Trusts act as separate legal entities which an individual can form to manage his/her assets. Trusts are highly effective financial vehicles which are regularly used in estate planning, asset protection, tax optimisation, and more. There are two distinct types of trusts: a revocable trust (also called a “living trust”) and an irrevocable trust.
These two basic types of trusts have distinct features which make them comparatively more or less useful in different circumstances. Simply put, a revocable trust is one where the terms can be modified at any time by the owner of the trust, or even cancelled entirely. An irrevocable trust, on the other hand, is one that cannot be changed after it has been created without the express consent of the beneficiaries (and even then, limitations often apply).
While many instinctively might feel that a revocable trust is more appealing, there are actually relative advantages and disadvantages to both. We will explore each in turn, and discuss which one to choose depending on your specific requirements.
What Is a Revocable Trust?
A revocable trust is a type of trust that can be changed or cancelled at any time by the grantor (i.e., the person who establishes and funds the trust). This means that whilst the grantor of the trust is alive, they can remove beneficiaries and/or designate new ones, alter the provisions about how assets are managed, add or remove assets to the trust, or even cancel the trust entirely.
What are the Benefits of a Revocable Trust?
The most obvious benefit of a revocable trust is that it allows the grantor to retain complete control and flexibility over the assets in the trust and how they are distributed. Circumstances change all the time, and so most people prefer the idea of being able to adapt the terms of a trust to changes in their situation.
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Key benefits and uses of revocable trusts include:
Flexibility: As mentioned above, the number one advantage of a revocable trust compared to an irrevocable trust is the flexibility that it offers the grantor of the trust.
Avoids Probate Court: Using a trust for estate planning allows the trust’s beneficiaries to avoid probate court, and so simplifies the process of inheriting the assets. This is in contrast to a will which involves lengthy and often expensive probate procedures. A revocable trust is not the only type of trust which provides this benefit, and the same is true for irrevocable trusts.
Privacy and Asset Protection: Revocable trusts do provide some level of financial privacy and asset protection, as ownership of the assets are separated from the grantor of the trust. Due to the avoidance of probate, it also provides a more discreet and private inheritance process. However, an irrevocable trust still provides much better privacy and asset protection.
Assets can be retrieved in exceptional circumstances: This can be either a benefit or a disadvantage depending on the situation. Revocable trusts allow you to terminate the trust and retrieve the assets if you find yourself in an unexpected situation where you need the money in the trust. The downside is that it also exposes the assets to higher levels of risk from outside parties, as we will discuss below.
What are the Downsides of a Revocable Trust?
While revocable trusts might offer greater flexibility and control for the owner of the trust, this comes with some disadvantages too:
Less Asset Protection: The fact that the grantor maintains control of and rights to the assets in the trust, means they are exposed to greater risk of seizure by creditors or court rulings. If the owner of the trust is sued, they could potentially be forced to liquidate the assets in the trust in order to pay what is owed.
Less favourable taxes: Revocable trusts do not allow the avoidance of estate taxes to the extent that irrevocable trusts do, as the trust remains a part of the grantor’s estate. In certain jurisdictions, there may still be tax advantages as compared to a will, but they fall short of irrevocable trusts.
Susceptible to fraud and manipulation: The fact that the terms of a revocable trust can be altered can lead to a greater risk of fraud or manipulation from outside parties trying to force the terms of the trust to be altered.
What Is an Irrevocable Trust?
An irrevocable trust is one where the terms of the trust cannot be altered or terminated by the grantor after the trust has been established and the deed signed. Only under exceptionally rare circumstances, and with the consent of the trust’s beneficiaries, can any changes be made. Once assets are transferred to the trust, the grantor relinquishes ownership and control of the assets.
There are various types of irrevocable trusts, including: Irrevocable Life Insurance Trust, Asset Protection Trust, and Charitable Remainder Trust. While these have different features, the main distinguishing characteristic is the same (the trust cannot be changed or revoked). Asset Protection Trusts have been used with great effect to shield assets from creditors and court cases, as they allow the grantor to simultaneously be the sole beneficiary and therefore maintain all benefits of the assets without being the legal owner of them.
The primary reasons for using an irrevocable trust are tax optimisation and asset protection.
What are the Benefits of an Irrevocable Trust?
While it might not seem ideal to transfer ownership of your assets into a trust which cannot be terminated or changed, irrevocable trusts come with some unique benefits compared to revocable trusts. The main advantages of irrevocable trusts are:
Superior asset protection: Because the grantor of an irrevocable trust gives up ownership and legal control over the assets, and the trust terms cannot be altered, irrevocable trusts are excellent tools for asset protection. It is extremely difficult for courts to successfully pass rulings to turn over the assets in an irrevocable trust. Some irrevocable trusts, such as Asset Protection Trusts are specially designed to provide maximum asset protection, with various mechanisms which safeguard the assets in the trust.
Tax benefits: The second major benefit of an irrevocable trust is its tax efficiency. As the assets in the trust are separated from the grantor’s estate, they are also not subject to estate tax when the beneficiaries inherit the assets.
Privacy: Irrevocable trusts, especially asset protection trusts, provide high levels of financial privacy. The assets are no longer a part of the grantor’s personal estate and as such do not need to be disclosed. They will also not be legally linked to the grantor’s identity, as they belong to the trust as a separate legal entity.
What are the Downsides of an Irrevocable Trust?
Lack of flexibility: The most obvious drawback to an irrevocable trust is that there is little to no flexibility. Once the assets have been transferred to the trust and the terms set, the grantor loses all control, and the trust cannot be changed or revoked. The exception is an Asset Protection Trust whereby some level of indirect control remains as the grantor is simultaneously the beneficiary.
Complexity: Irrevocable trusts are complex financial instruments by nature. It is precisely as a result of the layers of complexity that these trusts provide such solid asset security and privacy. However, they do require the help of an expert to effectively set up and manage properly.
Trusts are useful financial instruments which can be used in a variety of circumstances. There are distinct differences between revocable and irrevocable trusts, which make each more suitable in specific situations.
If you are looking to use a trust simply as a tool to avoid probate procedures, provide some measure of tax relief, and at the same time maintain full control and flexibility, then a revocable trust is the best choice.
If, on the other hand, you need a financial instrument which can provide the utmost in privacy, asset protection, and tax optimisation, without the need to keep control and flexibility, then an irrevocable trust (and specifically an asset protection trust) is the right option for you.
Whatever your needs may be, it is best to consult the advice of a trust expert who can help you determine the best trust structure to suit your needs, and guide you through the steps needed to establish it.
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***Note for U.S. citizens: US citizens are limited in their tax reduction possibilities due to FATCA and CFC laws. Opening an offshore company can increase privacy and asset protection, but you can not eliminate your taxes without giving up your citizenship. If you are a US citizen you are obligated to pay taxes on all worldwide income. Read more here about FATCA and CFC laws.