by Thomas D. Begley, Jr., CELA
Purpose
Income Only Trusts are a means by which seniors transfer assets to a trust rather than to their children. Seniors tend to view transfers to trusts as protection, while they tend to view transfers to children as gifts. Trusts provide them with a sense of dignity and security.
Requirements
Income only trusts are permitted by OBRA-93.[1] They must be irrevocable. The trust instrument provides that the grantor or the grantor’s spouse receive all of the income from the trust, but has no access to principal.
Design of the Trust
In order to structure the trust as a Grantor Trust and to receive a step up in basis on death, practitioners often give the grantor a right to substitute and reacquire property and/or a limited power of appointment. The grantor can reserve the right to income, but the trust must absolutely prohibit any access to principal by the grantor or grantor’s spouse. The trust can permit the trustee to make distributions to third parties, such as children.
When Income Only Trusts are Useful
There are a number of reasons why transfers to an Income Only Trust should be considered in lieu of transfers to children. When transferring assets to the Income Only Trust, the grantor can retain the right to receive income. The principal will not be counted as an asset, but there will be a transfer of asset penalty if the transfer occurs during the five-year lookback period.
If the elderly parent transfers assets to children, rather than put them in a trust, certain risks must be anticipated. These risks can be avoided if the assets are put in a trust. The risks of an outright transfer include:
- Claims of creditors. The claims of the creditors of the adult children could be satisfied through the assets of the parent, if the parent makes outright transfers to the children.
- Matrimonial action. If a child to whom assets are transferred is subsequently divorced, the transferred assets may become subject to a claim of equitable distribution. While the law dictates that assets transferred from a parent to a child are not subject to equitable distribution, practitioners in the field of family law indicate that judges often find ways to give additional assets, other than the transferred assets, to the other spouse. In addition, the assets transferred could affect alimony or support rights or obligations.
- Bad habits. If a parent transfers assets to a child who is a gambler, a drug addict, an alcoholic, or a spendthrift, the assets may be squandered and no longer available to the parent.
- Death of Child. If the child dies holding the parent’s assets in the child’s name, the assets will likely pass by Will or Intestacy to the spouse or children of the deceased child.
- Capital Gains Tax. If a parent has highly appreciated assets and transfers them to children, the transfer is subject to carryover basis and will result in the children paying significant capital gains tax in the future. If the highly appreciated assets are transferred to an Income Only Trust, since the trust is a grantor trust and the assets will be included in the estate of the parent on death, the children will receive a “step up” in basis and will be able to avoid paying significant capital gains taxes.
Planning Considerations
Availability
The principal in the Income Only Trust would not be considered an available resource, but the income would be available to the recipient of the income.
Transfer of Asset Penalty
The problem with Income Only Trusts is that if money remains in the trust at the death of the grantor, it is subject to Medicaid estate recovery. If assets are distributed out of the trust during the lifetime of the grantor, there is a transfer of asset penalty. The transfer to the Income Only Trust would be subject to the Medicaid and Supplemental Security Income (“SSI”) transfer of asset penalties. There is an issue as to whether a transfer from an Income Only Trust is subject to transfer of asset penalties. New Jersey takes the position that a distribution of principal from an Income Only Trust to a third party constitutes a transfer of an income interest. The penalty is calculated by multiplying the annual income by the actuarial life expectancy of the income beneficiary and dividing by the divisor. In states with a broad definition of estate recovery that would include assets in a Living Trust, it is necessary to distribute assets from the Income Only Trust at the time of the Medicaid application.
No payback provision is required for an Income Only Trust.
Ideal assets to fund an Income Only Trust are appreciated assets. Retirement accounts are not suitable, because the income tax would have to be paid on the withdrawal of the assets prior to funding the trust.
Tax Consequences
An Income Only Trust can be designed as a grantor trust. The trust assets are unavailable for Medicaid, but there are some potentially significant tax benefits to the grantor. The Internal Revenue Code contains certain requirements for a grantor trust.[2]
- Income tax. Income is taxed at the grantor’s individual tax rate, which is usually less than the trust’s compressed tax rate.
- Capital gains exclusion for sale of principal residence. Capital gains tax treatment is maintained. This is particularly important if the trust is funded with a primary residence. The §121 exclusion from capital gains tax can be maintained and the beneficiary can receive a step-up in basis on the death of the grantor, if the property has not been sold during the lifetime of the grantor. The trust must contain a provision that the trustee must allocate the gain on the sale of the home to principal and not to income. The benefit of the capital gains tax can be achieved for non-home appreciated assets as well.
- Estate Since the trust is a grantor trust, the entire value of the estate would be included in the grantor’s estate for federal estate tax purposes.[3]
Estate Recovery
The assets in the Income Only Trust would not be subject to estate recovery in states having a probate definition of estate, but would be included in states having a broad definition of estate for estate recovery purposes, such as New Jersey.
Elective Share
State Medicaid agencies require that a Medicaid recipient who is predeceased by a spouse assert the Medicaid recipient’s right to an elective share against the estate of the predeceased spouse.[4] Failure to do so is considered a transfer of assets subject to the Medicaid transfer penalty rules. If an Income Only Trust for the benefit of the community spouse provides for distribution to the children on the death of the community spouse, then these assets, in most states, would be subject to the elective share provisions. The surviving Medicaid recipient would, therefore, have an obligation to assert his or her right to the elective share against the trust assets. Failure to do so would constitute a transfer for Medicaid eligibility purposes.
| Trusts v. Transfers Comparison | ||||
| Issue | Income Only Trusts | Individuals | ||
| Look-Back | Five Years | Five Years | ||
| Control | None | None | ||
| Risk Avoidance | Yes | No | ||
| Estate Recovery | Maybe | No | ||
| Income Tax | Parent | Children | ||
| Gift Tax | Maybe | Yes | ||
| Step Up in Basis | Yes | No | ||
| Principal Residence Exclusion | Yes | No | ||
Funding the Income Only Trust
Ideally, the trust will be funded with the least amount of assets possible. In calculating how much to put in the trust, the client can carve out assets that can be used in the future for the following:
- Community Spouse Resource Allowance (CSRA)
- Spend down
- Key money to gain admission to a facility
- Any amount of money the client is willing to lose
Good/Bad Assets for Funding Trust
- Ideal assets. Ideal assets to fund an Income Only Trust would include appreciated real estate, such as a primary residence or a vacation home, or appreciated securities. There are significant tax advantages in utilizing trusts for these assets as opposed to transferring outright to children.
- Bad assets. Bad assets to use in funding trusts include retirement accounts, deferred annuities, and government bonds with significant accumulated interest. The problem is the transfer of those assets would result in immediate income tax. To the extent possible, these assets should be left outside the trust.
[1] 42 U.S.C. § 1396p(d)(3)(B).
[2] I.R.C. §§ 673–677.
[3] I.R.C. §§ 1014, 2036, 2038; Treas.Reg. §§ 1.1014-2(a)(3), (b).
