(This material was part of a presentation made by Dean S. Bress at an October 2000 Meeting of the Elder Law Section of the Westchester County Bar Association)

NEW DEVELOPMENTS IN ELDER LAW PLANNING

USING TRUSTS FOR MEDICAID PLANNING

1. Irrevocable. Revocable trusts do not work for Medicaid protection purposes because the trust property is considered available to the Grantor since the Grantor may revoke or amend the Trust. Thus the trust must be irrevocable if it is to work as a protection device.

2. Income Only. When drafting it makes sense to always consider the use of an income only trust. In many cases there will be no income because a residence is frequently the principal asset of the trust. If the assets are liquid or constitute an investment which produces income it is possible for the trustees to move the trust property to a new less income productive property. You might want to waive the Prudent Investor Act application to make sure your trustees are no locked into complying with that law. See EPTL § 11-2.3.

3. Residence. If a residence is an asset you want to make sure that the Grantor (usually a parent) has the comfort of knowing that the Grantor has specific rights to occupy and remain in his or her home without having to worry about a child or in-law putting pressure on the Grantor to take up a new residence in a nursing facility. So consider giving the Grantor the exclusive right to live in the home (similar to what be provided as a result of a life estate but it is not a life estate since a life estate is an interest in real property). Also consider giving the Grantor a veto power over a sale of the residence or a leasing of the residence. Another issue to deal with is the School Tax Relief Act in New York. See Real Property Tax Law § 425.3 (c). This allows a trust to be an owner of the subject property and to allow the Grantor to obtain the STAR exemption for the Trust provided that the Grantor is the beneficiary of the residence. You might want to place some language in the Trust that it is the Grantor's intent to qualify for the STAR exemption and the grantor is the exclusive beneficiary of the residence. Review the statute and use language in the Trust which apes, to the extent feasible, the statutory language.

(c) Trusts. If legal title to the property is held by one or more trustees, the beneficial owner or owners shall be deemed to own the property for purposes of this subdivision.

4. Grantor Trust Status. If a Trust qualifies for Grantor Trust status (see IRC §§ 671 et seq.), and if a residence is placed into the Trust, the Grantor will obtain through the Trust the same tax treatment afforded to the Grantor had no trust been established. This means that the tax benefits connected to home ownership will continue to be available to the Grantor as if the residence were never transferred to the Trust. This further means that if the residence is sold by the trustees of the Trust the Grantor will be entitled to the $250,000 exemption ($500,000 for couples if both spouses qualify irrespective of which spouse owns or owned the residence) from the capital gain on a sale of the residence. See IRC § 121.

5. Use of a Special or Limited Power of Appointment. Prior to the repeal of the New York State Gift Tax Law, it was important for practitioners to transfer the property to the Trust in a manner which avoided the need to treat the transfer as a completed gift. Under prior NY Gift Tax Laws, a transfer of greater than $108,000, then $115,000, then $300,000, produced the need to pay the state a gift tax. We avoided this by reserving to the Grantor a special or limited testamentary power of appointment which allowed the Grantor to appoint the Trust property upon the Grantor's death. This appointment would be effected through the Grantor's Will. By reserving such a power the gift was incomplete for tax purposes and thus no NYS gift tax would be imposed. Furthermore by using the power, the Trust property would come into the Grantor's gross taxable estate upon death (See IRC § 2041). This would result in a step up in the basis of the Trust property under IRC § 1014.

Since NY has eliminated the gift tax, we need only be concerned with the federal gift tax law which allows tax free gifts of up to $675,000 in 2000 (increasing to $1.0 million by the year 2006). In most cases having the gift treated as a complete gift would not cause the need to pay a gift tax since most our client's houses are valued at less than $675,000. But once the gift is treated as being completed, upon the death of the Grantor, assuming the residence were still in the Trust, there would be no step-up in basis. This creates an income tax problem for the Trust beneficiaries. The Trust beneficiaries are saddled with the lower basis in the residence and when the residence is sold after the death of the Grantor the $250,000 or $500,000 exemption from the capital gains tax is not available. Thus it makes a great deal of sense to continue to use the limited power of appointment.

Complicating the matter are some recent fair hearing decisions. We will start with the Murray decision which it is fair to say came as a surprise to many. (February 26, 1998). In Murray, Catherine Murray created an irrevocable Trust giving the Trustees the "sole and exclusive discretion to act with respect to the payment of income and the Trustees shall have no power to invade principal...." It appears that the Trust was funded with cash. The Trust also retained for the Grantor a special inter vivos power of appointment. The Grantor retained the right to change the Trustees. The fair hearing officer concluded that the Trust property was a properly countable resource. Because the Grantor retained the right to change the beneficiaries and the right to change the trustees, EPTL § 7-1.9 comes into play. Owing to the control over who the beneficiaries are (which happen to be the same people as the trustees) and since the change or potential change in beneficiaries may influence the decision of the trustees with respect to income being paid to the Grantor, the Grantor was in a position to compel the trustees/ beneficiaries to consent to an amendment of the Trust. This ability to influence the trustees by affecting the rights they would receive as beneficiaries, thus making it "reasonable to conclude that the appellant has retained a degree of control over the principal of the trust. ...the retention of control over a resource makes the resource (i. e. , the trust assets) an available resource."

What is the solution to Murray?

Consideration might be given to avoiding the power of appointment today because there will be no or little gift tax to pay since NY has repealed its gift tax law. Or, do we approach the matter from the point of view of the trustees? Why not have independent trustees who are not beneficiaries of the Trust? In Murray it was the combination of the lifetime power of appointment together with the relationships between the trustees and the beneficiaries which caused the problem.

Consideration might be given to using a retained right in the Grantor under IRC § 2036, to wit the Grantor's lifetime right to live in the residence or combining that with an income interest (since we can always control the amount of income by the nature of the investments, e.q., an investment in Microsoft will not produce dividends but an investment is Exxon will).

Other New Developments with powers of appointment.

Matter of James Hazeldine (November 28, 1997. You will note that this decision escaped attention for a while and antedated Murray): In 1991 Grantor created an irrevocable. Grantor retained a limited testamentary power of appointment allowing the Grantor to appointment the Trust property to the Trustee and the issue of the Trustee in any manner which the Grantor wished. It appears that the trust was funded with liquid assets. The Trustee also had a lifetime right to invade the principal for the benefit of the Trustee and the issue of the Trustee. The fair hearing officer concluded that the retaining of a testamentary power of appointment over the Trust property "constitutes a degree of control retained by the [Grantor] over the principal of the Trust- in this instance an ability to dictate who gets the monies upon death. In retaining a power of appointment, therefore, the [Grantor] has retained control over the Trust assets.

Planning: Hazeldine does not give us much room to maneuver. If you use a power of appointment , you have a problem. It may be worth noting that the purpose of counting assets is to make sure that assets which could be used to pay for a person's care are so used. Here the assets can not be used to pay for care yet are still counted. If the Trust property is available and the Trustee refuses to invade the principal, how does the Grantor obtain the Trust property to actually pay for the care?? This decision stands for the proposition that using a limited testamentary power of appointment could be dangerous even without the facts of Murray.

Laura S: June 29, 1999

LS created an irrevocable trust retaining a testamentary power of appointment. It does not say what the trust was funded with. The administrative judge concluded that the power of appointment constitutes a degree of control retained by the Appellant over the principal of the trust-in this case the ability to determine who gets the trust principal upon the death of the Grantor. The power of appointment constitutes a retained interest in the control over the trust property. The ALJ went on to say that the trust would still be no good since it was a Medicaid Qualifying Trust. The trust in question allowed the trustees to make loans including loans to the Grantor. Thus the entire trust corpus could be loaned to the Grantor without any possibility that the loans could be repaid. Owing to failure to properly evaluate the trust assets, the Agency determination was nevertheless reversed and remanded.

Antoinette Giubard: November 9, 1999

AG created an irrevocable income only trust in 1996 wherein she retained a testamentary limited power of appointment. There is no reference to what the trust was funded with. After reviewing the provisions of the NYCRR, the administrative law judge concluded: "The Trust Agreement specifically provides that the [Grantor] may not designate herself, her creditors, her estate or her estate's creditors as beneficiaries. She may designate only lineal descendants or charities. Therefore, according to the terms of the Trust Agreement, the trust corpus is not available to her."

What is the morale of these stories? It appears that employing the power of appointment is a very dangerous practice. What do you do with trusts that have been drafted but not reviewed by DSS? You might consider drafting a document releasing a power of appointment only after you have considered the full ramifications.

Note: Say you created an inter vivos irrevocable income only trust and a residence is placed in the trust reserving for the Grantor a power of appointment. The trust provides that if the house is sold the proceeds of sale are not subject to the power of appointment and the power of appointment is terminated. An application for Medicaid is submitted when the only asset of the trust is the residence. At the time of submission the applicant indicates an intention to return to the home if the applicant is in a nursing facility. (You might consider having your powers of attorney specifically authorize the agent(s) to exercise such a right on behalf of the principal.) Now DSS takes the position that the trust corpus is an available resource. OK, so what? If the residence were owned by the applicant, the home would nevertheless be exempt from the budgeting process. So lets say that the residence is available. Should we care? The main reason we are using the power of appointment is to get the step up in basis. If the home is sold we will use the $250,000 exemption. We will no longer need the step up. Do we really need to continue the power of appointment? Maybe!

USING A LIFE ESTATE

In view of the fact that the use of a power of appointment may present a problem of sorts, can we use the life estate to produce the same result?

Income Tax Issues:
Clearly the use of a life estate will insure that during the lifetime of the Medicaid Applicant, the income tax benefits associated with home ownership will be available to the Medicaid Applicant as owner of the legal life estate. That benefit is in the form of the deductions for real estate taxes and mortgage interest, if any. Thus the tax benefits remain the same. With respect to the STAR exemption, the life estate is a clear and easy method for obtaining the STAR benefits as well.

Gift Tax Issues:
It would appear that the full value of the gift which includes the value of the life estate is subject to gift tax. So if the home has a value of more than $675,000 there could be an issue but this is usually not the case. Remember there is no gift tax in NY.

Estate Tax Issues:
There should be a step up in basis under IRC § 2036 if the home has not been sold prior to the death of the Medicaid Applicant.

So what is the Problem? There are two problems with this approach and one positive element not discussed. First, for the good news, the transfer to the remainder owners by deed will produce a penalty period determined by the tables at the back end of 96 ADM -8, dated March 29, 1996. For example a 75 year old transferring an interest in a home having a value of $250,000 (fairly typical for our clients) will only be treated for Medicaid penalty purposes as having made a transfer of 47.851% of the fair market value of the property (don't forget you will need an appraisal for the gift tax returns and for DSS when the application is filed). Thus the transfer is $119,627.50. The life estate will not be budgeted for eligibility purposes. See 96 ADM -8. Thus we have a relatively short ineligibility period for institutional care. That's the good part.

Now for the problems. When the house is sold, if it is sold during the lifetime of the Medicaid Applicant, the portion of the proceeds attributed to the life estate holder must be paid to the life estate holder, to wit, the Medicaid Applicant. That will result in a loss of Medicaid. Next, upon a sale, there is a possibility of a loss of the $250,000 exemption certainly with respect to the remaindermen and possibly with respect to the Medicaid Applicant. The remaindermen will not have satisfied the two year test in most cases and thus the exemption attributed to the remainder interest will not get the benefit of the exemption. Also the Medicaid Applicant, in order to obtain that portion of the exemption attributed to the life estate must meet the residency requirements. See IRC 121 (d)(7).

Determination of use during periods of out-of-residence care. In the case of a taxpayer who--
(A) becomes physically or mentally incapable of self-care, and
(B) owns property and uses such property as the taxpayer's principal residence during the 5-year period described in subsection (a) for periods aggregating at least 1 year, then the taxpayer shall be treated as using such property as the taxpayer's principal residence during any time during such 5-year period in which the taxpayer owns the property and resides in any facility (including a nursing home) licensed by a State or political subdivision to care for an individual in the taxpayer's condition.

Even though the statutory test of residency is not met, there could be a partial exemption available as applicable to the life estate interest. You might want to determine the likelihood of a sale during the lifetime of the Medicaid Applicant. This is difficult to know but it is something to discuss with the client.

Consideration might also be given to transferring the life estate to an income only irrevocable trust. There will be no need for a power of appointment since the remainder interest has been spoken for at the time of the initial transfer. The benefit is that immediately before a sale of the residence the proceeds of sale will not need to be paid to the Medicaid Applicant but will instead be paid to the trust. But, upon a deed of the life estate to a trust, will that produce a penalty period? Does it make a difference whether the life estate transfer occurs before or after a person is declared eligible for institutional Medicaid benefits?

THE PRIVATE ANNUITY AS A PLANNING DEVICE

The Concept: Generally speaking assets or resources are transferred to a third party in return for a flow of income for a period of years or life, with or without a guaranteed period of payments even if the annuitant dies prior to the end of the term certain period. Thus what the Medicaid Applicant may have done is exchanged resources for a flow of income. In the normal course of events this is not a viable strategy for your clients but is a smart sale for the person suggesting the annuity using a commercial annuity and that person is making a commission on the sale. The traditional lawyer makes no commissions on a sale of an annuity and does not care whether the annuity is purchased from an insurance company or an individual. The problem with the strategy is that Medicaid budgets the increased income and that increased income is subject to a 100% pay down in most cases. Thus not much has been accomplished.

How to Use an Annuity for Planning: Under HCFA Transmittal No. 64, dated November, 1994, HCFA addresses the use of an annuity. Annuities are not prohibited in any regard. The annuity to be acceptable must be actuarially sound. That is, the value of what is transferred should be equal to the value of what is promised to be paid to the transferring person plus interest based on the current market and for that purpose I would recommend that the IRC § 7520 rate be employed (currently at 7.4% for the month of October, 2000). The fair market value of what is transferred is equal to the fair market value of what is to be received in return assuming the transferring person lives out the period of the annuity or for life. I use a lifetime annuity.

If a spouse is facing institutional care, and if there are assets in the family which exceed the community spouse resource allowance, there is the possibility that DSS can institute an action for support or under an implied contract theory to recover from the well spouse the excess assets. So what does the well spouse do? The well spouse transfers assets to children in return for a lifetime annuity. For income tax purposes this amounts to a sale. When the annuity is paid by the children to the well spouse the well spouse reports a portion of each payment as a return of capital assuming that the asset transferred was not cash but was an asset with a basis; a portion is reported as a capital gain (measured by the difference between the fair market value of the property (say securities) over the basis of those securities, and the balance is reported as a capital gain. The children pick up taxable income to the extent that the assets thereafter earn additional income. See the Attachment for an example of this calculation for a 70 year old female. You will note that the age appearing in the Example is 71. The reason for the difference is that my software is based on the IRS tables and not the HCFA tables and therefore to get the results I need to meet HCFA requirements I use the IRS software but add 1 year to the age. That usually works.

You will note the monthly payment is $2,145. Yearly the annuitant receives $25,742. You will also note the breakdown the return of capital, capital gain portion, and ordinary income portion. We have now taken $200,000 off the table in return for income. Say that Mrs. Smith had $750 of other income and $75,000 of other assets plus a home in her name. What happens? The home is protected unless she gets sick; the $75,000 is protected because it is within the CSRA, and the income is over the current MMMNA of $2,103. The excess income is $792. She would be wise to contribute $198 towards her husband's care. Not a bad deal!

Income Tax Issues If Mrs. Smith dies before the date of her life expectancy, she will have a tax loss equal to the unrecovered cost basis of the assets used to purchase the annuity. The loss is deductible on Mrs. Smith's final income tax return. If on the other hand Mrs. Smith lives beyond her expected life expectancy, then the monies paid to her will be subject to tax only with respect to those payments which did not represent a return of capital.

There are complicated issues involving the calculation to the children who sell the asset transferred to them and whether and when Mrs. Smith dies. We need not pursue them in this discussion.

INCOME FIRST POLICY

The Issue. Federal law creates a safe haven for community spouses ("CS") who need to retain income and resources to pay for their own needs while their spouse is in a nursing facility and thereafter. CSs would prefer to keep resources which exceed the CSRA so that after the institutionalized spouse dies, which results in less income to the couple, the CS has resources on which to live thereafter. If the CS is made to spend down excess resources to the level of the CSRA, when and if the institutionalized spouse ("IS") predeceases the CS, the CS will no longer have resources on which to live and the income (i.e., pension etc.) of the IS will frequently be reduced or terminated and therefore not available for use by the CS. Thus lawyers tried to allocate resources to the CS in excess of the CSRA and allow that CS to build and retain his\her own income. The excess income (in excess of $50 per month) would be lost to the costs of care of the IS but at least the assets would be available to the CS thereafter.

Matter of Golf: In 1998, after some other states had arrived at essentially the same conclusion, the NY Court of Appeals agreed that the method for bringing the income of the CS up to the MMMNA allowance (now at $2,103) was discretionary with the states and that a state could decide that such income needed to come from the income of the IS before allowing the CS to retain excess assets to generate the income to meet the MMMNA. 91 NY 2d 656, 674 NYS 2d 600 (1998).

Robbins v. DeBuono: The issue before the US Second Circuit was whether an allocation of an IS's social security benefits constituted an alienation of those benefits in violation of the anti-alienation provisions of 407 of the Social Security Act and whether a similar allocation of pension benefits constituted an impermissible alienation under ERISA. The Second Circuit concluded that an allocation of social security benefits was indeed an impermissible allocation involving "legal process" but that a pension was different and that ERISA's requirements were not as stringent as those of Section 407. 2000 U.S. App LEXIS 15683. Robbins offers an important opportunity for CSs to increase the amount of resources in their possession. Thus steps can be taken to ameliorate the effect of Golf and attorneys need to be aware of the possibilities.

Private Annuity Attachment