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Transfer of the Personal Residence to an Intentionally Defective Grantor Trust


(In which the authors discuss the advantages of the transfer of the family residence to an asset protective trust to insulate a family residence from Medi-Cal recovery claims.)

By Conrad M. Wilkinson, Esq. and Patricia J. Wilkinson, Esq.

Under current California Medi-Cal Regulations, the family residence is considered an "exempt asset" for purposes of qualifying an owner for state long term care assistance. Home ownership does not preclude an owner from qualifying for Medi-Cal if he or she would otherwise qualify. However, when the homeowner dies following receipt of Medi-Cal benefits, the property remaining in the homeowner’s name becomes a resource for Medi-Cal recovery claims and liens. Surprisingly, a donative transfer of the home does not invoke a "period of ineligibility" under the Medi-Cal regulations if the donor retains or is given a legal right to return to the home even if he or she is institutionalized and a Medi-Cal beneficiary.1 The Department of Health Services (DHS), the state of California Medi-Cal administering agency, has made it clear that a mere affidavit or sworn declaration by the donee is sufficient to make the transfer exempt.2 In particular, the home owner receiving Medi-Cal benefits may decide to give away the house during his or her lifetime so that the house is protected from a Medi-Cal estate recovery claim at the home owner’s death.

This article will discuss the donor control, creditor protection and tax issues surrounding gifting the home to an intentionally defective irrevocable grantor trust.

It is clear that inter vivos transfers to an inter vivos revocable trust in California provide no asset protection to the client. However, by transfer of the house to an irrevocable trust, the client may retain substantial control and flexibility, retain many of the tax benefits of home ownership, and obtain greater asset protection of the home and the proceeds from any sale of the home by the trust.

The transfer of the family residence to an irrevocable trust may afford the client even greater asset protection and flexibility than an outright gift. In particular, this article submits that the client can maximize the client’s retained control and flexibility by a transfer to an irrevocable trust that is intentionally defective for income, gift, and estate tax purposes. (This article assumes that the fair market value of the client’s estate is less than the current $1Million Applicable Exclusion.)

The analysis below will focus on structuring the IDIT to be controlled by the client following the transfer while preserving the asset protection, income tax, property tax and transfer tax advantages of home ownership.

A. Purposeful Defects in the Trust

1. Defect for Income Tax Purposes.

The prototype "intentionally defective irrevocable trust," or "IDIT," is drafted so as to be defective solely for income tax purposes. "Defective" in the context of an IDIT means that, for income tax purposes under §§ 671 through 678 of the Internal Revenue Code, the client is deemed the owner of the trust assets and is therefore obliged to pay all of the income tax (including capital gains) generated by the trust assets. This defect coupled with making the trust defective for gift and estate tax purposes provides a powerful estate planning vehicle for protecting the family residence from Medi-Cal estate recovery claims coupled with greater control and asset protection for the client and his or her transferees.

In some situations, the client also will want to retain some beneficial interest in the trust, such as the right to receive trust income if the house is ever sold by the Trustee. This right establishes the necessary defect for income and capital gain tax purposes (Viz.: Client will be responsible for paying all income and capital gain taxes under IRC Section 674). However, if the client does not wish to have the income (which would then be available to pay share of cost) then the trust could be structured so that client would not retain right to income or principal.

To ensure the trust is defective for income tax purposes, the practitioner needs to build into the document certain trust powers over which the client/grantor has control. Such powers could include the power to borrow trust funds without providing adequate security (IRC 675 (2))3 and a power to substitute trust assets with assets of an equivalent value to the trust in a non fiduciary manner (IRC 675 (4)).

Practitioners interested in a thorough discussion of the over-all estate and tax planning opportunities that exist with respect to this type of trust are referred to the excellent treatises and articles written by trust and estate attorneys Michael Mulligan of Missouri4 and Steven and Richard Oshins of Nevada). 5

2. Defect for Transfer Tax Purposes.

A client typically will want to retain control over the disposition of the property at death, such as by a special testamentary power to appoint the property to anyone but the creditors of the client, the client’s estate and the creditors of the client’s estate. This power coupled with an "Occupancy Agreement" with the Trustee of the IDIT will cause the "gift" to the trust to be incomplete or "defective" for gift tax purposes and estate tax "defective" for Estate Tax purposes because the property will be included in the client’s gross estate at death under IRC Code Sections 2036 and 2038. The Transferee will not, therefore, receive a carry-over basis in the home, and at the death of the client the transferee(s) will obtain the basis step and avoid capital gain if the property is sold following the death of the client.

B. Retained Control and Flexibility

As discussed above, a client may retain substantial control over a house using a two-part approach: (1) the client deeds the property outright to the donee but reserves a special testamentary power to appoint6; and (2) the client and donee enter into a stand-alone "Occupancy Agreement." Using an IDIT, the client may increase the client’s control and flexibility in several respects.

Under an IDIT, the client may reserve the right to receive all trust income during his or her life. This right to income may not be important so long as the house is used as a residence, but it becomes an important extra benefit if the house is sold. Moreover, the trustee may influence the amount of the IDIT’s income by investing primarily in securities that pay little if any dividends or current income. The trustee should be given such investment flexibility to override the Prudent Investor Rules under the Revised Principal and Income Act.

Many clients are concerned about the inflexibility of the irrevocable trust in that it is irrevocable. However, an independent third party (friend, accountant, attorney or financial advisor) may be given powers designed to create flexibility. The independent third party can hold flexible amending powers as special trustee. If a subordinate party, a child, is the original trustee, the independent third party can hold these powers as a "special trustee" or as a "trust protector." Some examples of such powers:

1. Power to Change Trust Situs.

The third party may be given the power to remove the trust from the state if it were prudent to do so. For example, this might be desirable if the trustee (e.g., a child) moves to another jurisdiction and the client is incapacitated and wants to move as well to be near his or her caretaker, or the trustee/client wishes to take advantage of favorable tax or Medicaid laws in another jurisdiction.

2. Power to Change or Add Beneficiaries.

The independent third party may be given the power to change or add beneficiaries within a given class.

3. Power to Remove and Appoint Trustee and Cotrustee.

The third party may have the power to remove and appoint trustees, which may be a safety valve for removal of a family member acting as trustee. The removal power typically may be exercised without any reason, but examples of events that might motivate removal include: (a) mental incompetence, (b) under-performing investment strategies, (c) misuse of trust funds, (d) excessive fiduciary fees, (e) the trustee’s own creditor problems, (f) beneficiary transfer tax concerns.

4. Power to Opt out of and into the California Prudent Investment Rule or Revised Principal and Income Act.

5. Power to Grant Beneficiary General or Limited Power of Appointment for Transfer Tax And/or Control Reasons.

6. Grantor Retains Power to Borrow Assets.

This power is very important for the many clients who feel insecure about transferring their primary asset during their lives. The power to borrow trust funds provides the client with a security blanket if there were a need for such funds in the future.(Example: the residence is sold and $300,000 of cash and securities now comprise the trust estate.) The third party may lend trust funds with or without security at an adequate rate of interest. This stratagem invokes grantor trust status (i.e., it may be desirable merely in order for the trust to qualify as an IDIT) and by itself would not necessarily cause inclusion in the gross estate for estate tax purposes but would cause the grantor to be considered the owner of the trust income for Income tax purposes.7

7. Power to Create Additional Trusts.

If the client or a trust beneficiary has special needs because of a disability, then the independent person might have the power to modify the terms of the trust or create a new trust to provide for the beneficiary’s special or supplemental needs without jeopardizing any private or government benefits to which the beneficiary would otherwise be entitled.

C. Increased Asset Protection

As part of Medi-Cal planning, if the client intends to spend down his or her liquid assets, then the client can pay rent to the IDIT for the privilege of occupying the house. As an alternative, the lease agreement may obligate the client to pay a lower amount of rent and also to pay for insurance and taxes. Even though the client will be paying for all taxes and other property expenses attributable to the trust property, the client will not be considered to have made additional gifts to the trust subject to Medi-Cal transfer penalty rules.

For the IDIT to be asset protective, the instrument should not permit any distribution of principal to the client. However, if a person other than the client is acting as trustee, the trustee may have the discretion to loan funds to the client in case this were ever needed as a safety valve if the house were sold and cash were needed to pay for basic necessities.

D. California Property Taxes

If the client is the IDIT’s income beneficiary, this should be an exempt transfer similar to the transferor retaining a life estate in the residence. If the children are the primary beneficiaries, then it is important for the family to apply promptly for the Proposition 58 parent/child exception so that there is no reassessment of the house for California property tax purposes.

If neither the client nor the children are the IDIT’s beneficiaries, then the local assessor will take the view that there is a change of ownership triggering reassessment. The fact that the trust is a grantor trust for income tax purposes does not preclude the assessor from declaring there has been a change of ownership for property tax purposes because the income and property tax laws are not in pari materia. However the authors have in one county successfully argued that a stand alone lifetime occupancy agreement between the Trustee and the grantor was equivalent to a life estate which obviated any reassessment by the county.

E. IRC Section 121 Exclusion

To the extent that the IDIT is grantor trust for income tax purposes, the IRS has determined in one Revenue Ruling and in at least two letter rulings that the grantor retains sufficient ownership interest in the residence to qualify for the Section 121 exclusion if the property is sold by the trustee.8

This may be one of the more important advantages of the transfer to an IDIT from the outright gift and gift deed with retained powers strategies. If it ever becomes important to sell the property during the client’s lifetime (Example: Trustee sells and purchases a smaller home for client and/or client needs to move into an assisted living arrangement), the capital gain tax savings could be of paramount importance, particularly in today’s housing appreciation market. In fact, it would be irresponsible for a practitioner not to document the importance of this strategy to the client if there is any possibility of a low basis residence being sold during the life of the client/grantor.

This article has focused on Medi-Cal planning for the client’s residence, particularly with the transfer of a personal residence to an IDIT. The client also should consider asset protection in the context of deciding whether property passing to the client’s beneficiaries should pass outright or in trust. If properly designed and structured, a trust for the client’s child or other beneficiary can be controlled by the client and is not subject to the claims of third party creditors, IRS liens, bankruptcy trustees, and divorcing spouses. Following the client’s death, the irrevocable trust (now no longer an IDIT because the grantor has died) could then simply continue to protect the trust assets for the benefit of the children and their issue. The trust could be designed to divide into as many sub-trusts as there are then living children. Each child could then be the trustee or co-trustee of his or her own trust share to invest and use the trust funds for the child’s health, education and support and to have the trust purchase real or personal property for the child’s use and enjoyment.

F. SUMMARY

A client’s lifetime transfer of the client’s house to a California asset protective intentionally defective irrevocable trust may be the preferred planning tool for elder law practitioners. In creating the trust, the client should retain controls sufficient to cause the trust to be a grantor trust for income, transfer tax, and property tax purposes without causing the corpus to be available for California’s Medi-Cal estate recovery claim. The client and the client’s advisors should consider this option not only as a strategy for avoiding estate recovery claims but as a planning tool for flexibility retention by the grantor and asset protection for the client’s heirs and descendants.

Conrad and Patricia Jo Wilkinson, Wilkinson & Wilkinson, are in private practice in Claremont, California.

Notes:

  1. Department of Health Services All County Directors Letter No. 90-01, January 5, 1990, page 5, Questions and Answers Nos. 7 and 8.
  2. For a sample form of the Declaration of Right to Return Home see Chapter 9-41, §9.32B of California Elder Law, An Advocates Guide, Volume 1.
  3. Caveat: The authors are aware of a recent case in Nevada County which interpreted a trust-borrowing clause as making the trust res an available resource for Medi-Cal recovery purposes.
  4. Michael D. Mulligan, Defective Grantor Trusts Offer Many Tax Advantages; Estate Planning, May/June 1992.
  5. Richard A. Oshins and Steven J. Oshins, PROTECTING AND PRESERVING WEALTH INTO THE NEXT MILLENNIIUM,; Trusts & Estates, 9/98 and 10/98.
  6. The authors believe that the decision in the case of Bonta v. Burke, 98 Cal. App. 4th 788 is distinguishable from and would not apply to an irrevocable transfer to a trust with grantor retaining a special power of appointment.
  7. The article assumes the value of the client’s estate is less than the applicable exclusion, currently $1.5 million as of January 1, 2004. The IDIT as described above is not only defective for income tax purposes but also for transfer tax purposes. The client has retained the economic use of the property during the client’s lifetime, thereby causing inclusion in the grantor’s gross estate for estate tax purposes. This also will make the property qualify for the step-up in basis for income tax purposes.
  8. Rev. Rul. 66-159, 66-1 C.B. 162; PLR 199912026; PLR 200124011.