Current Issues Involving Irrevocable Trusts in Planning for VA Pension Benefits
by Bradley Erdosi, Esq.
This article is intended to be general in nature. Planning with irrevocable trusts requires the planner to have specific knowledge and consideration of many different issues, including tax issues, and the effect of such planning on both VA and Medi-Cal benefits, all while considering the specific goals of the client.
The use of irrevocable trusts has become a popular tool among some practitioners in assisting clients in planning for VA pension benefits. While trusts have become a popular tool, there are many landmines and pitfalls in using irrevocable trusts when it comes to VA pension planning. In part, this is because there is very little guidance under existing law or precedent related to irrevocable trusts.
This article will discuss the use of irrevocable trusts, highlight some useful characteristics of such trusts, and point out the limited areas of authority which need to be considered in using irrevocable trusts in planning for VA pension benefits.
To begin, one should be familiar with the basics of the VA pension program. VA pension, also known as non-service connect pension, is a benefit paid to wartime veterans and certain dependents who qualify. This benefit is a means-based program which has the following five basic requirements: (1)
1. The veteran must be age 65 or older, or permanently and totally disabled, not due to the veteran’s own willful misconduct. Note that there is no age requirement for a surviving spouse to qualify for widow’s pension;
2. The veteran must have been discharged from service under conditions other than dishonorable;
3. Certain service requirements must have been met. For the majority of the clients applying for this pension entered active duty prior to September 7, 1980, the result of which is that the veteran must have served at least 90 days of active military service, one day of which was during a wartime;
4. Net worth must not be excessive; and
5. Countable family income must be below a yearly limit set by law.
Typically, the first three prongs set forth above are easily determined. Items number 4 and 5 (net worth and income) are the issues that create planning opportunities for veterans and/or their spouses, which require careful attention. Typically, irrevocable trusts are used to reduce net worth. Net worth often needs to be reduced to qualify for pension benefits, as the VA pension program is not intended to protect substantial assets or build up an estate for the benefit of heirs. (2) Net worth is a very subjective determination and a veteran service worker evaluating a claim has a significant amount of discretion in determining what is considered “excessive.” This is one of the primary frustrations for veterans seeking to obtain this benefit.
Currently, the VA does not impose a penalty for the transfer of assets, provided such transfers were made prior to the filing of a formal claim, or notifying the VA of the intent to file a claim.
The most common transfers of net worth are as follows:
1. Gift. Commonly, a veteran or spouse will make a gift of “excessive” net worth to a relative or other individual who is not residing with the veteran or spouse. (3)
2. Purchase annuity. Many individuals and organizations urge veterans (or surviving spouses) to purchase an immediate single premium annuity, insisting that the purchase of such an annuity would convert assets countable as net worth, into an income stream with no value for purposes of calculating net worth. Until recently, it was the VA’s unwritten policy to treat the income from single premium annuities as income for VA Purposes. This policy invited many individuals and organizations to undertake selling annuities to veterans and their spouses, with the promise that they would immediately qualify for “VA Aid and Attendance Benefits.” As of late, many VA adjudicators have taken the position that certain annuities have cash value and are thus attributing value to such annuities.
3. Transfer to irrevocable trust. Many practitioners create irrevocable trusts, for the purpose of holding assets gifted by a veteran claimant or surviving spouse in an effort to reduce net worth. This article will focus on these trusts and highlight some of the issues which should be considered by the practitioner in this type of planning.
Three Common Considerations in Drafting VA Trusts
1. Claimant or Spouse May not be Beneficiary
As a general rule, neither the veteran-claimant, nor his/her spouse may be an income or principal beneficiary of any self-settled trust established for VA benefits planning. The VA is clear in that any transfer of property will not reduce income or net worth unless the veteran can establish that there has been “actual relinquishment of rights to the property and income from the property.” (4)
Thus, a veteran may not transfer assets to another, while retaining a right to income from the property.
Interestingly, the VA seems to allow the transferee to gift back the income derived from the divested property. The VA Adjudication Procedures Manual (M21-1MR - Adjudication Procedures Manual Rewrite) provides that:
If a transferee takes legal title to the property and receives income from the property, a true transfer is deemed to have occurred. However, if the transferee turns income from the property back to the claimant, the income is countable under 38 CFR 3.271 as a gift of money.
Thus, under this logic, a claimant can transfer assets to an individual or trust. If the income is gifted back to the veteran-claimant (either from the individual transferee or the beneficiary of trust income), a divestiture has still occurred and the income will be attributed to the veteran-claimant. As the VA has been known to change its policy, it would be wise to anticipate that this may not be the case in the future, and if drafting an irrevocable trust, appropriate trust protector provisions should be included for future flexibility.
2. Grantor vs. Non-grantor trust
In drafting an irrevocable trust, a common concern is whether the trust should be drafted as a grantor or non-grantor trust. A grantor trust causes all items of “income, deduction, and credit” attributable to such trust (or portion deemed to be a grantor trust) to be taxed to the grantor on his or her personal income tax return. (5) Typically, the grantor is both the person who creates the trust, as well as the person who contributes trust property. Relevant grantor trust provisions are set forth in Internal Revenue Code sections 671 through 678.
A non-grantor trust causes all items of income and deductions to be borne by the trust to the or by the trust beneficiaries to the extent that income has been distributed to the beneficiaries from the trust.
The distinction of a grantor vs. non-grantor trust in the context of VA pension planning is significant. This is due in large part because the Department of Veterans Affairs compares income reported to the Department of Veterans Affairs (VA) by pension recipients with IRS and SSA income records. (6) This is commonly referred to as an Income Verification Match (or IVM). The IVM process has become increasingly important because the VA no longer requires Eligibility Verification Reports from pension recipients. Until recently, the Eligibility Verification Reports were required on a yearly basis for recipients to continue receiving pension. As of December 2012, the VA no longer requires these reports, and instead now works with the Internal Revenue Service (IRS) and the Social Security Administration (SSA) to verify continued eligibility for pension benefits.
Therefore, the income of a grantor trust which is reported on the grantor’s personal income tax return, and not reported to the VA can be very problematic. For example, if a veteran establishes a trust, which is taxed as a grantor trust, the income will be assumed by the VA to be the veteran’s (or surviving spouse in the case of a widow’s pension claim) and may terminate or compromise pension benefits.
Thus, in the author’s opinion, to the extent possible, it is safest (when using trusts in the VA planning context) to structure the trust as a non-grantor trust to avoid the attribution of trust income to the veteran (or spouse) establishing the trust.
The only caveat to the above is in the context of planning with the claimant’s personal residence. The personal residence is excluded in determining net worth. (7) However, the practitioner must consider any future sale of the residence for several reasons, the most important of which are as follows:
If the home is sold, the effect of such a sale is to convert a non-countable asset (the home), into a lump sum of cash, all of which is considered in calculating net worth; and
In order to preserve the exclusion of gain from sale of principal residence (commonly referred to as the Internal Revenue Code §121 exclusion), if the home is held by an irrevocable trust, the trust must be a grantor trust.
Therefore, a claimant’s personal residence should be held in a grantor trust, but the proceeds from the sale, once sold, should no longer be held in a grantor trust and should instead be distributed out of the trust to the trust beneficiaries or to another trust which is not a grantor trust.
Some practitioners continue to utilize grantor trusts and see the distinction between grantor trusts and non-grantor trusts as insignificant. However, in this author’s opinion, the distinction is important, especially in light of the fact that the VA has eliminated the requirement of Eligibility Verification Reports in favor of Income Verification Matches with the IRS and SSA.
3. Trust Protectors
Trust protector (also known as trust advisor) provisions have become popular and effective tools in drafting irrevocable trusts. Although California does not have any statutes defining a trust protector or its role, the benefits of a trust protector are relevant and helpful in drafting California trusts for purposes of planning for VA benefits.
The main purpose of a trust protector is to add flexibility to the irrevocable trust, while protecting the integrity of the trust, and ensuring that the original intent in creating the trust is carried out.
Some of the more common and relevant powers given to a trust protector in a trust drafted for VA benefits planning may include the following:
- Remove or appoint a trustee;
- Amend the trust to comply with the Grantor’s intentions or changes in the law which compromise the trust purpose;
- Toggle on or off grantor trust powers;
- Stopping or starting mandatory distribution of income;
- Approve the exercise of powers of appointment by a beneficiary;
- Correct ambiguities or scrivener’s errors within the trust instrument; and
- Approve the creation of new trusts or sub-trusts.
There are many ways to establish a trust protector. Provisions governing a trust protector should be included within the trust document and the trust protector may be appointed at the time the trust is established. Alternatives to initially appointing a trust protector include:
- A trust protector "designator" – In this instance, when the trust is established, a person is designated to appoint a trust protector at a later time. In some instances, attorneys have designated themselves as trust protector "designator's," with authority to appoint a trust protector at the time it becomes necessary.
- Appointment of a trust protector by a court - The safest and most conservative route, in the author's opinion, is to have a trust protector appointed by a court should the need arise.
A trust protector should always be an individual or corporate fiduciary who is not related or subordinate to a transferor or any beneficiary within the meaning of Section 672(c) of the Internal Revenue Code. Further, the trust protector and trustee should never be the same individual or corporate fiduciary, and the veteran (or surviving spouse) should never serve as a trust protector.
Relevant Office of General Counsel Opinions
Unfortunately, there is very little guidance from the VA on the effect of certain trusts on pension benefits. Below are a few of the more pertinent and relevant Office of General Counsel opinions with which the practitioner should be familiar related to irrevocable trusts in the context of VA benefits.
Office of General Counsel Opinion 33-97
This opinion clearly sets forth that a transfer to a trust, where the terms of the trust provide for the grantor’s support, will cause the trust assets to be counted in net worth calculations.
The facts of this case are as follows: Surviving spouse prepared an “Irrevocable Living Trust” naming her child as the trustee. The terms of the trust provided in part that “some or all of the income and principal of the trust fund may be paid by the trustee to or for the benefit of the surviving spouse only for the surviving spouse’s "special needs…"
The underlying holding in this opinion is that VA should include all of the trust assets in determining net worth if the trust assets are available for use for the claimant's support. In this case, the trust permits the use of trust assets for the surviving spouse’s benefit, thus all trust assets are available and countable in determining net worth.
Office of General Counsel Opinion 73-91
This is one of the few favorable OGC opinions related to trusts established by a veteran claimant. Here, the veteran was receiving pension benefits. While receiving benefits, the veteran received a payout of $80,000 from a life insurance policy of which he was the beneficiary. He also inherited some stock.
The veteran proposed to create an irrevocable trust, wherein he (the veteran) was the trustee and his grandchildren were proposed beneficiaries.
This opinion provides that although the inheritance counted as income to the veteran, once the assets were transferred to the trust, the trust corpus was not countable net worth to the veteran.
Specifically, this opinion states that assets transferred to an irrevocable trust for the benefit of the veteran’s grandchildren, where the veteran is the trustee and has retained no right or interest in the property or the income therefrom and cannot exert control over these assets for the veteran's own benefit, would not be counted in determining the veteran's net worth for pension purposes. Further, trust income would not be considered income of the veteran.
The facts provided to the General Counsel’s office did not state whether the veteran’s grandchildren lived with him – a fact noted by General Counsel as one that may have caused a different outcome. Because a transfer to a relative residing the same household is disregarded, (8) the outcome would likely be different if the beneficiaries of the trust reside with the veteran.
Office of General Counsel Opinion 72-90
This is another favorable opinion interpreting trusts established by a third party. The facts underlying this opinion are as follows: the veteran-claimant was the beneficiary of a testamentary trust. The terms of the trust provide that the trustee may distribute funds for the veteran’s comfort, but not as substitute for support and maintenance to which veteran is entitled from other sources.
The opinion correctly recognizes that under these facts, the veteran did not hold legal title to or control of the trust property. Thus, only the portion of the trust property, including trust-related income, that has actually been made available for the veteran's use, is, at the time of its allocation, countable for purposes of the income and net-worth provisions in determining pension benefits.
Thus, a properly drafted, fully-discretionary third party trust, of which the veteran is a beneficiary, should not provide issues in determining pension qualification until such time as the assets have been distributed and made available to such veteran.
Irrevocable trusts in VA pension planning can be a very valuable tool in the right circumstance. However, there is very little guidance or established law related to irrevocable trusts in the VA context. Thus, it is best to take a very conservative approach in drafting such trusts, while becoming familiar with the limited guidance offered by the VA, as well as the tax implications of drafting such trusts.
(Bradley Erdosi, Esq., is an attorney in private practice in Irvine, CA)
1 38 CFR Section 3.3(a)(3)
2 38 CFR Section 3.275
3 A transfer of assets to a relative residing in the same household is not recognized as reducing net worth. See 38 CFR Section 3.726(b).
4 See M21-1MR, Part V, Subpart iii, Chapter 1, Section I, 65 (emphasis added)
5 Internal Revenue Code Section 671
6 See M21-1MR, Part X, Chapter 9 for IVM basic components.
7 38 CFR Section 3.275
8 38 CFR Section 3.276 (b)