Revocable vs Irrevocable Trust Structures

Trusts serve as foundational tools in estate planning, providing mechanisms for asset management, distribution control, and tax planning. The two primary categories—revocable and irrevocable trusts—differ fundamentally in terms of grantor control, tax treatment, and asset protection. Understanding these differences is essential for selecting the appropriate structure based on individual planning objectives.

Revocable Living Trusts

A revocable living trust (also called a revocable trust or living trust) is created during the grantor's lifetime and can be modified, amended, or terminated at any time while the grantor retains legal capacity.

Key characteristics:

• Grantor control: The grantor typically serves as trustee and maintains complete control over trust assets
• Modifiable: Trust terms can be changed at any time
• Revocable: The entire trust can be terminated and assets returned to the grantor
• Tax treatment: The trust is a "grantor trust" for income tax purposes; all income is reported on the grantor's personal tax return
• Estate inclusion: All trust assets are included in the grantor's taxable estate
• No asset protection: Creditors of the grantor can reach trust assets
• No gift tax implications: Transfers to a revocable trust are not completed gifts

Primary purposes of revocable trusts:

1. Probate avoidance for assets held in the trust
2. Privacy (trust terms are not public record)
3. Incapacity planning (successor trustee can manage assets)
4. Coordinated distribution of assets at death

A revocable trust does not provide estate tax benefits or asset protection during the grantor's lifetime.

Irrevocable Trusts

An irrevocable trust, once established and funded, generally cannot be modified or terminated by the grantor. The grantor permanently transfers assets out of their ownership and control.

Key characteristics:

• No grantor control: The grantor cannot serve as trustee and has no power to change trust terms
• Permanent: Trust terms are fixed at creation (with limited exceptions)
• Tax treatment: May be a grantor trust or non-grantor trust depending on structure
• Estate exclusion: Properly structured irrevocable trusts remove assets from the grantor's taxable estate
• Asset protection: Trust assets are generally protected from the grantor's creditors
• Gift tax implications: Transfers to the trust are completed gifts

Primary purposes of irrevocable trusts:

1. Estate tax reduction by removing assets and future growth from the taxable estate
2. Asset protection from creditors
3. Medicaid planning
4. Life insurance ownership (Irrevocable Life Insurance Trust)
5. Charitable giving strategies

2024 Estate and Gift Tax Framework

Understanding current exemption amounts is essential for trust planning decisions.

Federal estate tax exemption (2024): $13.61 million per person ($27.22 million for married couples using portability)

Federal gift tax annual exclusion (2024): $18,000 per recipient per year ($36,000 for married couples using gift splitting)

Federal gift tax lifetime exemption (2024): Unified with estate tax exemption at $13.61 million

Top federal estate tax rate: 40%

Important timing consideration: The current elevated exemption amounts are scheduled to sunset on December 31, 2025. Without congressional action, the exemption will revert to approximately $6-7 million per person (adjusted for inflation) beginning January 1, 2026.

Estate Tax Inclusion Rules

For assets to be excluded from a grantor's taxable estate, the irrevocable trust must be structured to avoid "incidents of ownership" that would cause estate inclusion under Internal Revenue Code sections 2036-2038. The grantor generally cannot:

• Retain the right to income from trust assets
• Retain the right to use or possess trust assets
• Retain the power to revoke, alter, or amend the trust
• Retain the power to control who receives trust assets or income

Careful drafting by an experienced estate planning attorney is essential to ensure the trust achieves its intended tax treatment.

Grantor Trust Status for Income Tax

Many irrevocable trusts used for estate planning are structured as "grantor trusts" for income tax purposes. This means:

• The grantor pays income tax on trust income (even though they don't receive it)
• Trust assets grow without being diminished by income taxes
• The grantor's payment of taxes is an additional tax-free gift to beneficiaries
• The trust assets receive a step-up in basis at the grantor's death (for grantor trusts)

This intentional "defective" grantor trust status (Intentionally Defective Grantor Trust or IDGT) combines estate tax exclusion with income tax benefits.

Asset Protection Considerations

Revocable trusts: Provide no asset protection. Because the grantor retains control and can revoke the trust, creditors can reach trust assets as if they were owned directly by the grantor.

Irrevocable trusts: Generally provide asset protection from the grantor's creditors, with important exceptions:

• Fraudulent transfer rules: Assets transferred to avoid existing or imminent creditors may still be reachable
• Self-settled trust limitations: Most states do not protect trusts where the grantor is also a beneficiary
• Timing: The trust must be established before creditor claims arise

Some states have adopted Domestic Asset Protection Trust (DAPT) statutes that provide protection for self-settled trusts under certain conditions.

Worked Example: $15 Million Estate Using Irrevocable Trust

Robert, age 60, has accumulated a $15 million estate and wants to minimize estate taxes while providing for his three children.

Current financial situation:

Total estate: $15,000,000

Scenario A: No trust planning

If Robert dies in 2024 without trust planning:

• Gross estate: $15,000,000
• Estate tax exemption: $13,610,000
• Taxable estate: $1,390,000
• Estate tax (40%): $556,000

If Robert dies after 2025 (assuming exemption reverts to $7,000,000):

• Gross estate: $15,000,000 (assuming no growth)
• Estate tax exemption: $7,000,000
• Taxable estate: $8,000,000
• Estate tax (40%): $3,200,000

Scenario B: Irrevocable trust planning

Robert creates an Irrevocable Life Insurance Trust (ILIT) and an Intentionally Defective Grantor Trust (IDGT).

Step 1: ILIT Creation

Robert establishes an ILIT and transfers $500,000 in annual exclusion gifts over several years to fund premium payments on a $3,000,000 life insurance policy. The death benefit will be excluded from his estate.

• Annual gifts to ILIT: $54,000 ($18,000 x 3 beneficiaries, using Crummey powers)
• Total premiums paid: $500,000 over 10 years
• Death benefit excluded from estate: $3,000,000

Step 2: IDGT Creation

Robert creates an IDGT and funds it with $4,000,000 of his investment portfolio.

• Assets transferred: $4,000,000
• Gift tax exemption used: $4,000,000 (from his $13.61 million lifetime exemption)
• Remaining exemption: $9,610,000

Step 3: Sale to IDGT

Robert sells an additional $2,000,000 of assets to the IDGT in exchange for a promissory note bearing the applicable federal rate (AFR) of interest. Because the IDGT is a grantor trust, this sale does not trigger capital gains tax.

• Assets sold to IDGT: $2,000,000
• Promissory note: $2,000,000 at 5% AFR (9-year term)
• Annual interest payments to Robert: $100,000

Projected estate tax results (assuming 6% annual growth):

After 15 years (Robert age 75), assuming 6% growth:

• IDGT assets (initial $6M): $14,362,000
• Assets in Robert's estate (original $9M minus estate spending): $8,000,000
• Life insurance death benefit (in ILIT, excluded): $3,000,000

If Robert dies at age 75:

Without planning (entire $15M grew at 6% for 15 years):

• Projected estate value: $35,949,000
• Less exemption (assume $7M): $28,949,000
• Estate tax (40%): $11,580,000

With planning:

• Estate value: $8,000,000
• Less exemption ($7M): $1,000,000
• Estate tax (40%): $400,000

Estate tax savings: $11,180,000

Additionally, children receive $3,000,000 in life insurance proceeds (tax-free) and approximately $14,362,000 in IDGT assets (also estate-tax-free).

Common Irrevocable Trust Types

Irrevocable Life Insurance Trust (ILIT): Owns life insurance policies to exclude death benefits from the insured's estate.

Intentionally Defective Grantor Trust (IDGT): Removes assets from the estate while allowing grantor to pay income taxes (an additional tax-free gift).

Grantor Retained Annuity Trust (GRAT): Grantor receives annuity payments; remainder passes to beneficiaries at reduced gift tax cost.

Qualified Personal Residence Trust (QPRT): Transfers residence to beneficiaries at reduced gift tax value while grantor retains right to live in home.

Spousal Lifetime Access Trust (SLAT): Irrevocable trust for spouse's benefit that removes assets from both spouses' estates while maintaining indirect access.

Charitable Remainder Trust (CRT): Provides income to non-charitable beneficiaries with remainder to charity; offers income tax deduction and estate tax benefits.

Choosing Between Revocable and Irrevocable Trusts

Trust Planning Checklist

• Calculate your current estate value and projected growth
• Determine if your estate exceeds or will exceed the estate tax exemption
• Consider the impact of the 2026 exemption reduction on your planning
• For probate avoidance only, evaluate whether a revocable trust is sufficient
• For estate tax reduction, consult with an estate planning attorney about irrevocable options
• If using an irrevocable trust, select the appropriate structure for your goals
• Ensure irrevocable trusts are properly drafted to avoid estate inclusion
• Consider grantor trust status for income tax efficiency
• Fund trusts properly—unfunded trusts provide no benefits
• Review trust structures with a qualified tax advisor
• Coordinate trust planning with beneficiary designations on retirement accounts
• Review and update estate plans in light of changing tax laws
• Consider timing of gifts before potential 2026 exemption reduction