Q: When would a taxpayer want an irrevocable trust for minimizing estate taxes?

An irrevocable trust can be an effective tool for minimizing estate taxes because assets transferred to the trust are typically removed from the grantor’s estate. This means that the assets, and any future appreciation on them, are not subject to estate tax when the grantor passes away. One common strategy is to use the irrevocable trust in conjunction with the lifetime gift tax exemption, currently $13.61 million per individual (2024). By transferring assets to the trust, the taxpayer locks in their value at the time of transfer, avoiding estate taxes on future growth.

However, there are significant drawbacks. First, once the trust is established, the grantor cannot revoke or alter the trust terms. This loss of control can be concerning for those who may need access to the assets in the future. Additionally, any income generated by trust assets may be taxed at the trust's compressed income tax rates, which can reach the highest marginal rate quickly. Although many of these trusts are designed to be taxable to the grantor (maker of trust).

Another key trade-off is the potential impact on beneficiaries when low-basis assets are transferred. Assets in an irrevocable trust do not receive a step-up in basis upon the grantor's death, meaning beneficiaries could face significant capital gains taxes if they sell the assets. For example, if highly appreciated stock is placed in the trust, beneficiaries would pay capital gains taxes on the full appreciation when sold, compared to inheriting it with a stepped-up basis under transfers at death.

This strategy is often suited for taxpayers with highly appreciating assets or significant wealth that exceeds the estate tax exemption limits. It's essential to weigh these benefits against the loss of control and potential future income tax burdens on beneficiaries.

Most times, I recommend using both and irrevocable trust and a revocable trust to mathematically balance out the benefits - splitting the assets into the type of trust that make the most sense.