Introduction
The Medicaid asset protection trust, or the “Legacy Trust”, as it is sometimes called, is an irrevocable trust designed to hold and preserve assets and either accumulate or distribute income. An individual transfers his or her assets to the trust and usually retains a lifetime income interest in the trust. The ultimate purpose of this trust is for an individual(s) to qualify for Medicaid after five years from the creation and transfer of assets to the trust. Upon the death of the income beneficiary of the trust, the remaining assets may be held for the benefit of a surviving spouse or pass to the remainder beneficiaries, thus avoiding Medicaid estate recovery.
Prior to the Deficit Reduction Act of 2005 (the DRA), the look-back period for transfers of assets was three years for a direct transfer to a beneficiary and five years to a trust. After passage of the DRA, the look-back period for a direct transfer to a beneficiary became five years as well. By creating parity between direct transfers to a beneficiary or to a trust, the DRA had the effect of expanding the market of potential clients for the five-year trust. This article will discuss non-tax and tax issues, as well as suggested ways of marketing the five-year trust.
Non-Tax Considerations
When an individual or couple decide to transfer some or all of their assets to their beneficiaries in order to qualify for Medicaid in the future, a direct transfer to those beneficiaries will subject the assets to the creditors of the beneficiaries. In addition, if the assets are commingled with the beneficiary’s spouse, the assets could be lost in the event of a future divorce action. If the beneficiary dies prior to the death of the transferor, the assets may be inherited by the beneficiary’s spouse and/or children. In all of the above cases, the assets of the transferor(s) could be completely or partially lost. As a result, the assets may not be available to the transferor(s) if needed in the future. In comparison, when assets are transferred to a five-year trust, the assets are protected from the claims of the beneficiaries’ creditors, divorce actions, and premature death of the beneficiaries.
Other important advantages of a five-year trust over a direct transfer to a beneficiary include the selection of trustees to ensure proper asset management, preservation of family harmony, as well as probate and guardianship avoidance. In addition, the drafting of a five-year trust allows for successor trustees, contingent beneficiaries, and provisions for beneficiaries with substance abuse and/or special needs.
Tax Considerations
For income tax and estate tax purposes, the irrevocable five-year trust, or Medicaid asset protection trust, is drafted to be a grantor trust. A grantor trust is a trust in which the grantor, sometimes called a settlor or trustor, is taxed on the income from the trust because the grantor has retained an interest in the trust. One particular type of grantor trust, called an intentionally defective grantor trust (IDGT), leverages disparities in federal income and estate taxes to provide opportunities for tax, Medicaid, and asset protection planning. The interests that cause a trust to be a grantor trust are set forth under Sections 671 through 679 of the Internal Revenue Code (the Code).
The following is a list of some powers that would cause a trust to be considered a grantor trust for federal income tax purposes:
• The power to reacquire the trust corpus by substituting other property of an equivalent value under Section 675(4)(C) of the Code.
• The power to add additional beneficiaries, other than the grantor, which may include a charitable beneficiary, along with the power held by a non-adverse party to make distributions among those beneficiaries.
Historically, a grantor did not want the transfer to be a completed gift to avoid gift tax on transfer of the assets to the trust. However, with the federal estate tax exemption set at $11.4 million in 2019 for a single individual, this is of less concern today.
Some grantor trust provisions are not advisable for Medicaid asset protection trusts, such as:
• Giving the grantor the power to revoke the trust under Section 676 of the Code;
• Giving the grantor the power to control the beneficial enjoyment of trust assets under Section 674(a) of the Code.
Preservation of Section 121 Exclusion of Gain From Sale of Principal Residence
Section 121 of the Code creates an exclusion from capital gains tax of up to $250,000 if the taxpayer’s principal residence is sold and the taxpayer owned and lived in the residence at least two of the past five years before the sale. If the individual is residing in a nursing facility, the individual must have resided in the property for at least one year. A husband and wife may exclude up to $500,000 of gain upon the sale.
A trust can preserve this benefit if it is a grantor trust as to both income and principal. Such favorable income tax treatment is not available with an outright gift of the home to a child. The sale proceeds to a child will be subject to capital gains tax on the proceeds of the sale that exceed the parent’s cost basis in the property. The power to substitute property of equivalent value under Section 675(4)(C) of the Code is considered a power over both income and principal which will preserve the Section 121 exclusion.
Preservation of a Stepped-Up Basis at the Death of the Grantor
When an appreciated asset is included in a decedent’s taxable estate for federal estate tax purposes, it receives a stepped-up (or stepped-down) basis to the date of death value of the property under Section 1014 of the Code. For assets transferred during the donor’s lifetime, the donee receives a “carryover basis,” that is, the donee receives the assets with the donor’s adjusted cost basis, rather than the fair market value of the assets on the date of transfer.
For highly appreciated assets, as well as assets that are expected to increase in value after transfer to the trust, such as the donor’s residence or securities, obtaining a stepped-up basis at the death of the grantor can be a huge benefit for minimizing or eliminating capital gains tax when the donee sells the assets after the death of the grantor. The benefit of a stepped-up basis can easily be forfeited by outright gifting.
When the grantor retains the right to the income from the property for life, or the right to reside upon the property during his or her lifetime, the property will be included in the grantor’s estate under Section 2036(a) of the Code. Giving the grantor a limited testamentary power of appointment to change beneficiaries under Section 2038(a)(1) of the Code will also cause the assets to be included in the grantor’s estate at death, in those instances where the grantor has not retained an income interest in the property or the right to reside upon the property.