception being significant cash value in your life insurance policy).
Liquidity: Estate taxes are due in cash (the IRS doesn’t want the family business or your card collection). Often, people who owe estate taxes don’t have the money needed to pay. In such cases, the beneficiaries may be forced to sell the family business or another family asset in order to pay the tax bill. Because insurance is paid in cash relatively quickly, it is often used to pay the bill. By holding the insurance in the irrevocable trust, you can escape taxes on the proceeds you need for liquidity purposes.
Leveraged gifts: The value of a gift to an irrevocable life insurance trust is the amount of dollars transferred to the trust to purchase the life insurance. If the gift is a life insurance policy already in existence, the value of the gift is the terminal reserve value of the policy as determined by applicable tables. Either way, the gift is likely to be much less than the death benefit. Usually, the gift is small enough to escape gift tax while at the same time removing the large death benefit from the estate. A very small gift in real dollars becomes a much larger gift because it is leveraged into a much larger death benefit.
Example: You give $14,000 to a trust. When you die, the $14,000 goes to your beneficiaries tax free. Now, let’s say instead you give $10,000 to a trust, and the trustee uses the money to purchase a $250,000 life insurance policy. On your death, the whole $250,000 passes to your beneficiaries tax free.
The 3 Year Rule: If you transfer a life insurance policy to an irrevocable trust and die within 3 years of the transfer, the proceeds will be included in your estate. In other words, you will be taxed on it as if it was never in the irrevocable trust at all. There are 2 ways to get around this problem. First, you can do your best to survive the 3 years. If you do, your beneficiaries will inherit the proceeds tax free. Second (and the more sensible option), you can set up an irrevocable trust and transfer money to the trust. The trustee can then purchase the life insurance. If the trust purchases the life insurance, the 3 year rule does not apply. If you die the day after the insurance goes into effect, your beneficiaries will inherit the proceeds tax free.
Incidents of ownership: Even if insurance is held by an irrevocable trust, the proceeds will be pulled back into your estate if the IRS determines that you held incidents of ownership in the policy. If you have “incidents of ownership,” it basically means that you have sufficient control over the life insurance policy. For example, if you have the ability to change a beneficiary or cancel or assign the policy, the IRS may find that you have incidents of ownership in the policy. If that is the case, the proceeds will be brought back into your estate for estate tax purposes. It is critical that the irrevocable trust allows the trustee to act independent of your control.
Second to die insurance: This is a life insurance policy on two lives, usually those of a husband and wife. The policy does not pay out until the death of the second spouse (which, conveniently, is when estate taxes are due). Because the policy is on two lives, the premiums are usually spread out over a longer period of time. This type of insurance is well suited for an irrevocable life insurance trust.
Differences between Revocable and Irrevocable Trusts
An Irrevocable Trust is IRREVOCABLE: A revocable trust can be revoked, changed, amended, or altered during the grantor’s lifetime. An irrevocable trust can never be revoked, changed, altered, or amended (except by court order).
Gift taxes: Transfer of assets to a revocable trust are not subject to gift taxes. A transfer to an irrevocable trust over a certain threshold may be subject to gift tax.
Creditor protection: Assets in a revocable trust are not protected from creditors. Assets held in an irrevocable trust are protected from creditors (unless it was a fraudulent transfer).
Estate taxes: Assets held in a revocable trust are included in the grantor’s taxable estate (however, the grantor can reduce or eliminate the estate tax by using bypass trust planning). Assets held in an irrevocable trust are not included in the grantor’s taxable estate (passing to the grantor’s designated beneficiaries free of estate tax).
Tax filings: A revocable trust does not require a separate tax identification number or tax return. The grantor of a revocable trust simply treats all of the assets of the trust as his or her own income for tax purposes. An irrevocable trust requires a separate tax identification number and may require an income tax return.

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