For example, Alice Smith, a 77-year-old widow, wants to protect her family cottage from potential long-term care nursing home bills and preserve it for the benefit of her four children and their immediate families.  To do so she would need to establish an irrevocable trust, fund it with the cottage property, and have five years pass from the date of the transfer.  Additionally, to ensure her children have sufficient funds to maintain the family cottage, Alice also simultaneously transferred $250,000 of cash assets into the trust.  Finally, in order to bullet-proof the plan in the event of an accident, Alice purchased a traditional long-term care insurance policy which will provide her with five years worth of long-term care benefits, including home health, assisted living, and nursing home care.  The long-term care insurance policy also offered a full return of premium rider in the event that she passed away without using any of the coverage.  After such an event, the annual premiums would be refunded to her revocable living trust.

With the above plan in place, Alice was confident that her wish to have the family cottage remain in the family for many years to come would be long lasting.  Notwithstanding the above, Alice understood that when the maintenance funds ran out that a financial problem may soon develop.  However, to avoid a point of impasse among her children, Alice designed the trust so that if a financial problem persisted for more than 90 days, the trustee was directed to sell the property, giving each child an equal share of the sale proceeds.

This week’s blog originally appeared in a blog from Kraus Financial Services and can be viewed here.

An Irrevocable Trust can offer a grantor lifetime control over his or her assets of the trust is established with the following provisions:

• All taxable income shall be disbursed to the grantor;
• The grantor shall have the right to direct how the trust assets are held or reinvested; and
• The grantor shall have a limited power of appointment over the final distributions of the trust; this power shall be in favor of a limited class of beneficiaries, consisting of the grantor’s children and grandchildren; the disbursements do not have to be in equal amounts or shares.

After the trust is established, totally funded, and 60 months passes, the grantor can qualify for Medicaid benefits. None of the trust assets will be included in the grantor’s Medicaid application, in that they are outside of the 60 month look-back period for uncompensated transfers. The grantor will qualify for Medicaid benefits with generally his or her personal property, a prepaid funeral plan, and $2,000.00, or less, of cash assets.

Medicaid eligibility will require that the grantor pay substantially all of his or her monthly income to the nursing home, including that received from Social Security, any pension, and the trust. The only monthly income retained by the grantor is a personal needs allowance, which amount is designed to provide him or her with toiletries and other personal items. Nationally, the personal needs allowance ranges between $30.00 to $101.10.

From an income tax viewpoint, in that the grantor retained all the taxable income, and a limited power of appointment over the final distributions of the trust, the trust is deemed a “grantor trust.” See IRC 671-679. Grantor trusts do not pay any income taxes. Instead, the income flows directly out of the trusts to the grantor, to be placed on their personal income tax returns. For many, the end result is a lower total tax, in that the trust tax rates for individuals are much lower than those for non-grantor trusts.

From an income planning standpoint, in that the grantor retained the right to direct the investment of trust assets, the income taxes can be minimized, or totally eliminated, if the trustee is directed to invest the trust assets in tax-deferred annuities. No income is recognized from a tax-deferred annuity until the trustee either elects to take a withdrawal or annuitize the product.

From a gift tax viewpoint, again, since the grantor retained all taxable income, and a limited power of appointment over the final distributions of the trust, these provisions prevent the funding of the trust from being treated as a “completed gift.” See IRC 2036(a)(10). The end result is that without a taxable gift, no gift tax will be due, nor the requirement that a gift tax return be completed and filed.

Finally, from an estate tax viewpoint, in that the transaction is being treated not as a completed gift, the trust assets will be included in the grantor’s gross estate. The end result is that certain trust assets will receive an automatic step-up in basis. See IRC 1014(a). For example, if a grantor paid $50,000.00 for a house, and made lifetime improvements of $25,000.00, his or her cost basis is $75,000.00. At the time of the grantor’s death, assuming it occurred prior to 2010, if the house was worth $250,000.00, the beneficiaries would receive a tax basis of $250,000.00. Thus, if they later sold it for $250,000.00, or less, they would not owe any capital gains tax. The sale would be tax-free. However, as a result of IRC 1014(a) being repealed on December 31, 2009, the aforementioned tax result will not take place. Instead, if the grantor’s death occurs in 2010, the beneficiaries will receive a tax basis of $75,000.00 – which is likely to result in the payment of capital gains tax when the property is later sold. The present law states that each trust asset will receive a basis equal to the adjusted basis of the property in the hands of the grantor/decedent, or its fair market value on the grantor/decedent’s date of death, whichever is lesser. See IRC 1022.