The most important point to remember about irrevocable trusts is flexibility. When drafting a trust, it is best to craft it to allow the greatest possible flexibility, by allowing the trustee to withhold or distribute income and corpus.
If the trust is a non-grantor trust, flexibility allows the trustee to minimize income taxes for the trust and its beneficiaries. For example, if the trust earns $10,000 with no distributions, it is taxed on $10,000, with the beneficiary not being taxed on anything in relation to the trust. If there are distributions to the beneficiaries, those carry out distributable net income and taxation to the beneficiary. In 2012, after the first $11,650 of income, trusts are taxed at 35 percent for individuals. Nonetheless, there are good reasons to have as much flexibility as possible.
Perhaps more importantly, flexibility avoids forcing distributions that may result in assets being seized by creditors. If the trust is in a high bracket and the beneficiary is in a very low bracket, normally you’d want to distribute. However, if there are creditors waiting in the wings to seize the assets, the beneficiaries low tax bracket combined with the seizure by the creditor, amounts to a 100% loss of assets. This may also happen if the beneficiary is in the throes of a divorce. Forced distributions may go to the spouse, depending on the laws of the state of residence.
A trustee has discretion in making or not making distributions for compelling reasons that may include, but are not limited to:
- beneficiary not 18-years-old
- is a special needs individual
- how susceptible they are to undue influence or duress
- substance or alcohol abuse
- marital issues, such as separation, dissolution or divorce
- inability to manage money
- serious tax disadvantages
You also may draft extraordinary flexibility into a trust document, by allowing a non-related special co-trustee, or trust protector, the power to modify the trust in a variety of ways.
The powers may include, but are not limited to:
- Making distributions and performing other acts that would cause the trustee conflicts or tax problems
- Modify beneficiary interests upon change of circumstances
- Amend the instrument for particular reasons
Staying on top of the rapid changes in the area of irrevocable trusts means clients get the benefits of thorough and thoughtful estate planning.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (800) 846-1555