Revocable vs. Irrevocable Trusts

A living trust can be revocable or irrevocable, says Yahoo Finance’s recent article entitled “Revocable vs. Irrevocable Trusts: Which Is Better?” It is certainly true that not everyone needs a trust, and there are many different types of trusts you can establish. But, when considering a trust, clients need to consider the pros and cons of revocable versus irrevocable trusts.

Revocable Trust

A revocable trust is a trust that can be changed or terminated at any time during the lifetime of the trustor (i.e., the person making the trust). This means you could:

  • Add or remove beneficiaries at any time
  • Transfer new assets into the trust or remove ones that are in it
  • Change the terms of the trust concerning how assets should be managed or distributed to beneficiaries; and
  • Terminate or end the trust completely.

When you die, a revocable trust automatically becomes irrevocable and no further changes can be made to its terms.

The big advantage of choosing a revocable trust is flexibility. A revocable trust allows you to make changes and to grow with your needs. Revocable trusts can also allow your beneficiaries to avoid probate when you die.  Most clients use revocable trusts during their lifetimes, although they might establish irrevocable trusts for other people or to address specific circumstances.

However, a revocable trust doesn’t offer the same type of protection against creditors as an irrevocable trust. If you’re sued, creditors could still try to attach trust assets to satisfy a judgment. The assets in a revocable trust are part of your taxable estate and subject to federal estate taxes when you die, which is usually a good thing, but in some assets isn’t sufficient tax planning.  It also provides no advance asset protection for Medicaid.

Irrevocable Trust

An irrevocable trust is permanent. If you create an irrevocable trust during your lifetime, any assets you transfer to the trust stay in the trust. You can’t add or remove beneficiaries or change the terms of the trust.

Irrevocable trusts are commonly used for creditor protection or tax planning.  There are times, such as when considering long-term care Medicaid in a nursing home, or reducing the size of your estate for estate tax purposes, that you want the asset not in your name and out of your personal control.  The irrevocable trust can achieve that by having the trustee own it instead of you.

Irrevocable trusts created during your lifetime are often done in addition to a revocable trust so that you achieve the particular benefits of an irrevocable trust only for that property which needs the advantage.

Irrevocable trusts are more commonly something you set up to be effective at your death.  We’ve written extensively on this, but it is extremely common to leave your children’s inheritance to them in irrevocable trusts that set the rules by which they benefit from the trust and provide creditor and divorce protection to the beneficiary.  This also works with spendthrift beneficiaries and similar trusts are used when a beneficiary has a disability and is using government benefits.

See here for more:  https://galligan-law.com/how-do-trusts-work-in-your-estate-plan/  

It is worth noting that irrevocable trusts, despite their name, sometimes can be revoked, changed or you can remove property from them.

For example, irrevocable trusts might have a power of substitution allowing you to take out property as long as you put equal value property back in.  Irrevocable trusts can sometimes be revoked or changed by the agreement of all parties (including beneficiaries) although that doesn’t work if minors are involved.  Irrevocable trusts that are broken and no longer serve their original purpose can also sometimes be fixed by a process called decanting.  It involves creating a new trust and “decanting” the assets of the first into the second.

If you are using irrevocable trusts you are working with very sophisticated tax and creditor laws, so you’d have to check with your attorney if those options will fit with the trust you are creating.  It is also not something we like to rely on, which is one of the reasons irrevocable trusts are used less.

Speak with an experienced estate planning or probate attorney to see if a revocable or an irrevocable trust is best for you and your goals.

Reference: Yahoo Finance (Sep. 10, 2022) “Revocable vs. Irrevocable Trusts: Which Is Better?”

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Portability Elections: Update

A month ago I wrote a blog on portability, which is an estate tax concept in which a surviving spouse keeps the estate tax exemption of the deceased spouse.  That blog focused on what it is and its potential tax advantages for families.  See here for that article:  https://galligan-law.com/why-you-should-elect-portability/  

Incredibly, the IRS published a revenue procedure last Friday extending filing deadlines for estates which only need to elect portability to 5 years after death.  The time limit had been 2 years.

Previously, the IRS would consider an extension beyond the 2 year limit in private letter rulings.  Essentially, you could write to the IRS explaining why you would need more time or were unable to complete the return in 2 years, and the IRS would consider an extension.  Portability is sometimes so critical that many, many individuals made private letter requests for extensions past the 2 years.  The IRS indicated they received so many letter request that it placed a “significant burden” on IRS resources, so much in fact that the IRS extended the deadline to avoid the need for those letter requests.

You can find the full revenue procedure here:  https://www.irs.gov/pub/irs-drop/rp-22-32.pdf

Now, it is important to recognize this only changed the deadline for returns that are only filed for portability purposes.  If the decedent had sufficient assets so that a return was required (i.e. their assets met or exceeding their exemption), then it remains due within 9 months of death and not filing timely or paying timely could have serious consequences.  Accordingly, in all cases going forward you should assume the deadline in 9 months, but may have the option of up to 5 years.

The immediate advantage of this rule is it gives us more hindsight.  If you or someone you know lost a spouse in the last 5 years and they did not file an estate tax return, it might be worth considering.  Many people didn’t do this a few years ago because the exemptions were high.  They assumed that if the survivor’s exemption was going to be, say $10 million, then portability wouldn’t be necessary and they didn’t take steps to elect it.

However, currently Congress has not changed the estate tax law.  The exemption is still set to cut in half in 2026.  Further, COVID has disrupted the economy in a way that has negatively affected the market, but also lead to substantial growth in some industries and for some individuals.  So, whereas portability might not have seemed prudent 6 months after the death of a loved one, it might seem so 3.5 years after the death of a loved one.  Thanks to this new procedure, filing for portability is still possible.

Similarly, if you were in charge of an estate, either as an executor, administrator or trustee, it might be worth considering doing this as a prudent discharge of your duties. It would potentially assist a surviving spouse and ultimately lead to less tax for the family, and will avoid questions from beneficiaries about why you didn’t do it in the first place.

You can find the full revenue procedure here:  https://www.irs.gov/pub/irs-drop/rp-22-32.pdf

 

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Why you Should Elect Portability

Clients frequently have heard of the estate and gift tax, and have heard of the high exemption amounts.  The exemption is currently at a staggering $12.06 million, higher than it has ever been.  Many clients have also learned that for a married couple can double that exemption, so they have essentially $24 million combined. With these high exemption amounts, many clients ignore the estate tax or don’t believe it will be relevant for them.

However, it is important to recognize that a surviving spouse only gets the first spouse’s exemption by electing something called “portability.”  I’m going to talk about what portability, the process of electing it, and how it is beneficial even when your assets aren’t anywhere near the current exemption amount.  The recent article “It’s So Important to Elect ‘Portability’ For Your Farm Estate” from Ag Web Farm Journal describes it as well, specifically in the context of family farms.

When one spouse dies, the surviving spouse can choose to make a portability election. This means that any unused federal gift or estate tax exemption can be transferred from the deceased spouse to the surviving spouse.  This is why the second spouse may have $24 million.  They are electing to keep the first spouse’s exemption of $12 million, and have their own $12 million exemption.   It is critical to recognize, however, that it is not automatic, and that is where most married couples make a mistake.

The process of electing portability involves filing an estate tax return with the IRS.  In most portability cases, no taxes are due, but you must file a form to obtain the exemption.  Essentially, the process involves filing the return to show the IRS what the decedent’s exemption was, and that the surviving spouse will be entitled to it in the future.  In many cases where you are only filing to elect portability, the IRS has relaxed standards for describing and valuing assets which go to a surviving spouse.  They do this because in those scenarios, they recognize you are only filing to elect portability, and that the value of assets won’t be relevant as no tax will be due.

The time frame for filing the return varies based upon the case, but you should act quickly.  The standard due date is 9 months from death, although in some cases it can be extended up to 2 years from death.  That is especially helpful where the surviving spouse didn’t speak to an accountant or lawyer after the first spouse died, and they only learn about the benefit of portability long afterwards.

Before portability was an option, spouses each owned about the same amount of assets, or the amount of assets which would use up each other’s exemptions. They would then leave as much as possible to a trust for the spouse and potentially other family members designed to use as much of the first exemption as possible, because if you didn’t use it, it was lost.  This planning made sense, but also required more complicated estate planning that got you the same result as portability does now.  Once portability arrived we were able to simplify many estate plans that no longer needed this complexity of planning.

Here’s an example. A married couple owns assets jointly and their net worth is about $14 million. When the husband dies, the wife owns everything. However, she neglects to speak with the family’s estate planning lawyer. No estate taxes are due at this time because of the unlimited marital deduction between the two spouses.

However, when she dies, she owns $14 million dollars (or more based upon growth) and dies with an exemption of $12 million.  Her estate will pay the estate tax on the difference between the exemption and her assets.  That tax bill is about $800,000.

If the wife had filed an estate tax return electing portability when her husband died, her exemption would be $24 million, and no tax would be due.

Now, I said earlier that this will apply to more than just people with $24 million dollars.  The reason is the current exemption amount is set to return to its prior level of $5 million dollar indexed to inflation in 2026.  So, let’s go through that scenario again with updated, more realistic numbers.

Husband and wife own $14 million, everything goes to the wife when husband dies and wife doesn’t elect portability.  When she dies in 2026, her exemption is $6 million (this is an estimate based upon inflation).  So, the tax will apply on the difference between her $14 million and the $6 million dollar exemption.  That is roughly $3.2 million in tax.

With the exemption as high as it is now and with the expectation of it lowering in the future, portability is critical.  If husband died when the exemption was $12 million and wife elected portability, she would get both his $12 million exemption and her own of $6 million dollars.  The combined exemption of $18 million exceeds her $14 million in assets, and no tax is due.  It saved over $3 million dollars.

Hopefully this last scenario explains how timely this is.  We raise this issue in nearly every estate administration of a married couple as electing portability now is nearly perfect insurance against future estate tax.  It is worth considering in any case where the combined assets will be close to one person’s exemption, especially where more volatile assets such as insurance, businesses and real estate are involved as the market may value them higher than expected at the time of death.

An experienced estate planning attorney can work with the family to evaluate their tax liability and see if portability will be sufficient, or if other tools are necessary.  It is also worth discussing this with an attorney if you recently lost a spouse and want to take advantage of portability.  If estate tax is a concern for you, you may also want to review this article.  https://galligan-law.com/practice-areas/estate-tax-planning/  

Reference: Ag Web Farm Journal (April 18, 2022) “It’s So Important to Elect ‘Portability’ For Your Farm Estate”

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