Irrevocable Trusts & the Current Federal Estate Tax (IRC 1022), Friend or Foe?

The following is a repost of a blog recently written by Attorney Dale Krause of Krause Financial Services. Attorney Krause is also a fellow member of the National Academy of Elder Law Attorneys (NAELA). The original version can be found here.

question-imageAn 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.

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