What Are the Disadvantages of an Irrevocable Trust?

By Cindy DeRuyter, J.D.

What Are the Disadvantages of an Irrevocable Trust?

By Cindy DeRuyter, J.D.

Trusts are a common estate planning tool. Different types of trusts can help people meet different goals, including avoiding probate court, minimizing federal and state estate taxes, providing for the administration and distribution of assets after death, protecting assets for minor beneficiaries or people with disabilities, providing for children from previous marriages, and more. When a trust is irrevocable, it means the trust instrument cannot be unilaterally changed by the person creating the trust, called the "grantor."

Older couple looking over documents

There are potential advantages to using irrevocable trusts as well as some potential disadvantages, including a loss of control over trust assets and tax implications for both the grantor and the trust itself.

Limitations on Changes

Assets inside properly structured irrevocable trusts may avoid estate taxation when the grantor dies and may help protect beneficiaries' rights to receive government assistance. However, these benefits come with a significant trade-off because the grantor relinquishes control over, and rights to, assets placed into trust.

When the grantor signs an irrevocable trust agreement, the named trustee assumes control over trust property and is charged with administering and distributing those assets according to the terms of the agreement. For example, if a grantor transfers a life insurance policy into an irrevocable trust, the trustee will be the only person with rights to exercise policy options, make changes to the insurance policy, and maintain coverage.

With revocable trusts, the grantor has complete control to make changes to the trust agreement or to revoke the agreement in its entirety. That's not the case with irrevocable trusts. Changes after the agreement has been signed are generally limited to revisions designed to comply with future changes to the law. In some cases, it may be possible for a grantor to revoke or "decant" an irrevocable trust by court order. In other situations, the trust's beneficiaries may be able to unanimously agree to allow the grantor to revoke the agreement. However, grantors should never assume they will be able to undo an irrevocable trust.

Income, Gift, and Estate Tax Implications

Irrevocable trusts are separate legal entities for tax purposes with their own tax ID numbers. If the trust earns more than $600 in income in a tax year, the trustee must file and pay federal income taxes at the trust's tax rate. In addition to Internal Revenue Service (IRS) filings, the trustee may also need to file state income tax returns and distribute Beneficiary's Share of Income, Deductions, Credits, etc. (Schedule K-1 [Form 1041]) to each beneficiary of the trust.

Because irrevocable trusts are separate tax entities, transferring assets to this type of trust may also come with an obligation to file a gift tax return with the IRS or your state.

Finally, estate taxes may also be impacted. People often create irrevocable trusts as part of an estate tax planning strategy, but it is important for anyone doing so to understand IRS rules concerning transfers into irrevocable trusts. If you die within three years of transferring assets to your irrevocable trust, that property will come back into your estate for purposes of calculating your estate tax obligation. States with state-specific estate tax may also impose similar rules.

Irrevocable trusts can be beneficial, but it is important to understand all of the possible implications before establishing one. You may want to consult with an estate planning attorney licensed to practice in your state for information about whether an irrevocable trust makes sense for your situation.

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