People make incorrect assumptions about irrevocable trusts all the time. Yes, even attorneys, CPAs, and financial advisors. Irrevocable trusts are nothing to be afraid of. Here are the top 3 irrevocable trust misconceptions:
1. You Can’t Modify An Irrevocable Trust
This is not true. You can absolutely modify an irrevocable trust. Here are the three main ways to modify an irrevocable trust.
- Careful Drafting. You can include terms in the irrevocable trust document that provide flexibility for certain modifications. Your attorney should make sure that the ability to make modifications does not conflict with the purpose of the trust. These may include:
- Appointing a Trust Protector who can make certain trust modifications;
- Granting powers of appointment to someone (sometimes even the Settlor)
- Giving the trustee (or even yourself) powers to make certain changes.
- State Laws. State laws outline how to make modifications to irrevocable trusts. Sometimes you can modify an irrevocable trust without judicial approval.
- Decanting. This isn’t necessarily a modification to the irrevocable trust, but essentially results in the same thing. Decanting means that you transfer the assets out of the irrevocable trust into another trust with more desirable terms.
2. An Irrevocable Trust Pays Higher Income Tax
The fact that a trust is irrevocable has nothing to do with its income tax treatment. For income taxes, irrevocable trusts are either “grantor trusts” or “non-grantor trusts.” A grantor trust pays no income tax. It is a pass-through to the grantor (aka Settlor). All income tax aspects of the trust are reported on the grantor’s individual income tax return (Form 1040). A “non-grantor trust” is a separate taxpaying entity and could pay higher income taxes. Non-grantor trusts pay tax on income that is not distributed to beneficiaries. Non-grantor trusts reach the highest tax bracket much sooner than individual taxpayers. So, if an irrevocable trust is a non-grantor trust it must file a separate income tax return (Form 1041) and may pay income tax at a higher rate.
3. An Irrevocable Trust Requires Tax Returns (Gift Tax or Income Tax)
This is not necessarily true. When we talk about tax returns we need to separate two tax regimes; income tax and gift tax. I mentioned income tax above. A non-grantor trust must file a separate income tax return. However a “grantor trust” may file an income tax return but is not required to because the grantor reports all income/loss on their personal tax return (Form 1040). For gift tax treatment we must know whether the irrevocable trust is a complete gift trust. If so, then a you must file a gift tax return (Form 709) for gifts to the trust. If not, you don’t need to file a gift tax return.
Ask Questions. Don’t Make Assumptions.
The term irrevocable doesn’t tell us anything about the trust’s tax treatment, asset protection, or flexibility. While the 3 irrevocable trust misconceptions above may be true in some cases, they are not in others. Irrevocable trusts can be treated in many different ways for income, gift, and estate taxes, and can provide varying degrees of asset protection. If you hear the word “irrevocable,” ask questions, don’t make assumptions.