In estate planning, using an irrevocable trust involves risks. Once property is transferred to it, the grantor loses control and rights, often leading to taxable gifts if exceeding annual exclusions. The trust's income and gains might face taxes, depending on its structure. These assets aren't counted in the grantor's estate, potentially lessening estate tax upon death. It's crucial to consult an estate planning attorney to navigate these complexities.
Illinois Estate Tax and Gift Tax Explained
To understand how we use irrevocable trusts to minimize estate tax, let’s first explain how estate tax works and how it interacts with gift tax. Estate tax is taxed both on the federal and the state level in Illinois. It is a tax on the value of a deceased person’s estate over and above that individual’s remaining lifetime gift and estate tax exclusion limit. The lifetime gift and estate tax exclusion limit for Illinois estate tax is $4 million as of the writing of this article. The federal estate tax lifetime exclusion limit is about $11.4 million. For more on estate tax generally, check out our article: How to Avoid Estate Tax.
Lifetime Estate Taxes
Now let’s discuss how lifetime gifts impact your lifetime estate tax and gift tax exclusion limit. You can give up to $15,000.00 annually to a particular individual without any gift or estate tax ramifications. Gifts above this annual threshold reduce your lifetime exclusion limit for both estate and gift tax--it is a unified limit. If this limit is used up during your lifetime, then any further gifts above the annual exclusion amount ($15,000.00) will be subject to gift tax.
Gift Tax Example
In addition, the extent you reduce your lifetime exclusion limit through lifetime gifting, more of your estate will be taxable. For example, as discussed above, the Illinois lifetime exclusion limit is $4 million. This means that only assets over and above $4 million in your estate are taxable. However, if you give $1 million in gifts above your annual exclusion ($15,000.00) during your lifetime, then your remaining lifetime annual exclusion gifts' limit is reduced to $3 million. This means that everything in your estate over $3 million, rather than $4 million, will be taxable when you pass. For more on how gift tax works, check out our article: Illinois Gift Tax Explained.
The idea is that the government does not want people to simply give away their assets during their lifetime to avoid any federal estate taxes or tax. The government wants large amounts of assets that are transferred from your estate, whether during or after your lifetime, to be subject to either gift tax or estate tax. But there is a workaround: Irrevocable Trusts.
What is a Trust?
A trust is a legal entity that can own property separate and apart from its creator. The creator of the trust is known as the “grantor” of the trust. The grantor will name a series of trustees to act in order (based on who is willing and able at the time) with the responsibility of managing the assets of the trust for the benefit of the beneficiaries according to the rules laid down by the grantor in the trust document. For more on this, check out our article: Illinois Trusts Explained.
How Do Irrevocable Trusts Work?
Trusts may be either revocable or irrevocable. A revocable trust can be modified or terminated by the grantor at any time. These types of trusts are primarily used to ensure that a probate case is not required for the grantor’s estate when he or she passes. For more on this, check out our article: How to Avoid Probate With Revocable Living Trusts in Illinois.
Irrevocable trusts on the other hand cannot be changed by the grantor once created. Unlike a revocable trust, property transferred to an irrevocable trust is no longer considered the grantor’s property for most purposes. Irrevocable trusts are used mostly to minimize estate taxes when the grantor passes away. For more on how irrevocable trusts work, check out our article: Illinois Irrevocable Trusts Explained.
For more on the differences between revocable trusts and irrevocable trusts, check out our article: Revocable Trusts vs. Irrevocable Trusts.
Are Assets Owned by an Irrevocable Trust Subject to Estate Tax?
Assets transferred by a grantor to an irrevocable trusts are generally not part of the grantor’s taxable estate for the purposes of the estate tax. This means that the assets will pass to the beneficiaries without being subject to estate tax.
There is a catch, however. Transfers to an irrevocable trust are generally subject to gift tax. This means that even though assets transferred to an irrevocable trust will not be subject to estate tax, they will generally be subject to gift tax.
What Are Crummey Powers for Irrevocable Trusts?
To qualify for the annual gift tax exclusion, gifts must of be a present interest, meaning that the beneficiary has full control over the gift. Gifts to irrevocable trusts are generally not present interest gifts. For example, if Dad transfers $1 million to an irrevocable trust which provides for distribution to Daughter when Dad passes, Daughter does not have present control over those funds. This means that the entire amount will be subject to gift tax and that Dad won’t be able to use his annual exclusion.
However, there is a technique that Dad can use to make transfers to his irrevocable trust that will qualify for the annual gift tax exclusion. This technique is known as “Crummey Powers.”
Crummey Powers Technique
Crummey Powers are based on a case called Crummey vs. Commissioner, in which the court ruled that the as long as a trust beneficiary has the right to withdraw a gift to a trust, the gift qualifies as a present interest gift and the annual gift tax exclusion will apply. Importantly, this is the case even if the beneficiary does not exercise the right to withdraw the gift from the trust.
So how does this work? In order to take advantage of his annual gift tax exclusion, Dad will transfer $15,000.00 to his irrevocable trust. The trustee will then send a letter to Daughter, known as a Crummey Letter, informing Daughter that she has 30 days to withdraw the $15,000.00 and gift tax return from the trust, and that if she fails to do so, she will forever lose this right. Dad and Daughter have an understanding that she will not actually withdraw the money from the trust. The $15,000.00 has now been transferred to the trust free of estate tax because it is treated as a present interest gift and the annual exclusion can apply.
How Are Irrevocable Trusts Used to Minimize Estate Tax?
So if transfers to irrevocable trusts are subject to gift tax, how can we use them to minimize estate tax? The magic of the irrevocable gift trust trusts is the concept of leveraged gifts. Let’s take a look at how leveraged gifts to an irrevocable trust work.
The grantor can use Crummey Powers to transfer the maximum annual exclusion ($15,000.00 per beneficiary or $30,000.00 if the grantor is married) to the trust. This amount will pass to the trust free of gift tax and will also be removed from the grantor’s estate for estate tax purposes.
Once this tax-free amount has been transferred to the trust, it can accumulate in value without the accumulated value being considered part of the grantor’s taxable estate or being subject to gift tax. An asset can accumulate in value in several ways:
- Interest;
- An increase in the fair market value of the asset itself; or
- Income, such as rents, that are redeposited into the trust.
Again, this accumulated value will effectively pass from the grantor to the beneficiaries of the trust without being subject to any gift or estate taxes.
Lifetime Exclusion Loophole
For this reason, one strategy is to transfer amounts in excess of the grantor’s annual exclusion to the trust. For example, if the grantor transfers $2 million in assets to the trust, his or her lifetime exclusion will be reduced by approximately $2 million (accounting for the annual exclusion). However, the $2 million in assets that were transferred from the trust are now removed from the grantor’s estate. Gift tax is not actually paid on the transfer, because the grantor is using his or her lifetime exclusion to exclude the transfer from gift tax. Now the assets can grow in value without the increased value being subject to either estate taxes or gift taxes.
Irrevocable Life Insurance Trusts
Probably the most popular strategy to leverage the annual gift tax exclusion is through Irrevocable Life Insurance Trusts (“ILITs”). In this scenario, a life insurance policy on the grantor’s life is owned by the irrevocable trust. The grantor uses his or her annual gift tax exclusion to pay the premiums on the policy. The end game is that the death benefit of the policy owned by the irrevocable trust will pass free of estate and gift taxes to the trust beneficiaries. If the policy were owned by the grantor rather than by the irrevocable life insurance trust, the death benefit of the policy would have been part of the grantor’s taxable estate. In this way, $15,000.00 per year can be leveraged to provide a multi-million dollar payment to the beneficiaries of the trust that will not be subject to estate and gift taxes.
What Are the Advantages of Irrevocable Trusts for Estate Tax Planning?
We have explained how irrevocable trusts can be used to further a gifting strategy that will ultimately transfer wealth to the beneficiaries of the trust free of estate tax. Now we will explain why giving the assets to an irrevocable trust may be preferable to the tax benefits than giving the assets to the beneficiaries directly.
It generally comes to down to a question of the grantor’s control over the assets. Grantors may not want to make large gifts directly to young beneficiaries. Irrevocable trusts allow the grantor to control the timing of distributions and control the management and investment of trust assets for long periods of time.
In addition, some types of irrevocable trusts allow the grantor to continue to benefit from the assets owned by the trust during the grantor’s lifetime. For example, a grantor may retain possession of a piece of real estate owned by the trust during the grantor’s lifetime, while giving up the right to dispose of the property through sale or inheritance to parties other than the grantor trust beneficiaries. For more on this, check out our article: Illinois Medicaid Planning Explained.
Grantor Retained Income Trusts, Grantor Retained Annuity Trusts, and Grantor Retained Unitrusts (GRITS, GRATS and GRUTS) allow the grantor to receive annual payments from the trust while the assets accumulate in value free of estate tax.
As explained above, leveraged gifting strategies such as the use of Irrevocable Life Insurance Trusts allow the grantor to pass much more than the annual gift tax exclusion to the beneficiaries tax free. This is often preferable to simply gifting the annual gift tax exclusion to the beneficiaries directly.
Finally, assets owned by an irrevocable trust are protected from the creditors of the trust agreement by both the grantor and the beneficiaries. For more on this, check out our article: How to Protect Assets From Creditors in Illinois.
Answering a Reader Question on Estate Planning
One of our readers asked the following question that inspired this article.
Q: I am a practicing attorney in Naperville in good standing with the Supreme and lower courts of Illinois.
I hope you don't mind me asking as question or two.
Facts:.
Client, a widow is worth 5M (No AB Trusts). She wants to transfer 2M to an IRT with her adult daughter as Trustee and the daughter and the grandkids as beneficiaries., one of whom is in high school, and the other in college. If properly drafted and administered will that remove the 2M from the 5M for purposes of avoiding the 4M Illinois Estate Tax threshold.
A: As you can probably tell from the article, the answer is complicated. Whether transferring $2 million into an irrevocable trust makes sense for your client really depends on her particular goals for the money.
If your client transfers $2 million to an irrevocable trust, the assets will be removed from her estate for estate tax purposes. However, her lifetime estate and gift tax exclusion will be reduced by approximately $2 million (the amount of the transfer less the annual exclusion she can apply, which will vary based on the number of grandkids).
This means that although the $2 million will no longer be part of her taxable estate, her estate tax exclusion will be reduced from $4 million to $2 million. As discussed above, there is an upside to making this transfer, in that the $2 million will be able to grow in value within the trust without the accumulated value being part of the client’s taxable estate.
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