There are two general classes of Trusts: Revocable and Irrevocable. A Revocable Trust, discussed in Section VI, is created by, controlled by, and taxable in the estate of the Donor. A Revocable Trust can be amended as necessary by the person creating the Trust.
An Irrevocable Trust cannot be changed once it is created, and property transferred to an Irrevocable Trust cannot be taken back by the Donor of the Trust. The purpose of an Irrevocable Trust is to remove an asset from the estate of the Donor for estate tax purposes. For example, in a Family Irrevocable Trust, if you transferred $15,000.00 to the Trust, that money would not be taxable in the Donor's estate for estate tax purposes.
Irrevocable Trusts are most often used to own life insurance policies. Properly implemented, an irrevocable life insurance can be used to create an estate tax-free source of life insurance proceeds. This can be significant for two reasons. First, large assets that can be a significant portion of an estate can be removed from taxation. Second, an estate tax-free source of funds can be used for liquidity needs when estate taxes are payable, typically within nine months of a person's death. For example, instead of selling a vacation home at a loss to satisfy a tax obligation that must be paid within nine months of a person's death, surviving family members can use the proceeds of an Irrevocable Trust to satisfy the tax obligation, so the property can be retained or sold in a more favorable market.
A very important rule, commonly called the five year rule, must be considered when creating an Irrevocable Life Insurance Trust. If an existing life insurance policy is transferred to an Irrevocable Trust and the insured dies within five years of the transfer, the death benefit of that policy is included in the taxable estate of the insured. If, instead of transferring an existing policy, the Trustee of the Irrevocable Trust purchases a new policy, the five year rule does not apply. In that case, the death benefit is not taxable in the estate of the insured regardless of when the insured dies, so long as the formalities of the Trust have been followed.
Irrevocable Trusts may require annual maintenance. What must be done on an annual basis depends upon the terms and design of the Trust. For instance, some Trusts are designed to receive contributions on an annual basis and require the Trustee to notify the beneficiaries of the contributions to the Trust. The formalities and financial implications of such a Trust should be discussed in detail with qualified estate planning counsel and an experienced financial advisor, respectively.
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