Listen to Lawrence…When changing a revocable trust to an irrevocable trust, is there any tax applied?

LISTEN TO LAWRENCE

Dear clients and friends,

Here is another one of your questions:

QUESTION:

Is there any tax applied to move a revocable trust to an irrevocable trust?

MY RESPONSE:

It is often the case that my clients’ estate planning needs change over time.  When people are younger, the main focus may be on who gets what, how they get it, the tax ramifications and perhaps to avoid probate. While the latter goal is often oversold, some clients create revocable trusts for that sole purpose. As we age, another concern dominates many estate planning discussions, and that is protecting assets from long term care. Often, an irrevocable trust is the right tool in the toolshed to meet this challenge. So the question is, is there a tax consequence when you move from a revocable trust to an irrevocable trust?

First, there is no tax consequence when you create a revocable trust. Why? Because you retain so much control, the IRS ignores the trust. For all practical tax purposes, you still own the assets in the trust. This is not true when you create an irrevocable trust…or for that matter, amend a revocable trust to become an irrevocable trust. Normally, when you create and fund an irrevocable trust, a potentially taxable gift takes place and the trust now is subject to income tax at higher levels. “Wait!!!! That sounds terrible. Why would anyone do that?”

Never fear, none of these bad things happen. My irrevocable Medicaid trust contains a clause that says, even though the trust is irrevocable, you still retain the right to change the trust beneficiaries at any time while you are living, among a limited group of people, like your children and grandchildren. This is called a limited power of appointment. This limited power of appointment means that no trust beneficiary has a vested right to the gift because it can be taken away at any time. This makes the gift “incomplete” and therefore, no gift tax is due. Of course, these days the gift tax has relatively little importance because New York abolished its gift tax and the federal gift tax has an exemption of $11,580,0000. Clearly, clients worried about how they are going to pay for long term care have no worries about gift tax.

That same limited power of appointment invokes a section of the IRS code called the grantor trust rules. Essentially, the code says that if you retain too much control over the trust, the IRS will ignore the trust for income tax purposes and you will still be deemed the owner of the trust assets as if the trust did not exist. A limited power of appointment is one such example of retaining too much control. Therefore, putting assets in the irrevocable trust is ignored and you will be taxed the same as if the trust was never created…or, the same way as if the assets were still in a revocable trust.

Isn’t this cool? Okay, I am a tax nerd. Guilty!

I hope this helps! Please forward this information to your friends and relatives.

As always, please send me your questions. If you are thinking about it, others are probably too, so my answers will no doubt help you and many others.

Let’s stay connected.

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Stay safe!