Irrevocable Trusts

An irrevocable trust is a trust arrangement that, once established, generally cannot be modified, amended, or terminated without the consent of the beneficiaries. This fundamental characteristic distinguishes it from revocable trusts and creates significant estate planning opportunities.

Key Characteristics of Irrevocable Trusts

Permanence and Control

When a grantor creates an irrevocable trust and transfers assets into it, they permanently relinquish ownership and control over those assets. The grantor:

• Cannot serve as trustee
• Cannot modify trust terms unilaterally
• Cannot reclaim transferred assets
• Must rely on the trustee to manage trust property

Estate and Gift Tax Treatment

The transfer of assets to an irrevocable trust constitutes a completed gift for tax purposes:

• Assets are removed from the grantor's gross estate
• Gift tax may apply at the time of transfer
• Future appreciation occurs outside the taxable estate
• The 2025 annual gift tax exclusion is $19,000 per donee ($38,000 for married couples who split gifts)
• The 2025 lifetime gift and estate tax exemption is $13.99 million per person

Types of Irrevocable Trusts

Irrevocable Life Insurance Trust (ILIT)

An ILIT is specifically designed to hold life insurance policies outside the grantor's taxable estate.

Key Features:

• The trust owns the life insurance policy, not the insured
• Death proceeds pass to beneficiaries free of estate tax
• Grantor makes gifts to the trust to pay premiums
• Three-Year Rule: If an existing policy is transferred to an ILIT, the grantor must survive three years from the transfer date; otherwise, proceeds are included in the estate

When to Use an ILIT:

• Estate exceeds or approaches estate tax exemption
• Need for liquidity to pay estate taxes
• Desire to provide tax-free inheritance to beneficiaries
• Business succession planning requiring insurance

Section 2503(b) Trust (Mandatory Income Trust)

A 2503(b) trust is designed to provide income to beneficiaries while preserving principal.

Section 2503(c) Trust (Minor's Trust)

A 2503(c) trust is created exclusively for minor beneficiaries with specific distribution requirements.

Key Difference: The 2503(c) trust offers a full annual exclusion but requires assets be available at age 21, while the 2503(b) trust allows principal to remain in trust indefinitely but only the income interest portion qualifies for the exclusion.

Crummey Trust

A Crummey trust incorporates Crummey powers (named after the Crummey v. Commissioner case) to convert what would otherwise be future interest gifts into present interest gifts, qualifying for the annual gift tax exclusion.

How Crummey Powers Work:

1. Grantor contributes assets to the trust
2. Beneficiaries receive written notice (Crummey letter) of their right to withdraw
3. Beneficiaries have a limited time period (typically 30-45 days) to exercise withdrawal rights
4. If not exercised, the power lapses and funds remain in trust

The 5-and-5 Rule

Under IRC Section 2514(e), the lapse of a Crummey power is treated as a release (deemed gift) by the beneficiary. However, an exception applies:

The lapse is NOT treated as a taxable gift if it does not exceed the greater of:

• $5,000, OR
• 5% of the trust assets subject to the power

Important Considerations:

• The $5,000 amount is NOT indexed for inflation
• Lapses exceeding the 5-and-5 limit can cause gift and estate tax consequences
• Hanging powers can be used: excess withdrawal rights "hang" rather than lapse, carrying over to future years

Example: If a beneficiary has a $19,000 (2025 exclusion) withdrawal right and the trust has $100,000 in assets:

• 5% of $100,000 = $5,000
• Only $5,000 can lapse tax-free in year 1
• The remaining $14,000 would "hang" and lapse in subsequent years at $5,000 per year

Comparison of Trusts for Minors

When to Use Irrevocable Trusts

Trade-offs: Loss of Control for Tax Benefits

The fundamental trade-off with irrevocable trusts is surrendering control in exchange for tax advantages:

Benefits:

• Removes assets from taxable estate
• Freezes value for estate tax purposes
• Provides asset protection from creditors
• Future appreciation escapes estate tax

Costs:

• Loss of flexibility to change terms
• Cannot reclaim assets if circumstances change
• Must rely on trustee judgment
• Potential gift tax on initial transfer

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Quiz: Irrevocable Trusts

Question 1: Marcus, age 45, wants to ensure his $2 million life insurance policy does not increase his taxable estate. He transfers an existing policy to a newly created ILIT. Marcus dies 2.5 years later. What is the estate tax consequence?

A) The death benefit is excluded from Marcus's estate B) Only the cash value is included in the estate C) The entire death benefit is included in Marcus's estate D) 50% of the death benefit is included

Answer: C

Explanation: Under the three-year rule, if an existing life insurance policy is transferred to an ILIT and the insured dies within three years of the transfer, the entire death benefit is included in the insured's gross estate. Marcus should have had the ILIT purchase a new policy to avoid this rule.

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Question 2: A parent establishes a Section 2503(c) trust for their 15-year-old child with a $50,000 contribution. Which statement is TRUE?

A) The trust must distribute all income annually to the child B) The child must have access to the trust assets at age 21 C) Only the income portion of the gift qualifies for the annual exclusion D) The trust can continue until the child reaches age 35

Answer: B

Explanation: A 2503(c) trust requires that the beneficiary have the right to receive trust assets at age 21. This is the key distinguishing feature from a 2503(b) trust. The entire contribution qualifies for the annual exclusion (not just the income interest), and the trustee has discretion over income distribution.

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Question 3: Sarah creates a Crummey trust for her three children, contributing $57,000 ($19,000 per child). The trust has $200,000 in assets. If each child's withdrawal power lapses after 30 days, what is the maximum amount per child that can lapse without gift tax consequences under the 5-and-5 rule?

A) $5,000 B) $10,000 C) $19,000 D) $66,667

Answer: B

Explanation: Under the 5-and-5 rule, the lapse is not a taxable gift if it does not exceed the greater of $5,000 or 5% of the assets subject to the power. Here, 5% of $200,000 = $10,000, which is greater than $5,000. Each child can have $10,000 lapse without gift tax consequences. The remaining $9,000 per child ($19,000 - $10,000) would need to "hang" and lapse in future years.