by Todd E. Lutsky, Esq., LL.M
Most people associate the words "irrevocable trust" with the relinquishment of control, inflexibility and rigidity. However, this article will explore the use of an irrevocable income only trust and show how such a trust will enable an individual to retain a significant degree of control over their assets during their life, while at the same time provide creditor protection as well as tax planning opportunities. In addition, these trusts will serve to reduce the risks associated with transferring assets outright to children. Finally, this irrevocable income only trust will help to dispel the common asset protection planning myth that one must gift their assets away and give up complete control over them in order to protect them from both the costs associated with long term care and general creditors.
In this regard, as individuals age, they begin to become concerned about the potential costs associated with long term care. Their focus may shift to discovering strategies that will protect their assets from both general creditors and the costs associated with long term care. These assets often consist of their home, vacation home, rental property and/or liquid investments. However, many individuals are generally reluctant to transfer such assets directly to their children or other family members for fear of relinquishing total control over them. Often, this fear results in procrastination or inaction, thereby leaving the individual's assets at risk. Instead, an individual may consider transferring such assets to the irrevocable income only trust mentioned above.
Let's take a typical example. Assume a married couple, living in Massachusetts, who are generally healthy, age 75, have two children, own their own home worth approximately $300,000, other liquid investments worth approximately $200,000 and are concerned about avoiding the costs associated with the probate process as well as protecting their assets from both the costs associated with long term care and general creditors. The solution may be to transfer all or a portion of these assets to an irrevocable income only trust. The trust will provide that both husband and wife will be the donors as well as the trustees of the trust during their lives. In addition, husband and wife, as trustees, will retain the ability to make discretionary distributions of the income from the trust to themselves during their lives. Furthermore, as trustees, they would retain a significant degree of control over the assets transferred to the trust including, but not limited to, the ability to determine how such liquid investments should be invested as well as the ability to sell any such trust assets, specifically including the home. These powers alone generally provide the individual with a much greater sense of independence and control during their life than would be the case with outright transfers to the children.
With regard to the primary residence, the husband and wife, like many couples, considered using a simple life estate as means of protecting the home instead of implementing the irrevocable trust mentioned above. This is accomplished by preparing a deed which transfers the remainder interest in the property to the children with the husband and wife retaining a joint and survivor legal life estate. In other words, this means that our couple would retain the legal right to live on the property for the rest of their lives. Although this approach may ultimately provide protection from the costs associated with long term care, depending on the state in which you reside, it tends to create more unnecessary problems than its worth.
First, in the event any of the children in our example were to get divorced or have financial difficulty during the lives of the parents, the creditor would be able to put a lien on the property. Although the life estate will prevent the creditor from moving against the property while the parents are living, it will nonetheless provide complications for the living children following the death of the parents. In addition, in the event the parents desire to sell their home during their life, they would be required to obtain the permission from all of their children. Even if the children agreed to sell the property, assuming none of the children use this property as their primary residence, there may be a capital gains tax to be paid by the children. The sale would result in a portion of the proceeds equal to the value of the parents= life interest being allocated to them with the balance of the proceeds, which represents the remainder interest, being allocated to the children. The children would also be allocated a respective portion of the parents' cost basis in the property to be used in determining the children's capital gain.
In our case, assuming the parents paid $50,000 for their home and sold it for $300,000, the children, based on current Medicaid tables, would be allocated approximately 50% of the cost basis, and approximately 50% of the sale proceeds. The result would be that each child would receive $75,000 of the proceeds and $12,500 of the cost basis, which would result in a capital gain for each child of approximately $62,500 with a corresponding income tax liability of $12,500 each, not to mention the fact that the children now have an early inheritance.
With regard to the parents, provided they have owned and used such property as their primary residence for two of the last five years and were married on the date of sale, they would have a capital gains tax exclusion of $500,000. In other words, they would only be responsible for capital gains tax to the extent their portion of the gain exceeded $500,000.
Upon further consideration, the couple decided to transfer their home to a nominee realty trust with the schedule of beneficiaries being the irrevocable income only trust. The deed, as mentioned above, will reflect the reservation of a joint and legal life estate, but instead of granting the remainder interest to the children, the remainder interest will be in the irrevocable income only trust. Unlike the simple life estate, if the parents wanted to sell their home they would not need the children's permission and would avoid the capital gains tax problems discussed above. In this regard, since the trust is a grantor trust, which means the husband and wife are considered the owners for income tax purposes, they would retain the ability to avail themselves of certain capital gains tax exclusions associated with the sale of their primary residence. Therefore, in the event they chose to sell their home during their life, provided they have owned and used such property as their primary residence for two of the last five years, were married on the date of sale, and the resulting gain did not exceed $500,000, there would be no capital gains tax due. Furthermore, since assets of this trust are not accessible to the creditors of their children during the parents' lives, it eliminates the concern of transferring assets outright to a child who may encounter financial difficulties, or be a gambler, drug addict, alcoholic, or spendthrift. Finally, this type of trust will also provide some general creditor protection for our couple during their lives.
Insofar as annual income tax consequences are concerned, in the event the trust has earned income (i.e., interest, dividends, or rent), a fiduciary income tax return, Form 1041, may be required to be filed. However, since the grantor (i.e., husband and wife in our example) retains the ability to appoint the remainder or principal of the trust to a class consisting of their children of all generations in equal or unequal shares, it makes the trust a grantor trust for income tax purposes. This retained power is generally referred to as a limited power of appointment. Since it is a grantor trust, it does not pay any income taxes, but instead flows the income through to the grantors (i.e., husband and wife) to be taxed at their lower individual rates, rather than at the higher, more compressed, trust tax rates. In other words, they will continue to pay the income taxes at their lower individual rates just like they use to prior to establishing this trust. This limited power of appointment also prevents the transfers to this irrevocable trust from being treated as gifts, thereby eliminating the concern of any gift tax due upon the funding of this trust.
Upon the demise of the survivor of the husband and wife in our example, the assets of the trust will be includible in his or her gross estate and not their probate estate. This distinction is important with regard to the state's ability to recover any medical expenses spent on their nursing home care. Some states define the recoverable estate to include only probate assets, while other states define the recoverable estate to include the broader definition known as the gross estate. Massachusetts currently defines the recoverable estate to include only those assets in the individual's probate estate. The probate estate would include any assets an individual dies owning in their own name. Assets owned in this irrevocable income only trust are not considered assets owned in one's own name, thus are not includible in the probate estate and would not be subject to Medicaid's estate recovery provisions in those states that define the recoverable estate to only include the probate assets. Therefore, these trust assets will ultimately be protected for the children.
The estate inclusion also provides a significant income tax benefit known as a step-up in basis for capital gains tax purposes, which is not available for those who gifted appreciated assets outright to their children. For example, if an individual were to gift their highly appreciated home or stock outright to their children in an effort to protect it from the cost of long term care, the children would receive the parents' cost basis in such property, which is known as a carry over basis. In other words, whatever the parents paid for the particular asset will carry over to the children, which means any capital gain that is built into this property will remain there waiting to be recognized whenever the property is sold. In our example, if the husband and wife transferred their home worth approximately $300,000 outright to their children, and had paid only $50,000 for it, the children would receive the parents' $50,000 cost basis in the property. In the event the children decide to sell the house for $300,000 shortly after the parents died, they would realize and recognize a $250,000 long term capital gain, with a corresponding federal tax liability of approximately $50,000.
However, if the parents instead transferred these highly appreciated assets to this irrevocable income only trust, such assets would be includible in the gross estate of the deceased parent and would receive a step-up in basis. The step-up in basis is equal to the fair market value of the property on the date of death. In our example, if the parents had put their home in this irrevocable income only trust, and the fair market value upon their demise was $300,000, the children would receive the home with a basis equal to this $300,000 value. Therefore, if the children were to sell the home shortly after the parents' demise, there would be little or no capital gains tax to be paid.
In conclusion, this irrevocable income only trust allows the parent to transfer assets to a vehicle that will provide protection from their creditors, their children's creditors, and the cost of long term care, while at the same time allowing them to retain a significant degree of control over such assets during their lives. In addition, this trust provides some estate and income tax planning benefits. This irrevocable trust is about as close as you can get to having your cake and eating it too.
Todd E. Lutsky graduated from the University of Toledo School of Law in 1991 and obtained a Masters Degree in Taxation from the Boston University School of Law in 1992. His email address is Email Todd.