In general, a trust is a legal arrangement that allows the person creating the trust to control how and when a beneficiary will receive assets. Here are the key players involved in a trust arrangement:
- Settlor. The settlor is the person who establishes the trust. The settlor gives his property to a trustee for the benefit of one or more beneficiaries.
- Trustee. The trustee holds and manages the settlor’s assets for the benefit of the beneficiaries. The trustee must act in accordance with the terms of the trust and North Carolina law.
- Beneficiary. The beneficiary receives distributions from the trustee of the trust. How and when the beneficiary may receive trust assets is up to the settlor.
Although trusts all have the same structure, they can be divided into two categories—revocable trusts and irrevocable trusts.
Here are four of the main differences between revocable trusts and irrevocable trusts:
The first main difference between revocable and irrevocable trusts is evident from the difference in names. One is revocable, and one is not. A revocable trust can be modified after execution and an irrevocable trust cannot.
A revocable trust usually contains language in the trust agreement giving the settlor the right to change, modify, or completely revoke the trust agreement after it is executed. This provides the settlor with a significant amount of flexibility. The settlor of a revocable trust is not locked into the initial terms of his or her trust agreement. A revocable trust can always be amended in part, or fully restated unless the settlor becomes incapacitated or dies, at which point a revocable trust becomes irrevocable.
On the other hand, an irrevocable trust is much less flexible. An irrevocable trust will typically contain language stating that it cannot be changed or modified once it is executed. Some terms of irrevocable trusts can be altered in limited situations, but irrevocable trusts generally cannot be modified.
The second difference between revocable trusts and irrevocable trusts involves ownership of trust property. While property titled into a revocable trust is owned by the revocable trust, ownership can be changed at any time. The settlor can change the terms of the trust itself at any time or simply, acting as a trustee, have full and unrestricted access to trust property. Because of this extraordinary level of control over a revocable trust, the law considers the settlor to be the owner of revocable trust property. A revocable trust is not considered a separate entity for tax purposes, or in the event creditors of the settlor are coming after his or her trust assets.
Due to the lack of control, a settlor has over an irrevocable trust, an irrevocable trust is considered an entity separate and apart from the settlor. An irrevocable trust will have its own tax identification number. Once property is transferred into an irrevocable trust, the trust becomes the owner of that property.
The third difference between revocable and irrevocable trusts is the degree to which each type of trust can protect assets from creditors. As mentioned above, the settlor of a revocable trust retains unrestricted control over trust assets. As a result, the trust assets are essentially owned by the trust in name only. If the settlor of a revocable trust is sued or files bankruptcy, the revocable trust assets are just as available to creditors as the settlor’s individually owned property that has not been titled into the trust.
An irrevocable trust is much better than a revocable trust when it comes to asset protection. The settlor of an irrevocable trust gives up control of the property inside the trust when the property is retitled. Thus, the settlor cannot access the property even if he or she wants to. What happens to irrevocable trust property is solely dictated by the terms of the trust agreement as carried out by the trustee. As a result, if a creditor obtains a judgment against the settlor of an irrevocable trust, the assets in the irrevocable trust should not be available to satisfy the judgment.
The fourth difference between revocable and irrevocable trusts is federal estate taxation treatment. North Carolina does not currently have a state-level estate tax. Currently, federal law provides an $11.7 million per individual, or $23.4 million exemption for a married couple before any estate tax is owed. In other words, under current law, a couple will not owe any federal estate tax unless the value of their estate is greater than $23.4 million. For couples whose estates are larger than this amount, or whose estates may grow over time to exceed either this amount or the anticipated future federal estate tax exemption amount, a trust could be a valuable estate planning tool to help avoid paying federal estate taxes. However, just any type of trust will not work, the trust must be an irrevocable trust.
Because a revocable trust can be modified, or even revoked, the IRS considers revocable trust assets to be part of your taxable estate. When you die, assets in a revocable trust will avoid probate, but will still be part of your taxable estate. Thus, a revocable trust will do nothing to help you avoid paying federal estate tax. An irrevocable trust, on the other hand, can help.
An irrevocable trust is a separate legal entity from yourself, an individual. This is why an irrevocable trust must obtain its own tax identification number. When the settlor of an irrevocable trust funds the trust, he or she makes a gift to the trust. In order to avoid paying gift tax on the transfer, the settlor should file a federal gift tax return electing to use some of his or her estate tax exemption. From that point forward, however, all growth in the irrevocable trust will not be subject to estate tax when the settlor dies. Thus, funding an irrevocable trust with assets likely to appreciate in value can be an excellent tax strategy for individuals and couples with taxable estates.