Irrevocable Trusts and the Importance of Trust Formalities

Irrevocable trusts can provide a variety of benefits, including gift and estate tax savings, creditor protection, and the ability to control how assets are distributed. To preserve these benefits, however, it's critical to respect all trust formalities.

This article looks at one court case in which a couple discovered, to their dismay, that having a home's title held by a trust was not sufficient to protect it from government foreclosure. The court held that the protection had been forfeited because the couple had continued to treat the asset as their own after transferring it to the trust. In other words, they did not respect trust formalities.

Consider U.S. v. Tingey. In that case, a taxpayer set up an irrevocable trust for the benefit of

his wife and children, naming someone else as trustee. Around the same time, the taxpayer and his wife purchased a ski cabin, the title to which was transferred to the trust.

Later, the couple got into financial trouble and ended up owing more than $2 million in federal taxes. The government successfully foreclosed several tax liens on the ski cabin. The couple argued that the government couldn't enforce the liens against the ski cabin, because title was held by the trust and not by the couple. But the 10th U.S. Circuit Court of Appeals disagreed. The court explained that a tax lien may be satisfied by property if it's held by the taxpayer's "nominee." In other words, "the taxpayer has engaged in a legal fiction by placing legal title . . . in the hands of a third party while actually retaining some or all of the benefits of true ownership."

Several factors indicated that the couple had done just that. Among other things, they maintained the ski cabin, paid the utility bills and insurance premiums (on a policy issued in the taxpayer's name), used the cabin without the trustee's permission or supervision, and rented the cabin to friends without the trustee's knowledge. Additionally, note payments in connection with the purchase of the cabin came from a variety of sources, including rents, payments directly from the couple, and payments from the taxpayer's business.

As this case illustrates, if you continue to treat assets as your own after transferring them to an irrevocable trust, they may be at risk. Not only would the gift, estate or income tax benefit for which the trust was created be lost, but you also subject the assets to your creditors' reach, thereby risking the loss of the assets themselves.