Irrevocable Trusts: Not As Frightening As You Might Think!

by Todd E. Lutsky, Esq., LL.M

Most people associate the words “irrevocable trust” with the relinquishment of control, inflexibility and rigidity. However, in this article, we will seek to change that. An irrevocable income-only trust can actually enable an individual to retain a significant degree of control over their assets. At the same time, it can 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. This irrevocable income-only trust will help dispel the myth that one must gift their assets away to protect them. It allows individuals to retain control over their assets while ensuring protection.

Shifting Concerns Of Aging Individuals

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 long-term care costs.

These assets often consist of their:

• Primary home
• Vacation home
• Rental property
• Liquid investments

However, many are reluctant to transfer these assets directly to their children for fear of losing 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.

Case Study: A Married Couple In Massachusetts

Let’s take a look at a typical example, a married couple of 75-year-olds living in Massachusetts. They are generally healthy and have:

• Two children
• A home worth approximately $300,000
• Other liquid investments worth roughly $200,000

Their primary concerns are:

• Avoiding probate
• Saving on costs associated with long-term care
• Protecting their assets from creditors

The solution may be to transfer all or a portion of these assets to an irrevocable income-only trust.

The Benefits Of An Irrevocable Income-Only Trust

In a situation similar to the above example this kind of trust would offer several benefits, including:

• Providing that both husband and wife will be the donors and trustees of the trust during their lives
• Retaining the ability to make discretionary distributions of the income from the trust to themselves during their lives
• Keeping a significant degree of control over the assets transferred to the trust
• Having the ability to determine how much liquid investments should be invested
• Being able to sell any such trust assets, specifically the home

These powers provide the individual with a greater sense of independence and control than with outright transfers to children.

Irrevocable Income-Only Trust Vs. Life Estate

The couple in the example considered using a simple life estate to protect their home over the trust. Preparing a deed that transfers the remainder interest in the property to the children accomplishes this. The husband and wife would retain a joint and survivor legal life estate.

This means that they would keep the legal right to live on the property for the rest of their lives. This approach may provide protection from the costs associated with long-term care. However, depending on the state you live in, it creates more unnecessary problems than it is worth.

Potential Issues With Life Estate

Let’s say one the children in our example were to go through a divorce or struggle financially while their parents are alive. In that case, the creditor could put a lien on the property. The life estate would prevent the creditor from moving against the property while the parents are living. However, it will nonetheless provide complications for the living children following the death of the parents.

Additionally, if the parents want to sell their home during their life, they would need to get their children’s permission. Even if they agreed, assuming none of them use it as their primary residence, there may be capital gains tax.

The sale would result in a portion of the proceeds equal to the value of the parent’s life interest being allocated to them. The balance of the proceeds, which represents the remainder of interest, would be assigned 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.

How Capital Gains Tax Works

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.

Capital Gains Exclusion For Parents

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.

The Nominee Realty Trust Solution

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. Still, 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.

Income Tax Consequences

Insofar as annual income tax consequences, in the event the trust earns income (i.e., interest, dividends or rent), a fiduciary income tax return, Form 1041, may be necessary.

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 used 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.

Estate Inclusion And Step-Up In Basis

Upon the demise of the survivor of the husband and wife in our example, the assets of the trust will be includible in their gross estate and not their probate estate. This distinction is significant with regard to the state’s ability to recover any medical expenses spent on 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 consist of any assets an individual dies owning in their own name.

Assets in this irrevocable income-only trust do not count as assets owned in one’s own name. Thus, they 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 only to include the probate assets. Therefore, these trust assets will ultimately be protected for the children.

The Tax Benefits Of Step-Up In Basis

The estate inclusion also provides a significant income tax benefit known as a step-up in basis for capital gains tax purposes. This is not available for those who gave appreciated assets to their children outright.

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 a carry-over basis.

In other words, whatever the parents paid for the particular asset will carry over to the children. This means any capital gain in the property will stay there, waiting for recognition at the property’s eventual sale.

In our example, if the husband and wife transferred their home worth approximately $300,000 outright to their children and paid only $50,000 for it, the children would receive the parents’ $50,000 cost basis in the property. If 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.

The Advantages Of Trust Transfer

If the parents instead transferred these highly appreciated assets to this irrevocable income-only trust, the gross estate of the deceased parent could include these assets 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 house shortly after the parent’s demise, there would be little or no capital gains tax to be paid.

Conclusion

In conclusion, this irrevocable income-only trust allows parents to transfer assets to a vehicle that protects them in multiple ways, including from:

• Their creditors
• Their children’s creditors
• The cost of long-term care

At the same time, it will allow them to retain a significant degree of control over their assets. 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.

About The Author

Todd E. Lutsky graduated from the University of Toledo School of Law in 1991. He obtained a Master’s Degree in Taxation from Boston University School of Law in 1992. His email address is Email Todd.