This is the second of three blogs (yesterday, today, and Monday) on this important topic. I hope you find it helpful.
Ability to Select Whether Trust Income is Taxable to Trustmakers or Beneficiaries
"Grantor trusts" are treated by the Tax Code as “owned” by the Trustmaker (also called the grantor) for income tax purposes. As mentioned in yesterday's blog, preservation of the Section 121 exclusion of capital gain upon the trustee’s sale of the Trustmaker’s primary residence that was earlier funded into the trust requires that the trust be a “grantor trust” as to both income and principal. The creation and significance of grantor versus nongrantor trust status takes an entire seminar but the choice of whether a trust will be a grantor or nongrantor trust and how that will be accomplished are key design decisions. Grantor trust status is an important goal for tax reasons for many of my clients.
Ability to Design Who Will Receive Trust Income
Unlike an outright gift, by which the donor gives up the right to receive income generated by the transferred assets, an irrevocable trust can be designed so funding constitutes a completed gift for Medicaid purposes although the Trustmaker reserves the right to receive income from the trust. This is an attractive option for some seniors, although it does result in an inherent downside for Medicaid planning purposes: Any income that the trustee has the power to distribute to the Trustmaker will be counted for Medicaid eligibility purposes, even if the trustee decides not to actually distribute the income to Trustmaker. Some seniors avoid trustee discretion by making distribution of all trust net income to them mandatory, rather than discretionary. In this case, the income would also be counted for Medicaid eligibility purposes as well. Others go the entirely opposite direction by prohibiting the trustee from distributing any income to the Trustmaker, thereby ensuring that trust income will not be part of the Trustmaker’s cost of care budget when the Trustmaker is on Medicaid. There are several factors to weigh in such decision-making, but the key point for this discussion is that use of an irrevocable trust in Medicaid planning gives the client these design choices, whereas an outright gift does not.
Ability to Make Trust Assets Noncountable for Beneficiaries’ Medicaid or SSI
It is a sad fact that an outright gift or bequest from a donor, such as a parent, to a disabled donee can result in the donee becoming ineligible for means-based governmental benefits that he or she was eligible for before the gift or bequest, or soon would have become eligible for. In such situations, unless irrevocable trust planning is then done to establish a “self-settled special needs trust,” the gifted or bequeathed assets typically get consumed for the donee’s care and once they are gone, the donee goes onto the governmental benefits from which the gift or bequest disqualified him or her until consumed. One way of looking at this outcome is that the indirect recipient of the gift or bequest was the governmental benefit program from which the gift disqualified the disabled person for a period of time. This is generally considered poor planning.
Better planning is for the gift or bequest to be made in an irrevocable special needs trust for benefit of the disabled beneficiary, so the gift or bequest will be managed to enhance the living conditions of the disabled beneficiary by paying for things that the governmental benefits do not pay for. If a disabled person becomes entitled to an outright gift or bequest, or an outright gift or bequest recipient later becomes disabled, depending on the age of the disabled person, it may be possible to establish a “self-settled special needs trust” for the disabled beneficiary. Such trusts (funded with assets of the disabled person) must contain a provision stating that upon the death of the disabled beneficiary any remaining trust assets must pay back the state up to the full amount of Medicaid benefits received by the beneficiary, and only after the state is reimbursed may any excess pass to other beneficiaries such as other relatives. The payback provision requirement is Congress’s “quid pro quo” – the balancing deal that makes it fair for the disabled person’s otherwise disqualifying assets to be set aside in a Medicaid- and Supplemental Security Income-noncountable trust that is nonetheless able to be consumed by the trustee for benefit of the disabled person to supplement but not replace the governmental benefits.
Part III (tomorrow) will continue our discussion on the benefits of Irrevocable Trusts for Medicaid Planning.