For clients who are asset-rich but cash-poor, an irrevocable income-only trust can be a good asset protection tool. Texas elder law attorney John K. Ross explained how to draft these trusts and how they relate to Medicaid eligibility during a session at the National Academy of Elder Law Attorneys' recent 2012 Annual Conference in Seattle, Washington. Ross practices in a rural area where clients may have timber land or mineral rights but not a lot of cash. The problem with this type of asset is that it is illiquid and can't be converted to cash quickly if a crisis arises.
Ross began by reminding his listeners how Medicaid treats an irrevocable trust. If any part of the principal can be distributed to the Medicaid applicant, then the trust is an available resource. On the other hand, if it is not a countable resource, there will probably be a transfer penalty on any property transferred to the trust.
The most important provision in an irrevocable income-only trust is one stating that the trustee may distribute income to the grantor but is prohibited from distributing principal. Ross explained that clients are often nervous about putting assets into a trust where there is no access to the principal. The way to ease their mind is to have a secondary beneficiary -- e.g., the grantor's children – to whom the trustee can distribute principal.
But secondary beneficiaries can become incapacitated themselves. "You don't want to create a problem for the child if the child needs Medicaid," cautioned Ross. To avoid this scenario, you can add a provision that cuts off principal distributions if any beneficiary is on a needs-based program. This could be considered an uncompensated transfer for Medicaid eligibility purposes, and the beneficiaries need to understand how this will affect future Medicaid eligibility.
What if the grantor wants the ability to change beneficiaries? You can put a power of appointment in the trust, but be careful. "Do not use a general power of appointment where a grantor could appoint that property to anyone including to himself and his estate" because then the trust will be an available asset, explained Ross. However, limited powers of appointment will not affect Medicaid eligibility. In Verdow v. Sutkowy (N.D.N.Y., 5:01-CV-1468 (HGM/GJD, Sept. 9, 2002) the state claimed that giving the grantor a limited power of attorney made the trust effectively a revocable trust because the grantor and the beneficiaries could collude. The court rejected that argument, holding that the possibility of collusion is irrelevant.
If you do put a power of appointment in the trust, you need to make sure it doesn't conflict with the grantor's power of attorney. Does the power of attorney give the agent the power to exercise a power of appointment?
When drafting termination and final distribution provisions, Ross cautioned not to include the same provisions as you would for a revocable living trust. Revocable living trusts usually include a provision to have the trust pay the expenses of the last illness. This should not be included in an irrevocable income-only trust because it would defeat the whole purpose of the trust, although it is fine to include a provision for payment of estate taxes.
Draft Out of the UPIA
The trust management provisions of an income-only irrevocable trust should reiterate that no principal can be distributed to the grantor. One thing to be very careful of is the Uniform Principal and Income Act (UPIA), which among other things allows the trustee to dip into the principal for the benefit of the income beneficiary. If the state law says that the trustee may access principal for the benefit of the grantor, then the whole trust will be a countable resource. In addition, the UPIA requires the trustee to invest in the most prudent manner, but there may be circumstances where you do not want the trust to generate any income. If your state has enacted the UPIA, Ross warned that you need to draft out of it or it could destroy the whole trust.
If the grantor enters a nursing home, her income will go to the nursing home. It is possible to restructure the investments in the trust so that they aren't creating any income as long as the trust does not prescribe how funds are to be invested. Ross cautioned that doing this may make the state mad and "there is something to be said for paying out some income just to make them happy."
Although irrevocability often frightens clients, irrevocability is a "bit of misnomer," according to Ross. The trust can be made revocable by unanimous agreement of the secondary beneficiaries. Ross cautioned that you need to pay attention to state regulations. Even though technically "every trust can be amended by a court," the Texas Medicaid manual states that if the trust can be amended by order of the court, then it is a revocable trust. Therefore, you don't want to put anything about the beneficiaries being able to revoke the trust directly in the document, but you may be able to reassure your clients.
If your grantor serves as trustee, then you don't need a tax ID number. However, Ross advised that "banks make up their own laws," so you may need to get one anyway. The transfer of property into the trust is an incomplete gift for purposes of the gift tax, but it is still a good idea to file a gift tax return related to the future gift. Having gift tax returns is "good evidence" that you intended to make a gift, according to Ross. There will be a step-up in basis upon termination of the trust.
An irrevocable income-only trust should not be subject to Medicaid estate recovery, but the law is not totally clear in states with the expanded definition of estate, Ross said. If you live in a state that does not have the expanded definition, then the trust is a non-probate asset and it cannot be recovered. In states with the expanded definition, Ross believes that for the purposes of estate recovery, the asset is out of the estate at the creation of the trust even though it does not vest in the beneficiaries.
In summary, Ross stressed that the income-only trust is not perfect for everyone and is only one part of a larger plan. It is primarily used for clients with illiquid assets that they aren't going to use and is better than an outright gift because the clients can retain control. Ross cautioned never to counsel clients to impoverish themselves with this tool.
The sessions of the 2012 NAELA Annual Conference are, or soon will be, available on DVD (including materials). Contact naela@naela.org for more information
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