INCOME ONLY TRUSTS:

HAVING YOUR CAKE AND EATING IT TOO

Recently a healthy single woman came to my office with the following demand: “Protect my money in case I ever enter a nursing home, make sure my children do not pay any capital gains tax on the appreciation of the assets, and protect my dignity and self-respect so that I do not have to go my children and ask for money every time I need it.”

The woman’s assets included a home which she and her late husband had bought over thirty years ago for $45,000.00 and is now worth approximately $500,000.00. She also has stocks and bonds in the amount of $600,000.00 which were purchased for $80,000.00. I proceeded to enumerate the three options available to her and the consequences of each.

WAIT & SEE” APPROACH

This first option is also known as the “do nothing” alternative. Here, the client’s hope is that she will never need long term care. If it is eventually required, she will do something about it “when the times comes.” This usually results in the senior citizen spending all of her hard-earned assets on nursing home care. Clients and family members lose greatly and are often left with nothing, while the nursing homes are the big winners.

GO ALL OUT” APPROACH

This second option is where the client transfers all of her assets to her children, without considering capital gains tax and nursing home penalty periods. The children now own these largely appreciated assets, but upon any sale, will suffer a 20% tax hit, in the amount of $195,000.00.

Furthermore, several risks are associated with an outright transfer to children. If the children were to divorce or declare bankruptcy, the client’s money would be used to satisfy the claims of the children’s creditors. Additionally, if the client needed nursing home care immediately, that money may not be available to her, since it now legally belongs to her children. Here the client certainly loses her dignity by asking her children for money as she needs it.

INCOME ONLY TRUST

The third strategy is the course of action the client selected. Income Only Trusts provide a wonderful planning opportunity for both single and married couples who wish to protect their appreciated assets from the nursing home, while at the same time retain control over the income.

Clients who wish to protect their hard earned assets from future nursing home care usually list several factors why they decide to create a trust rather than transfer the assets to children outright. Control is one of the top reasons cited by clients. By transferring the assets to an Income Only Trust, as opposed to an outright transfer to children, the client has more control over the assets, since income is being paid directly to the grantor, rather than to the children. The client feels a greater sense of independence because of this direct payment.

In order to ensure that the assets in the trust are protected from the nursing home, the trust must be irrevocable. The grantor retains the right to receive income but the principal can not be accessed. For Medicaid planning purposes, the five year lookback period begins when assets are transferred into the trust. When assets are transferred from this trust to third parties, no lookback period is imposed because the penalty had been imposed when assets were placed into the trust.

Another reason not to transfer assets directly to children is to avoid some potential risks. If the child has creditors, gets divorced or has certain types of bad habits (gambling, drug addiction, alcoholism, and the like), the assets in the child’s hands may be squandered and will no longer be available to the parent. These risks are not found when creating an Income Only Trust, because the assets only belong to the Trust and not the child, and can’t be attached by the child’s creditors or divorcing spouse, or squandered due to the child’s bad habits.

Tax implications also warrant the use of an Income Only Trust. Since the income flows back to the grantor, the parent will be taxed on the income at the parent’s lower tax rate. Furthermore, if appreciated real estate is placed in the trust, the $500,000.00 exclusion from capital gains tax on the sale of the principal residence is preserved if sold by the trust; it is lost if the house is transferred directly to child who then sell it. From a capital gains tax perspective, the appreciated assets placed into this trust would be included in the client’s estate upon her death. Thus, the children will receive a step-up in basis and avoid paying significant capital gains taxes.

Income Only Trusts can be used in crisis planning but are even better in situations where it does not appear that Medicaid will be needed for a considerable period of time. The Deficit Reduction Act of 2005, signed February 8, 2006 created a five year lookback period for nursing home Medicaid eligibility for both transfers to individuals and to trusts. As a result of this level playing field, many clients have chosen to establish an Income Only Trust, if it is anticipated that Medicaid nursing home will not be required for five years, or if the Medicaid penalty period is less that the look back period.

The sole pitfall using this trust is that the State may seek to recover against the principal, to the extent of payments made by Medicaid on the grantor’s or spouse’s behalf. To prevent this from happening, the trust must terminate before the grantor or spouse applies for Medicaid. Distributing the principal to the beneficiaries during the grantor’s or spouse’s lifetime will not create a penalty as the gift was made when the trust was created. Distributing the income to the beneficiaries during the grantor’s or spouse’s lifetime will create a penalty but only on the income that is foreclosed to the grantor or spouse.

In summary, a properly drafted Income Only Trust is a marvelous planning technique that is easier for clients to accept than outright transfers to children. By properly drafting an Income Only Trust, I can ensure that your money will be protected from the nursing home, your children will not pay significant capital gains tax on the appreciation of the assets, and your dignity and self-respect will be preserved. This way you and your family members are the big winners!

Benjamin D. Eckman, Esq. concentrates his practice on Elder Law & Estate Planning. Elder law is intended to broadly assist “extended living”. An elder law practitioner provides the legal information necessary for persons whose lives will extend or have already extended beyond the time when all children are usually out of the house and when regular employment ceases. After the elder law attorney and client complete their work, legal documents have been drafted, tax considerations have been analyzed, and a plan to protect the elder’s estate has been implemented.

Benjamin D. Eckman’s practice focuses on Estate Planning & Elder Law – legal issues facing senior citizens. Benjamin D. Eckman received his Bachelor’s Degree in Business/Accounting from Touro College and his law degree from Seton Hall University School of Law. He is a member of the New York State Bar Association, the New Jersey State Bar Association, the National Academy of Elder Law Attorneys, the Elder Law Section and Real Property, Probate and Trust Section of the New Jersey State Bar Association, the Union County Bar Association, Passaic County Bar Association and the Bergen County Bar Association. He can be reached at (973) 709-0909, (908) 206-1000 or (201) 263-9161.