By Paul Hyl, Esq
The Deficit Reduction Act of 2005 (“DRA”) was not all bad news for our clients. Sure there’s the extended look-back period, the delayed running of the penalty period, the annuity and home value limitations, as well as several other provisions that make it more difficult for seniors to become eligible for Medicaid benefits. However, by extending the look-back period to five years for all asset transfers, the DRA has resulted in the increased use of trusts by elder law practitioners, and this is good news for clients.
Prior to February 8, 2006, the effective date of the DRA, a typical Medicaid plan likely involved the use of real property transfer with a retained life estate. The use of the life estate allowed a senior to retain some control over their home, while effectively taking it out of their name for Medicaid purposes. Since the gift of a remainder interest in their homes to their children represented a transfer to individuals and not a trust, it resulted in the three-year look-back period instead of a five-year look-back period. Second, since the amount of the gift was calculated on the value of the remainder interest, the penalty period, which, in that “pre-February 8, 2006 Medicaid world,” began running shorter than on a gift of the entire property. In addition to their homes, senior clients also would make outright gifts of cash, securities or other assets to their children, rather than establishing a trust. After all, that too resulted in a shorter look-back period and, as many clients indicated: “I trust my children and a trust seems too complicated.” Try as we might to convince our clients that children (or at least shouldn’t) always be trusted, that trusts are not as complicated as they seem, and that our attorneys’ fees are well worth the multitude of benefits gained by using a trust. Further, without the proverbial crystal ball to tell us if the clients would require Medicaid in more than three but less than five years, it was hard to advocate the use of a trust and its longer look-back period. Now, thanks to the DRA and its unification of the look-back periods, it is much easier to convince a client to establish a trust rather than making outright gifts to children. I will outline below an overview of the reasons why trusts are better than outright gifts and life estate transfers for the Medicaid planning (non-taxable-estate) client.
From an asset protection standpoint, assets gifted outright by a senior client to the children’s creditors, bad judgment, spousal influences or even divorce. However, assets gifted to a trust are protected from the beneficiaries’ creditors and spouses. This protection can even be extended beyond the client’s death, if the assets continue to be held in a spendthrift trust for the benefit of their children.
From an inheritance standpoint, if a senior gifts asset outright to a child, and the child predeceases the senior, the senior would have no control over who would inherit such funds upon their child’s premature death. Those assets would pass as part of such child’s estate, either under their will or under the laws of intestacy. This result sometimes was avoided by having the assets held by all of the children as joint tenants with right of survivorship, but then the predeceased child’s issues were left with no inheritance. However, by utilizing a trust, the senior client can control what happens if one of their intended beneficiaries were to predecease them, and allows greater control when planning for a minor, disabled or irresponsible beneficiary. Moreover, through the use of a limited testamentary power of appointment, a senior can retain the right to change those beneficiaries, even though the trust may be irrevocable (which it must be for Medicaid and asset protection purpose.
From a gift tax standpoint, the federal credit against gift tax permits up to $1,000,000 of taxable gifts during life without imposition of a gift tax? Even if the amount gifted by a senior to their children were less than $1,000,000, if it were over the annual gift tax exclusion amount of $12,000, although no gift tax would be due, a gift tax return would have to be filed. On the other hand, a trust can be drafted so that gifts to the trusts are not considered completed gifts for gift tax purposes, and, therefore, the client would not need to file any gift tax returns and no one gift tax would be due.
From an income tax standpoint, when assets are gifted outright, the future income earned by those assets will be taxed to the new owners of those funds. Many times a senior’s children inquire if they can use the money they received from their parents to pay the extra income taxes they owe a as result of having such funds titled in their name. However, a trust can be drafted as a so called grantor trust for income tax purposes, so that the grantor would continue to be responsible for paying income tax on the income earned by the trust. Assuming that the grantor’s children are in a higher income tax bracket than the grantors themselves, this grantor trust status obviously is preferable.
From a capital gains standpoint, since the recipient of a gift receives the donor’s cost basis in the transferred asset, outright gifts to children can result in unnecessary capital gains tax. When dealing with stock or real property, the current value could be a substantial increase over what the senior originally paid for such asset. On the other hand, when the same assets are transferred to a trust, provided the trust is structured in such a way that the assets in the trust would be included in the donor’s taxable estate, the trust beneficiaries receive a stepped-up cost basis in the trust assets they receive upon the donor’s death. Accordingly, all appreciation or gain on the assets during the donor’s life will escape taxation.
From a real estate tax standpoint, a properly drafted trust that provides the grantor with the sole and exclusive right to reside in any real property owned by the trust will preserve a senior’ s current real estate tax exemption. While this benefit can also be obtained through the use of a life estate, a trust is still preferable as there are limitations to the life estate. For example, if a senior transfers ownership to their house to their children while retaining a life estate, and the house is later sold, several problems arise. Often times, the desire to sell the house arises when the senior enters a nursing home and is approved for Medicaid benefits. The children, not wanting to maintain the now vacant home, desire to sell it. However, upon such a sale, the senior receives a portion of the sale proceeds (representing his life estate), thereby making him ineligible for Medicaid benefits until such funds are spent down. Other times it is the senior who desires to have the house sold, so he may downsize or relocate. While the children, as owners of the remainder interest in the house, can legally be forced to cooperate with such a sale, there is no requirement that they use their share of the sale proceeds to help their parent purchase or rent a replacement residence. In either event, regardless of who wants the house may be, the children likely will owe capital gains taxes on their portion of the sale proceeds, since they likely do not meet the requirements for the principal residence exclusion. When title to the home is transferred entirely to a trust, all sale proceeds remain within the trust. This avoids any funds going to the senior who may be on Medicaid, or their children who may not be willing to use the funds to help the senior purchase a replacement residence. Furthermore, if the trust were structured as a grantor trust for income tax purposes, the entirety of the capital gains taxes would be taxable to the senior who presumably meets the requirements for the principal residence exclusion.
Lastly, and perhaps most important, from a lifestyle standpoint, by using a trust, clients can guarantee themselves the right to receive the income earned on trust assets, without requiring the cooperation of their children. All those benefits and no increased look-back period for Medicaid eligibility purposes make the use of trusts far more preferable in asset protection planning.
Paul Hyl, Esq. is a senior associate of the Melville based law firm, Cona Elder Law PLLC. He practices exclusively in the field of Trusts and Estates and Elder Law, advising clients on sophisticated Estate Planning matters, Medicaid planning, charitable giving and estate and gift taxation issues. Mr. Hyl practices before the Surrogate’s Courts of Nassau and Suffolk Counties, the five boroughs of the City of New York and Westchester County. He is a Member of the Nassau County Bar Association and the New York State Bar Association, and its Elder Law and Trusts and Estate Sections.