Why Create an Irrevocable Trust?

Why would anyone make a trust they couldn't revoke? Typically, wealthy people create these trusts to shield their assets from taxes.

An irrevocable trust is one that can’t be changed or terminated (revoked) by the person who created it. (That person is called the settlor or grantor.) The settlor also gives up control over the trust assets.

In contrast, most trusts used for ordinary estate planning are "revocable living trusts," which people set up to avoid probate after their death. The settlor can amend or revoke that kind of trust at any time during your life. Its terms become irrevocable only after the settlor’s death.

Kinds of Irrevocable Trusts

Trusts that start out as irrevocable aren’t very common except among the wealthy. Lawyers have, however, invented many different kinds of irrevocable trusts to serve their rich clients.

For example, some people concerned about federal estate tax (which currently affects only about the top one-half of one percent of estates) create what’s called an "irrevocable life insurance trust" (ILIT). The trust owns a life insurance policy on the life of the settlor; that way, when the policy proceeds are paid out, they aren’t included in the settlor’s estate. A smaller estate means a smaller estate tax bill for the surviving family.

Tax avoidance is the goal of many irrevocable trusts, but not all. Some irrevocable trusts are designed to shield assets from creditors, pass on a family business while minimizing taxes, or keep a spendthrift child from running through an inheritance. Some so-called "dynasty trusts" are designed to last for generations, preserving and increasing family wealth without allowing the settlor’s descendants to get their hands directly on the money.

The settlor, in the document that creates the trust, sets out the terms under which trust assets are to be managed, invested, and spent. The trust document also names a trustee to do that managing and spending. Once the trust is operating, the settlor doesn’t have any further control over the trustee. A settlor who has control over the trust assets might be considered, for tax purposes, the owner of those assets—which in most cases is exactly what the settlor was trying to avoid by creating the trust.

When Revocable Trusts Become Irrevocable

A simple revocable living trust, which lets family members transfer the settlor’s property after death without probate court proceedings, starts out as a fully revocable document. The settlor can change it or revoke it completely at any time, for any reason (or no reason). In this way, it’s like a will—it doesn’t take effect until death and is revocable until then.

After the settlor’s death, however, the deceased person’s wishes must be honored. If the trust document names you as the successor trustee, then at the settlor’s death you take responsibility for the trust assets, and you must follow the settlor’s instructions as set out in the trust document. The trust is no longer revocable, and its terms can no longer be changed. Again, this is just like a will, which can be changed as long as the will-maker is alive.

Some trusts are split into two trusts—one irrevocable and one revocable—when a settlor dies. The most common example is the "AB" trust, often used by married couples to avoid estate tax at the second spouse’s death.   Spouses make a trust together. When one of them dies, the trust is split into two parts:

•      The survivor’s trust, which is revocable. Assets aren’t subject to estate tax because they pass to the surviving spouse, who is entitled to inherit any amount tax-free.

•      The bypass trust, which is irrevocable. Assets aren’t taxed because the amount of property in this trust is kept under the estate tax exemption amount.

Assets in the bypass trust don’t belong to the surviving spouse, though he or she is usually entitled (by the terms of the trust) to use them or collect any income they generate. When the second spouse dies, typically the bypass trust assets go to the couple’s children. They aren’t subject to estate tax because they were already taxed at the first spouse’s death.

For more information on the wide array of trusts available, see Do You Need a Living Trust or Other Type of Trust?

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