Question: My friend has an irrevocable trust to protect assets in case she needs Medicaid to pay for her long-term care. What are the tax ramifications of this kind of trust?
Answer: The typical Medicaid trust is a grantor trust for income tax purposes and is includible in your estate for estate tax purposes.
The grantor trust rules came about after high earners tried to lower their income tax consequence by scattering their income to various trusts over which they maintained control. By spreading their income out, the earners were subject to the lower tax brackets since each trust was considered a separate entity, rather than all the income being taxed to one individual. Eventually, the IRS caught on to this technique and the grantor trust rules were born.
The grantor rules state that if the grantor, that is, the creator of the trust, maintains certain “strings” of control over the trust, such as the right to exchange property of like value, then all the income from said trusts must be reported on the grantor’s individual tax return. In addition, the IRS imposed compressed tax rates for trusts. For instance, in 2020 once the income of a trust exceeds $12,950.00, the trust is taxed at the highest tax bracket of 37%. An individual would have to earn $518,000 to reach that rate.
Medicaid trusts are also typically includible in the estate of the grantor. This would mean that despite the fact that the grantor transferred assets to an irrevocable trust during their life, if they retain certain rights under the terms of the trust, the assets are still includible in their estate for estate tax purposes.
While this combination of rules from the IRS does not help to lower income or estate tax, it provided for the perfect vehicle for Medicaid planning. Nursing Home Medicaid imposes a penalty for any transfers made within the 5 years prior to the date of the application. If assets are transferred to a trust, the trust must be irrevocable and must provide that the grantor has no right to principal in order for Medicaid to consider the asset unavailable for eligibility purposes. Individuals interested in Medicaid planning were anxious to protect assets, but did not want to give up complete control of their assets, nor did they want to incur any negative tax treatment. The grantor trust rules solved those concerns. While Medicaid does prevent the trust from returning principal to the grantor, the grantor can still receive any income earned in the trust, can retain the right to reside in any real property in the trust and can change the trustee or beneficiaries at any time. Moreover, because the grantor retains the right to reside in any real property tax exemptions and still receive their $250,000 capital gains exemption if the property is sold.
As mentioned above, if property drafted, a grantor trust will provide that any income generated within the trust will be reported on the creator’s individual tax return, thus eliminating the possibility of a compressed tax rates. Additionally, since the assets are still includible in the grantor’s estate when they pass away, there will be a 100% step-up in cost basis equal to the fair market value as of the date of their death. This means that if a grantor purchased her home for $30,000.00 in 1980, the property will be re-assessed upon her death to the fair market value. Therefore, when the beneficiaries sell the property there will be no capital gains tax incurred.
Not all trusts are created equal. If you are considering a Medicaid trust, consult with an Elder Law attorney in your area to learn more.
- Kimberly Trueman, Esq. and Nancy Burner, Esq.