Irrevocable Trusts: Value for Estate and Medicaid Planning

People often wonder about the value of using irrevocable trusts in estate and Medicaid planning. Outright gifts have the advantages of being simple to do with minimal costs involved. Many financial institutions have their own documents they use for changing ownership of assets so there are typically no out-of-pocket costs for the transferor.

So why complicate things with a trust? Why not just keep the planning as simple and inexpensive as possible? The short answer is that gift transaction costs are only part of what needs to be considered. Many important benefits that can result from gifting in trust are forfeited by outright gifting. These benefits are what give value to using irrevocable trusts in estate and Medicaid planning.

We will briefly outline ten possible benefits of gifting assets through irrevocable trusts. Each of these potential benefits depends on the specific language selected in drafting the trust. None of them is automatic or inherent in every trust.  Thoughtful planning and careful drafting are necessary to take advantage of the benefits available.  We at Elder Law of East Tennessee are available to discuss any of these issues in more detail.

10 Benefits of Gifting in Trust

1. Protect Assets from Future Creditors of Beneficiaries. A central benefit of gifting in trust is to protect the gifted assets from creditors and predators of the beneficiaries. This is accomplished by means of a spendthrift provision in the trust that makes trust assets not subject to attachment, foreclosure, garnishment, or other undesirable actions by the creditors of the beneficiaries.

2. Preserve Exclusion of Capital Gain on Sale of Principal Residence. Section 121 of the Internal Revenue Code creates an exclusion of capital gains of up to $250,000 when the taxpayer's principal residence is sold if the taxpayer owned and lived in it at least two of the past five years before the sale (or one of the past five years if the homeowner had to move to a nursing home). If there are two qualifying co-owners, they can each exclude $250,000 of gain upon sale in such circumstances.  This exclusion of gain is preserved when using a grantor trust but is lost if an outright gift is made.

3. Preserve Step-Up of Basis. Assets such as homes and stocks appreciate considerably in value from their original purchase price during the time they are owned. Normally when an appreciated asset is gifted outright to a beneficiary, the beneficiary receives the basis that the giver had in the asset. Using a grantor trust, however, allows the giver to make a gift to trust and at death, the beneficiary of the trust receives the appreciated asset with a stepped up basis equal to the fair market value on the date of death.  For highly appreciated assets, obtaining step-up of basis can be a huge benefit for minimizing or eliminating capital gains tax when the beneficiary later sells the assets. So, in short, capital gains taxes may be due on property gifted out right and avoided for property placed into an irrevocable grantor trust.

4. Select Whether Trust Income is Taxable to Settlors or Beneficiaries. A trust gives a settlor the ability to determine who will pay taxes on income generated by the trust.  Grantor trusts are treated by the Tax Code as “owned” by the settlor for income tax purposes, whereas nongrantor trusts place the tax burden elsewhere.

5. Designate 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 that the settlor reserves the right to receive income from the trust.  This can be a valuable tool in planning for public benefits such as Medicaid, since only the trust income, not the gifted assets, counts against the settlor’s qualification for those benefits.

6. Specify Terms and Incentives for Beneficiaries’ Use of Trust Assets. Many parents or grandparents desire to infuse their planning for their children or grandchildren with positive aspirations.  A trust can set conditions on how the gifted money may be spent, such as on the beneficiary’s education, or establish that the intended recipient will only receive the gift or bequest if he or she participates in a rehabilitation program or gives up some behavior designated by the donor.

7. Make Trust Assets Noncountable for Beneficiaries’ Medicaid or SSI.  An outright gift or bequest from a donor, such as a parent, to a disabled beneficiary can result in the beneficiary becoming ineligible for means-based governmental benefits that he or she was eligible for before the gift or bequest.  In such situations, the gifted assets are typically consumed for the beneficiary’s care.  Once they are gone, the beneficiary goes onto the public benefits program from which the gift temporarily disqualified him or her.  This can be prevented by including the gift in a trust established to pay for the trustee’s needs above and beyond what public benefits programs will cover.

8. Decide Which Beneficiaries Will Inherit Upon Settlor’s Death. A trust grants the settlor power of appointment, which gives the settlor the ability to decide who within a designated class of recipients will receive the benefits of the trust, how much they will receive, and in what way they will receive it. The class of potential recipients can be very broad or narrow. Most often it consists of the settlor’s descendants, certain other relatives or in-laws, and/or certain charities. A power of appointment is sometimes referred to jokingly as a “power of disappointment” because it truly retains for the settlor or other power holder the power to disinherit someone who acts badly.

9. Determine Successor Beneficiaries. A major concern in Medicaid asset protection planning and estate planning in general is who will be the successor beneficiaries of anything a donor leaves to someone. If the gift or bequest passes outright, the recipient has total control over who will receive any assets that the initial recipient doesn’t use up.  The recipient’s creditors or predators may also gain control over assets which are gifted outright. But by use of an irrevocable trust, the settlor has the option to decide who the possible recipients will be and even to grant limited powers of appointment to the named recipients in order to give them some control as well.

10. Eliminate of Need to File a Federal Gift Tax Return. A goal of many planners in design of irrevocable trusts is to make the initial trust-funding gift “incomplete” for tax purposes. The purpose is generally to prevent the settlor from having to file a federal gift tax return for the year(s) of the funding transactions, assuming that the taxpayer makes no other “taxable gifts” in any such year.

Is an irrevocable trust appropriate for meeting your estate planning or Medicaid planning needs?  We at Elder Law of East Tennessee are happy to assist seniors and their loved ones with considering whether an irrevocable trust may be appropriate for them. Please contact our office to schedule a time to discuss these issues further.