A revocable trust is a type of trust fund in which the grantor that creates the trust retains the legal right to collect the income created by the trust fund and modify the trust whenever he wants. Because of the degree of control that the grantor retains—he can cancel the trust and take the proceeds and spend them however he pleases—the grantor actually has to pay taxes on the income generated by the trust. If he chooses to distribute some of this money to another beneficiary rather than himself, the beneficiary does not have to pay taxes on his distribution because the grantor/creator of the trust has already paid taxes on it.
What must you do if you want to want to lower your tax bill? You must give up control and create an irrevocable trust.
The trade-off of creating an irrevocable trust is that you must give up two things: (1) you must give up the right to modify the trust beyond the initial written instructions that govern the trust, meaning you can’t prevent a chosen beneficiary from receiving proceeds if you have a falling out years later and want to change your mind; and (2) you can no longer benefit financially from the trust by collecting income or even receiving distributions from the principal of the trust that you created. There are also specific rules relating to control and voting rights if you include shares of a closely held family corporation in your trust fund.
The point is this. In order to kick a trust fund out of your taxable estate, you must cut off your relationship to the trust by ceding control and the right to receive any financial benefit from the assets that you contribute to the trust. This option works when you have a beneficiary in mind (other than yourself) that you would like to receive the benefit from your capital.
What are the tax advantages that come with creating an irrevocable trust designed to benefit a third party?
First, it is a superior method to transfer assets to a beneficiary because, in nearly every state, irrevocable trusts go to the beneficiary and exist beyond the reach of a creditor or divorcing spouse. Some states make exceptions for torts, and allow irrevocable trusts to be reached when the beneficiary, say, kills a third party in a drunk-driving crash. Some states, as a matter of public policy, permit the estate of the deceased to reach into the beneficiary’s irrevocable trust income on the theory that the injustice to the grantor of the trust is less than the injustice that would be created by refusing to make the estate of the innocent deceased whole.
Second, the trust documents can contain generation-skipping provisions so that the grantor of the trust can give income to his children and then give income to the grandchildren after the children’s death. Absent a trust, the transfer of assets from the children level to the grandchildren would be a taxable event. A generation-skipping trust therefore keeps principal intact by removing a taxable event at the point of the children’s death when the grandchildren become the new income beneficiaries of the trust.
Third, the income from an irrevocable trust can be tax efficient because the taxes to the beneficiary may be lower than if the funds were transferred via an outright inheritance at the time of the grantor’s death or through a gift tax if the money were given outright.
Fourth, they allow the creator/grantor of the trust the opportunity to dodge federal estate taxes and reduce the burden on his own gross estate.
The tax law in the United States follows control and benefit. If you control and benefit from the capital that you contribute in a revocable trust arranagement, you are going to have to pay taxes on the income and capital gains because it is still effectively your asset to command. If you want to receive tax benefits, you will have to relinquish the rights to benefit financially or control the assets put into an irrevocable trust. The tax benefits of an irrevocable trust can be substantial compared to making a large outright transfer to a beneficiary.