by Thomas D. Begley, Jr., CELA
The following chart compares the advantages and disadvantages of an outright transfer of assets and putting assets in a Children’s Trust.
Trusts v. Transfers Comparison | ||||
Issue | Children’s 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 | ||
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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:
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]
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:
Good/Bad Assets for Funding 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).
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