What is an Irrevocable Trust?
To put it very simply, an irrevocable trust agreement is a contract which creates a new person and whereby the Trustee has absolute control and authority over the new person. This new person under Pennsylvania trust law, or "grantor" has no legal right to recover assets from the irrevocable trust, therefore the assets, which are considered "out of the pocket" or "off the rosters", removed from the grantor. Irrevocable Trusts are generally used to either save money from the claims of creditors or for purposes of qualifying for Medical Assistance for nursing home care in Pennsylvania and other Medicaid benefits. While the trust is irrevocable, there are a number of techniques in having some back doors in order to either retrieve funds or obtain some money for the grantor.
Because the Grantor has no authority over the assets of the Irrevocable Trust and has effectively removed the trust assets from his/her estate, it is necessary then to have an individual who acts as the Trustee. The Trustee may not be the Spouse of the Grantor , but may be the spouse of a Trustee if it is a Co-Trustee arrangement. It is common to set up a bank account that will have both the Trustee and Grantor as joint signers; this is something that works for most bank protocols. The Trustee is subject to the laws of Pennsylvania Trust Law as well as the terms and provisions of the trust agreement.
The Trust can be broken down Basically, an Irrevocable Trust can be created by the Grantor in a few different ways, but the basic principles underlying an Irrevocable Trust are:
- Name the Grantor as the Grantor
- Name a person to act as trustee with full authority to manage the trust assets and possibly name a successor or Co-Trustee if necessary.
- Name a beneficiary or someone who should benefit from the trust during their lives.
- Make the trust irrevocable for either the entire life of the trust or just for a certain period of time such as the grantor’s life.
- Distribute the trust property either at the end of the term or when certain conditions are met, such as reaching a certain age or the proper stage of education.
- Allow the beneficiaries after the death of the Grantor the right to continue the trust under the Pennsylvania Principal and Income Act or similar such provisions.
- Plan for the ultimate distribution of the trust property to the beneficiaries.
Key Features of Pennsylvania Irrevocable Trusts
Unlike revocable trusts, an irrevocable trust cannot be changed after it has been created. When the trust is created by the Trustmaker and he or she also serves as Trustee, the Trustmaker can make changes (amendments) to the trust contract as long as he or she is living. Irrevocable trusts can only be changed by court order. More often than not, an irrevocable trust, once created, cannot be changed unless certain events occur. For example, divorce or the death of a spouse.
In Pennsylvania, the law at 20 Pa.C.S.A., Section 7746 defines the powers and duties of the Trustee of an Irrevocable Trust, and those powers and duties may not be modified. The exception to this rule is if the Trustmaker is also a Trustee on the Trust, the Trustmaker’s control and authority over the direction or interest in the property may be modified by the Trustmaker’s directions in writing or expressly authorized in the Trust Contract.
If an Irrevocable Trust has been created by a deceased person you are likely dealing with a Pennsylvania Trust in a probate estate. All assets in an Irrevocable Trust have to be accounted for either on the estate inventory list, or a separate accounting must be filed with the Orphans’ Court. The Executor should request a copy of the annual accounting for the period of the decedent’s death and those annual accountings should be verified at the same time the estate’s accounting is examined.
Benefits of Establishing an Irrevocable Trust in Pennsylvania
Setting up an irrevocable trust can yield a host of benefits. Irrevocable trusts enjoy asset protection, tax benefits and can play a role in sound estate planning.
One of the primary benefits of an irrevocable trust is asset protection. Once the assets are transferred into an irrevocable trust, they are no longer considered owned by the grantor, or the person establishing the trust. This means that the assets cannot be pursued by creditors and are protected from further taxation.
Many individuals setting up irrevocable trusts are concerned that they will lose access to the assets. In theory this is true, but once you have transferred property into an irrevocable trust, you cannot have your cake and eat it too. If you retain access and control over the assets in the trust, this will be considered "pulling them back into your estate" and they will be available to creditors and taxation.
Aside from straight asset protection, there are specific reasons why some people would want to consider asset protection for their home or their personal assets. Medicaid planning is often the most significant reason why individuals choose to establish an irrevocable trust, particularly for married couples. Medicaid, or medical assistance, is a government program that pays for medical care even after personal assets have been depleted. However, to be eligible for this aid, a person must meet strict requirements. One requirement is that the person be under a certain income level. In addition, you must not own any non-exempt property, such as your home or non-IRA accounts over $2,000.
By transferring your assets into an irrevocable trust you are deemed to have given them away. As a result, you no longer have ownership of less than $2,000, your home and your IRA accounts. Under current Pennsylvania Medicaid laws, these assets are protected from seizure by the government. If you are aware that you will need Medicaid assistance within 5 years, you can very strategically transfer assets into an irrevocable trust to increase your eligibility for Medicaid assistance.
Irrevocable trusts also have specific tax benefits, both for estate taxes and income taxes. When an irrevocable trust is established, the assets are transferred out of the grantor’s estate for purposes of estate tax. This means that they are not subject to any future estate tax consequences after the grantor’s death. However, many people prefer to retain control over their assets and do not want to relinquish that control during their lifetime. Unfortunately, to take advantage of an irrevocable trust for estate tax purposes, you must give up that control.
A potentially more lucrative result of transferring assets into an irrevocable trust is income tax savings. Once assets are transferred into an irrevocable trust, the income from those assets will no longer be taxed on the grantor’s income tax returns. Instead, the irrevocable trust will be taxed separately. The marginal tax brackets on trusts are much less than the individual taxpayer tax brackets. This is advantageous for the grantor of the trust, particularly if the grantor is earning $250,000-500,000 per year. Once income generated from the asset is taxed to the irrevocable trust, the trust must now pay capital gains taxes on future appreciation of the asset. This is a downside, particularly if the property has already appreciated in value. For this reason, irrevocable trusts are popularly used in combination with life insurance, so that the grantor does not give up that control of the asset if it is debt-producing. Irrevocable trusts are used to hold the life insurance policy, so that the income generated from the insurance is taxed to the trust directly.
Because irrevocable trusts are separate taxpayers, estate planning becomes much more complicated. Forms 1041 are required to be filed for the irrevocable trust in the years after the grantor’s death, but "distributable net income" must be calculated. The trustee must determine whether the trust will receive a deduction for the income it generates, or the income must be distributed elsewhere, like debt servicing on property held in the name of the trust. Trustees will need to consult an experienced tax advisor to determine how the NET INCOME is taxed.
Challenges and Limitations
Generally, the principal drawback of an irrevocable trust is that once the client has executed the trust, he can no longer serve as trustee or retain any control over the assets in the trust. The trust generally cannot be amended or revoked and the original trust maker cannot receive any benefits from the trust assets.
An additional downside involves what can occur when the client’s interests changes. For instance, B has four children he wishes to provide for after his death. Prior to the execution of the trust, all of his children have considerably higher and lower incomes than each other. However, as his children progress into their late 20s and early 30s the income levels of all four children even out among one another. Therefore, B believes that distributing equal amounts to each child will better serve their changing needs. However, he cannot amend the trust to change his provisions.
There are also complicated decisions to be made when determining the type of irrevocable trust to use and the timing of funding the trust. There could also be unforeseen adverse tax implications, which again is why it is necessary to seek the advice of an experienced attorney and accountant prior to creating any irrevocable trust.
Additionally, if a trust does not meet certain requirements, it can lead to some dramatic and costly tax issues. Some irrevocable trusts even become unintentionally included in the taxpayer’s gross estate due to a provision that allows the grantor to retain important powers or interests.
Legal Process of Setting Up an Irrevocable Trust
The process of setting up an irrevocable trust in Pennsylvania will be based upon the particular facts and types of assets to be held in the trust. However, for most situations the process will involve at least the following steps.
Information Gathering
The first step in establishing any trust, including an irrevocable trust, is to gather information about the client (the Granter or Trustor) and the beneficiaries of the trust. In some cases, such as where special needs are involved, the type and age of the beneficiaries may have a major impact on how the trust is established. Spousal issues are also often critical, particularly in the case where the Granter has remarried, but has children from a previous marriage. The attorney may also ask about the attorney’s age, health, etc., for determining when the trust should be funded and when it may be appropriate to transfer assets to an irrevocable trust.
Clients may be asked to provide asset information, not just to assist in drafting the proper document, but also to obtain a preliminary value of the estate and determine the likely estate tax exposure. Clients are generally asked for a one page schedule of assets before the initial meeting, as this assists the lawyer in determining what type of trust is best for the client. Finally, the attorney will usually ask whether the Granter is acting as his or her own trustee or whether a family member or friend will act in that capacity.
Signing and Funding the Trust
After the estate planning process is completed, you and your attorney will determine when to set up the trust. In many situations the document is prepared and executed on a "word processor" basis (the attorney initials the trust draft, and after the client approves the trust is signed). In other situations, the trust plans may be more complicated (for tax purposes, for example) and the planning may involve drafting, receiving comments and revisions, and repeating that process until the proper document is completed. Several revisions and reconstructions of the trust may be required before the document is ready to be signed.
The Schedule of Assets attached to a Pennsylvania Irrevocable Trust usually includes a provision that some assets from time to time may be transferred into the trust. That may involve assets that already owned, or assets that the Grantor will acquire in the future. It may also include the ability to add beneficiaries to the trust so that there is flexibility for tax planning purposes.
Revoking and Amending an Irrevocable Trust
In certain limited circumstances, an irrevocable trust can be modified or even revoked in Pennsylvania. The leading case in Pennsylvania is Hirt v. Hirt, 82 A.2d 528 (Pa. Super.Ct. 1951). Hirt addresses the question whether a court can modify the terms of an irrevocable trust to correct a mistake.
The Pennsylvania Superior Court said that a mistake in the terms of a trust document, either resulting from inadvertence or ignorance, may be rectified by a court of equity, where the intention of the testator is clear and can be clearly and unmistakably followed. The court must be careful to make no alterations or changes in the instrument which would create a power in the settlor to repudiate the trust or to inject into the trust any features and powers not contemplated in the terms of the document as executed. See also Ryan Estate v. Bank of Pennsylvania, No . 1935 WDA 2010, 2013 WL 3863239 at *8 (Pa. Super.Ct. July 29, 2013)(court found that it had power to order modification or termination of irrevocable trust where settlor’s intent was clear).
The Restatement (Third) of Trusts § 66 (2003), which has been adopted in part by Pennsylvania, holds out the possibility of modification of an irrevocable trust with consent of the trustee and all the beneficiaries. The Restatement specifically provides that the interest of a creditor may be transferred to a beneficiary.
The Uniform Trust Code § 412(a)(2), which has not yet been adopted in Pennsylvania, does permit modification with the consent of the trustee and all the beneficiaries, and permits a court to modify the terms of a trust with the consent of the trustee and all the beneficiaries even if the modification is inconsistent with a material purpose of the trust.
Comparing Irrevocable and Revocable Trusts in Pennsylvania
The comparison between irrevocable and revocable trusts is most likely a major issue when clients approach the subject. When you hire an attorney to draft an irrevocable trust on your behalf, the attorney may suggest that the revocable trust would help achieve your goal. However, what are the actual benefits and drawbacks of each? Do you really need to create an irrevocable trust? Is a revocable trust enough?
It is crucial to understand the basic difference between the two trusts. A revocable trust can be terminated by the Individual who creates it. Whereas an irrevocable trust is created to be permanent and the grantor cannot change any terms or beneficiaries of the trust. Below you will find a breakdown of the benefits of both irrevocable and revocable trusts.
One major benefit of establishing a revocable trust is the income tax benefits. It is assumed that income from a revocable trust is considered taxable to the grantor for five years. This income includes interest, dividends and capital gains. In Pennsylvania, a revocable trust is reported to the Department of Revenue on the personal income tax return of the grantor. The revocable trust assets will not have to be reported on the inheritance tax return because they are included as part of the estate of the grantor.
Although the grantor must pay income tax on all distributions from a revocable trust, there is one major disadvantage. The grantor cannot take distributions out of an irrevocable trust. Therefore, there are no income tax implications of tax distributions from an irrevocable trust since all distributions are subject to taxation to the beneficiary, not the grantor. All income, which is earned by the assets in the irrevocable trust, is distributed to the beneficiaries. If the beneficiaries are receiving an income distribution then the tax will be paid at the beneficiaries’ income tax rate.
Besides the income tax benefit of a revocable trust, the other major advantage is that in Pennsylvania real estate is excluded from the calculation of the Inheritance Tax. A revocable trust is not required to file an Inheritance Tax Return. Pennsylvania trust law does not address which portions of the trust can and cannot be excluded. The Compensation Bureau of Revenue (CBR) has ruled to use the value of the real estate portion of the trust to determine the allowed real estate exclusion. The CBR does allow for the deduction of the full value of the real estate held in the trust.
By creating an irrevocable trust, you lose the ability to terminate such trust. This means that you are essentially taking your assets and placing them into a box that cannot be opened. The benefit of the irrevocable trust is that income tax planning and asset protection are achieved.
If you want to protect assets from the cost of healthcare within the confines of a nursing home or skilled nursing facility, the irrevocable trust is the best choice. If the assets are structured properly, the grantor is not entitled to any distribution from the trust. This also means that the grantor may not face any liability if a lawsuit is filed against him.
When reviewing Pennsylvania irrevocable trust law, it is crucial to make sure that the new assets may still qualify for the exclusion from taxation for an inheritance tax. An irrevocable trust can allow for the exclusion of values not exceeding $350,000. If the block of real estate in an irrevocable trust exceeds $350,000, then you risk the total amount placed in the trust becoming taxable.
Expert Tips for Effective Trust Management
One of the most common complaints that arise with irrevocable trusts is the complexity involved in administering those trusts. Most of the tips below are written with the goal of making trust administration more straightforward.
Tip: Trusts Need to be Inventoried
Tip: Use a Trust Ledger
Since trustees are ultimately responsible for any tax liability associated with the trust, it is exceedingly important to ensure that everything is above board. Keeping accurate records is essential, and having a ledger for the trust and all transactions is recommended. The trust ledger should start with the value of assets and liabilities, and show anything that might be added or subtracted.
Tip: Follow the Terms of the Trust
Every irrevocable trust has specific terms that must be followed when carrying out the functions of the trust. If a trustee does not follow the trust terms, they are in violation of the law.
Tip: Have a Back-Up Plan
If something were to happen to a trustee, the responsibilities would likely fall to a family member or trusted friend. It is important that original trustees keep relevant information about the trust in a safe place that is easily accessible by whomever would be left in charge.
Tip: Always Enlist an Accountant
All actions related to an irrevocable trust must be monitored by an accountant, especially if the trust is meant to generate income that would be taxable. In that case, the trust needs to file a federal income tax return. No matter the size of the irrevocable trust, finding the right accountant is key.
Tip: Utilize Help from Pennsylvania Trust Lawyers
Seeking legal advice from Pennsylvania trust lawyers is always a good idea. An attorney can help an executor determine whether or not he or she is fulfilling all legal duties.
Common Misconceptions About Irrevocable Trusts
One of the reasons we did an entire blog series on Pennsylvania irrevocable trusts is that there are so many misconceptions regarding them. Below we outline some of the most common one’s we hear from clients and that regulators see frequently:
Irrevocable = not able to be changed or amended. In actuality, irrevocable means not able to be changed, without the consent of all persons with a vested interest. For example, if Mom created an irrevocable trust and named Dad as a beneficiary along with her children and grandchildren, Dad must consent to any modifications of that trust. However, you can create additional irrevocable trusts later on that can handle future transactions as circumstances dictate.
Thinking that by transferring assets into an irrevocable trust the creator has given up the ability to control those assets afterward. This is not true. Clients can be named trustee of their own irrevocable trust, or can name a corporate trustee to do so on their behalf . In either event, the client can maintain the ability to make investment decisions and maintain a level of control over the assets.
The fear that creating an irrevocable trust will limit how much the creator can receive from the trust. The opposite is usually true. Pennsylvania law provides a mechanism to allow the creator to withdraw principal and interest from an irrevocable trust without losing the benefits of it being irrevocable.
Similarly, the misconception is that if you get all principal from your irrevocable trust there’s nothing left for the beneficiaries. Again, Pennsylvania law provides the option to provide your beneficiaries with their own withdrawal rights when the principal is withdrawn that will not disturb the principal.
When creating an irrevocable trust, the points above are vocalized and understood to avoid inconvenient surprises down the road.
