Why An Irrevocable Trust Is Better than giving a Gift.

Why Use a Trust? Why Not Just Give the Money Away?

If someone is trying to protect assets and still qualify for long-term care benefits from the government, their strategy could be to gift away their assets to children or other family members. After the transfer, they apply for their benefits, or in the case of Medicaid, wait five years before applying.

This strategy poses a number of dangerous risks. The person who receives the assets could die, become estranged, get divorced, invest badly, spend the money, or even lose the money to creditors.

Consider that a long-term care crisis could bring about the need for assisted living. If the assets have been lost or spent, there may be no way to pay for care.

What is an Irrevocable Trust?

A trust is a fancy term for a three-party legal relationship. The trust involves the Settlor (person funding the trust), the Trustee (person managing the trust), and the beneficiaries (people who will receive the trust property).

When you create a trust you actually transfer ownership of property from yourself to your trustee(s). The trustee(s) then holds legal title to the property, the beneficiaries hold equitable title, and you, the Settlor, no longer have any title to the property. This is a significant step, especially where the trust is irrevocable.

Irrevocable means that once you create the trust, you can't undo the trust and get the property back without the consent of the trustee and the beneficiaries.

An Irrevocable Trust Could Have Many Advantages Over an Outright Gift Continued Control

The Settlor who creates and funds an irrevocable trust can establish the rules and determines the uses of the trust assets. The settlor can name the trustees and beneficiaries and retain the right to change beneficiaries through a power of appointment in the grantor’s will.

The Settlor can even choose to employ a Trust protector.  You can design a trust to have a third party "trust protector" (see Forbesmagazine: 8/25/2012 Trust Protectors), which is a position usually filled by a close relative overseeing the trustee. The protector has the power to change a trustee, remove a beneficiary, eliminate or reduce distributions, or even change the terms of the trust itself.

Retained Income

The settlor can decide to retain the income produced by the trust, even if there is no access to the trust principal. Receiving income tends to make the grantors feel like the assets still belong to them. This may ease their concerns about funding an irrevocable trust and losing the direct control of their assets.

Tax advantages

An irrevocable trust offers many tax advantages over a direct gift, especially on the subject of capital gains taxes. If the trust is structured as a grantor-type trust, all appreciated assets transferred into the trust, such as real estate or a stock portfolio, can still receive a step-up in basis upon the death of the grantor. If these same assets were gifted directly to the beneficiaries, they would retain the same basis as the donor had, and in most cases owe a great deal more in capital gains taxes.

This style of trust also provides a tax advantage for a grantor’s principal home. The trust retains the  grantor’s capital gains tax exclusion under 26 U.S.C. § 121, which would not be available if the residence was gifted directly to the beneficiaries during the lifetime of the owner.

Settlors can even set up their trusts so all of the trust income is tax deferred until the trustee distributes the income to beneficiaries. This can provide some incredible tax advantages to the grantor’s family.

Creative Options

Consider that you could designate your spouse as a "discretionary" beneficiary. The trust could be drafted so that a distribution could be made to your spouse when needed.

Another option would be for each partner to create a trust for the other. Each trust just has to have enough differences so that they aren't considered reciprocal.

Protection From Beneficiary Mistakes

Using a trust avoids the risk that a beneficiary could die and that the funds are inherited by the beneficiary’s heirs. It also protects the assets if the beneficiary loses money in a divorce.