By Michael A. Dolan

Trusts are often used as tools when designing and implementing an effective estate plan. But all trusts are not created equal. Two main categories of trusts are revocable trusts and irrevocable trusts.

The most common form of revocable trust used in estate planning is referred to as a “living trust.” Living trusts are an alternative to a last will and testament. These revocable trusts may be amended, revoked or changed by the maker of the trust (the “trustmaker”) while living.

They are easy to change, and during life are disregarded for tax purposes, so no additional tax filing is necessary. The living trust does not need a separate tax identification number. They are used to increase the efficiency of the transfer of assets upon death. Living trusts can also create irrevocable trusts upon the death of the trustmaker.

Irrevocable trusts are also commonly used in estate planning. These trusts come in many forms and are designed to address very specific purposes and needs. Once the trust is created, it is very complicated and expensive, and sometimes impossible, to make any adjustments or changes to the terms of the trust.

Before creating and funding an irrevocable trust, careful thought and consideration should be undertaken. Once assets are transferred to the irrevocable trust, the trustmaker gives up some, or all, control over the assets contributed to the trust. The trustee of the trust, who is usually not the trustmaker, controls the trust.

In almost all circumstances, the irrevocable trust is a separate taxable entity, and its trustee will obtain a tax identification number and file a tax return separate from the trustmaker. Unlike a living trust, the transfer of assets to an irrevocable trust generally has gift tax implications that require the filing of a gift tax return.

Steps to take

Before forming an irrevocable trust, the trustmaker should have a thorough understanding of what steps are necessary to assure that the trust produces the desired result. Proper tax filings, record keeping, documentation of distributions, annual accountings to the beneficiaries, and operating only within the terms of the trust are critical to a successful result.

Many irrevocable trusts are set aside because the proper formalities are not followed, especially when a family member is named as the trustee. Understanding what needs to be done after the trust is formed is just as important as understanding the benefit of forming the trust.

When forming an irrevocable trust, there is always an opportunity cost that is sacrificed when the trust is established. Reduction of available death tax exemption, loss of adjustment in basis eliminating capital gains upon death, and a less favorable income tax structure are all possible sacrifices. Control is usually the biggest factor given up by the trustmaker. Being clear about exactly what is being sacrificed is important in the decision-making for implementing an irrevocable trust.

Revocable or irrevocable, trusts are valuable tools used in most effective estate plans. When these tools are recommended for use in your plan, make sure you ask questions regarding what the trust will accomplish, what regular activities are necessary to make it effective, and what the opportunity cost is of implementing such a strategy. Understanding these answers is critical to have a successful plan that benefits your family.

Dolan, an attorney, helps farm and ranch families achieve comprehensive estate, succession and legacy planning objectives. He  is the principal of Dolan & Associates, P.C. in Brighton and Westminster, Colo. Learn more on his website, estateplansthatwork.com.