Estate Taxes & Irrevocable Trusts

Under tax law in the United States, any estate consisting of an amount higher than a set annual limit is subject to estate taxes. Under President Obama, the annual amount was set at $5 million for 2011 and 2012 (adjusted for inflation).

In 2013, Congress made permanent the basic exclusion (exemption) amount, $5 million per person. With the inflation adjustment, in 2017, the estate tax exemption amount is $5,490,000 per person ($5,450,00 in 2016).  Under the 2017 Tax Cuts and Jobs Act, the basic exclusion amount of $5 million was doubled to $10 million dollars, without taking into account the required annual cost of living adjustment.

For 2019, the inflation-adjusted figure is $11.4 million, up from $11.18 million in 2018.

The purpose of estate tax is to reduce the amount of wealth distributed to the next generation. This is especially seen in the high amounts that must be paid by the estate.

The current estate tax amount starts at 40 percent. That amount must be paid in cash before anyone can inherit on an estate. Any wealth placed into an irrevocable trust, however, is not considered part of the deceased person’s estate. In other words, money placed into an irrevocable trust will not be taxed upon death.

Advantages of an Irrevocable Trust

For those who want to avoid their estate being consumed by the federal government, irrevocable trusts are a useful estate planning tool. It is important to keep in mind that the annual estate exclusion amount changes every year because it is adjusted for inflation.

If an estate has extensive assets, moving some of the portfolio into an irrevocable trust can make a large difference. Among the advantages, the assets placed in the trust keep your basis from the time of transfer. In other words, if you transfer a piece of property into the trust, its value for tax purposes will remain the same. So, as the house remains in the trust for 20 or 30 years, its entire acquired value cannot be added to the property taxes.

Disadvantages of an Irrevocable Trust

The primary disadvantage to using an irrevocable trust is the loss of control of the asset. Once the asset is in the trust, it is no longer the original owner’s property and that person cannot control it. This is the reason the IRS will not include the assets in the estate because legally speaking, they are no longer owned by the trustor. In addition, irrevocable trusts must be planned in advance to avoid the IRS finding the trust invalid. On average, trusts must be established at least 3 years before death. There are some exceptions, but this is the general rule.

How to Plan an Irrevocable Estate Tax-Free Trust

As with any other form of estate planning, the key word is planning. In order to make an irrevocable trust that is free from estate tax, the trust must be established, funded, and existing before death. This process can take some time, so it is best to start creating an irrevocable trust as soon as personal assets reach a point that estate taxes would apply.

For married couples, the best kind of irrevocable trust is known as an AB trust. This form of trust takes advantage of each spouse’s maximum contribution amount, successfully removing a larger amount of funds from the overall estate without any estate taxes attached. This form of trust does nothing until the first spouse dies. At this point, the first spouse’s maximum annual contribution is pulled from the wealth and placed into an irrevocable trust. This trust cannot be accessed by the other spouse, therefore preventing the estate taxes. The remainder of the deceased spouse’s estate is placed into a second trust for the care of the first spouse.

This trust keeps the assets away from probate once the second spouse passes away. Should the second spouse or any single person still have more wealth in their estate, this wealth can also be placed into an irrevocable trust. In this case, the person can leave out an amount of wealth below the annual exclusion amount to avoid further estate taxes.

This is only one example of an estate planning irrevocable trust set up. Couples can establish trusts for family, for charities, and even for grandchildren, that will be free of estate taxes. The key is finding a qualified estate planning lawyer and establishing the trust early.

Case Studies: Estate Taxes & Irrevocable Trusts

Case Study 1: Maximizing Exclusion Amount

John, a wealthy individual, utilized an irrevocable trust to minimize the impact of estate taxes on his assets. By placing a portion of his wealth into the trust, he effectively removed it from his taxable estate.

This allowed John to take advantage of the annual exclusion amount and protect a significant portion of his estate from the high estate tax rate. The irrevocable trust ensured that his assets would be preserved for future generations, rather than being diminished by taxes.

Case Study 2: AB Trust for Spouses

Mary and David, a married couple, established an AB trust as part of their estate planning strategy. With this trust, they were able to maximize each spouse’s annual exclusion amount and effectively double the amount of wealth they could remove from their taxable estate.

The trust provided financial security for the surviving spouse while also ensuring that their assets would pass to their chosen beneficiaries without being subject to estate taxes. The AB trust allowed Mary and David to leave a lasting legacy for their family, free from the burden of excessive taxation.

Case Study 3: Strategic Planning for Business Succession

Emily, a successful business owner, used an irrevocable trust to plan for the future succession of her company. By transferring ownership of her business to the trust, she ensured a smooth transition and avoided potential estate tax issues. The trust allowed Emily to retain control over the business during her lifetime while providing clear guidelines for its transfer after her passing.

Through careful estate planning and the use of an irrevocable trust, Emily secured the long-term viability of her business and minimized the tax implications for her beneficiaries.