What Is an Irrevocable Trust and How Does It Work?

An irrevocable trust is a legal arrangement that, once created, generally cannot be altered, amended, or terminated. When a grantor transfers assets into this trust, they permanently relinquish ownership and control. This action separates the assets from the grantor’s personal estate, placing them under the management of a third party for the benefit of others. Unlike a revocable trust that a grantor can change, an irrevocable trust’s assets are no longer considered the grantor’s property for tax and liability purposes.

Core Functions of an Irrevocable Trust

Estate Tax Reduction

A primary function of an irrevocable trust is to minimize potential estate taxes. When a grantor transfers assets into an irrevocable trust, those assets are removed from their taxable estate. This is advantageous for individuals whose estates exceed the federal estate tax exemption, which is $13.99 million per individual in 2025. By reducing the size of the taxable estate, the tax liability due upon the grantor’s death can be significantly lowered or eliminated.

Asset Protection

An irrevocable trust can shield assets from future creditors and legal judgments. Once assets are transferred to a properly structured trust, they are no longer legally owned by the grantor. This means that if the grantor later faces a lawsuit, creditors cannot seize the assets held within the trust to satisfy personal debts. This protection applies to future creditors, as transferring assets to defraud existing creditors is illegal and can be reversed by a court.

Government Benefits Eligibility

Irrevocable trusts are used in planning for needs-based government benefits like Medicaid. These programs have strict limits on the assets an individual can own to qualify for assistance. By transferring assets into a specially designed irrevocable trust, an individual can legally reduce their countable assets to meet eligibility requirements. It is important that the transfer of assets is subject to a “look-back” period, which is five years for Medicaid, and applying for benefits within this period can result in a penalty that delays eligibility.

Gifting to Minors or Irresponsible Heirs

An irrevocable trust provides a controlled way to make financial gifts to beneficiaries who may be too young or not financially responsible. Instead of gifting assets outright, a grantor can place them in a trust and set specific terms for how and when the funds are distributed. The trust document can specify that distributions are made at the trustee’s discretion or upon the beneficiary reaching certain milestones, like a specific age. This allows the grantor to provide for loved ones while building in safeguards.

Key Roles and Responsibilities

The Grantor (or Settlor/Trustor)

The grantor, also known as a settlor or trustor, is the individual who creates the trust and provides the assets to fund it. This person’s role is in the establishment phase, where they make the foundational decisions about the trust’s purpose, beneficiaries, and terms. The grantor is also responsible for selecting the trustee and for legally transferring ownership of the chosen assets into the trust.

The Trustee

The trustee is the individual or institution appointed to manage the trust’s assets according to the trust document. This role carries significant fiduciary duties, including the duty of loyalty, which prohibits using trust assets for personal benefit. The trustee holds legal title to the assets but must manage them exclusively for the beneficiaries.

A central obligation is to follow the “prudent investor rule,” which requires managing the trust’s portfolio with a balance of risk and return. This involves diversifying investments to minimize risk and making decisions in the best interests of all beneficiaries. The trustee must also provide regular accountings to the beneficiaries, detailing all income, expenses, and distributions.

The Beneficiary

A beneficiary is a person or entity designated to receive benefits from the trust. The trust document names the beneficiaries and outlines their rights to the trust’s assets. There can be different classes of beneficiaries, such as an income beneficiary who receives income generated by the trust. A remainder beneficiary is entitled to receive the principal assets after the income beneficiaries’ interests have ended.

Information and Decisions for Creation

Choosing a Trustee

Selecting a trustee is a foundational decision. The trustee can be an individual, such as a family member, or a corporate entity like a bank. The choice depends on the complexity of the assets and family dynamics. The grantor must evaluate a potential trustee’s financial acumen and ability to act impartially. It is also wise to name one or more successor trustees to ensure a smooth transition of management if the initial trustee can no longer serve.

Identifying Beneficiaries

The grantor must clearly identify the individuals or entities who will benefit from the trust. Beneficiaries should be named specifically to avoid confusion. In addition to primary beneficiaries, the grantor should consider naming contingent beneficiaries. These are the individuals who would inherit if the primary beneficiaries are no longer living or disclaim their interest.

Determining Distribution Terms

The grantor must specify the rules governing how and when the trustee distributes assets. These terms can be customized, with distributions being mandatory at certain ages or tied to life events like graduating from college. Alternatively, the grantor can give the trustee discretion to make distributions based on a standard like “Health, Education, Maintenance, and Support” (HEMS). This provides the trustee with clear guidelines while offering flexibility.

Creating an Inventory of Assets

Before the trust can be funded, the grantor must compile a comprehensive inventory of all assets that will be transferred into it. This list should include all necessary identifying information to facilitate the legal transfer of ownership. Assets like real estate, financial accounts, business interests, or valuable personal property need to be clearly identified and appraised. This schedule of assets is typically attached to the trust agreement.

The Trust Document

All decisions regarding the trustee, beneficiaries, and distribution terms are formalized in a legal document known as the trust agreement. This document is the operational playbook for the trust and must be drafted with precision. Given the permanent nature of an irrevocable trust, this document should be prepared by a qualified estate planning attorney to ensure it complies with state laws and achieves the grantor’s goals.

Establishing and Funding the Trust

Executing the Trust Agreement

After the trust document is drafted, the next step is its formal execution. This involves the grantor signing the agreement in the presence of a notary public, which verifies the grantor’s identity. The trustee may also need to sign the document, formally accepting their appointment. This act brings the trust into existence as a valid legal entity.

Obtaining a Taxpayer Identification Number (TIN)

Because an irrevocable trust is a separate taxable entity, it must have its own Taxpayer Identification Number (TIN) from the IRS. The specific TIN for a trust is called an Employer Identification Number (EIN), even if it has no employees. The trustee is responsible for obtaining this number, which is necessary for the trust to open bank accounts, hold investments, and file its annual income tax returns.

The Funding Process (Transferring Assets)

A trust is an empty shell until assets are legally transferred into it, a process known as funding. The trustee must systematically retitle each asset from the grantor’s name into the name of the trust. The method for doing this varies depending on the type of asset. For example, a new deed must be recorded for real estate, and financial accounts must be reregistered in the trust’s name. Each transfer must be done meticulously to ensure the assets are officially owned by the trust.

Tax and Administrative Duties

Trust Income Tax Returns

The trustee must manage the trust’s tax obligations, including filing an annual income tax return with the IRS using Form 1041. The trust must report all income it earns, such as interest, dividends, and capital gains. The taxation of this income depends on whether it is retained by the trust or distributed to the beneficiaries. If income is kept within the trust, the trust pays the tax. If income is distributed, the trust receives a deduction, and the beneficiaries report the income on their personal tax returns via a Schedule K-1.

Trust Accounting

A trustee has a fiduciary duty to maintain meticulous records of all financial activities within the trust. This involves tracking all income received, expenses paid, and distributions made to beneficiaries. The trustee must provide a periodic accounting to all beneficiaries as required by the trust document or state law. This report details the trust’s assets, liabilities, receipts, and disbursements.