When clients first hear the words “irrevocable trust,” they often assume that transferring assets to the trust means giving up all of the tax benefits they enjoyed when they owned those assets individually.
That is not necessarily the case.
A properly drafted Medicaid Asset Protection Trust (MAPT) is a good example of why the word irrevocable does not tell the whole story. Although the trust is designed to restrict the grantor’s access to principal so that the assets can eventually be protected for Medicaid purposes, it can also be structured to preserve several important tax benefits.
In fact, a well-designed MAPT can look very different for Medicaid purposes, income tax purposes, and estate tax purposes.
The Trust Can Remain a “Grantor Trust” for Income Tax Purposes
Many people assume that once assets are transferred to an irrevocable trust, the trust becomes a separate taxpayer and must pay income taxes at the higher tax rates applicable to trusts.
A Medicaid Asset Protection Trust can generally be drafted as a grantor trust for income tax purposes.
When a trust is treated as a grantor trust, the IRS essentially looks through the trust and treats the grantor as the owner for income tax purposes. The trust's income, deductions, gains and losses are generally reported as belonging to the grantor rather than being taxed as income of a separate trust.
This can be particularly important because trust income tax brackets are highly compressed. A non-grantor irrevocable trust can reach the highest federal income tax bracket at a much lower level of income than an individual taxpayer.
Grantor trust status can also make tax reporting and management of the assets considerably more familiar to the person creating the trust.
In other words: the trust can be irrevocable for Medicaid planning purposes without necessarily becoming a separate taxpayer for income tax purposes.
Appreciated Assets Can Still Receive a Step-Up in Basis at Death
Another common concern is:
“If I put my house or investments into an irrevocable trust now, will my children lose the step-up in basis when I die?”
With a properly structured Medicaid Asset Protection Trust, the answer can be no.
Consider a simple example. Suppose a parent purchased a home many years ago for $200,000 and it is worth $1 million at the parent's death.
If the children simply received the parent's $200,000 basis, a later sale of the property could potentially result in approximately $800,000 of taxable capital gain.
However, if the trust has been properly structured so that the property is included in the grantor's gross estate for federal estate tax purposes, the property can generally qualify for an adjustment in basis at death under Internal Revenue Code §1014. The new basis would generally be the property's fair market value at the date of death.
If the property were worth $1 million when the parent died and the children later sold it for approximately $1 million, there may therefore be little or no capital gain attributable to the appreciation that occurred during the parent's lifetime.
This is an important distinction between a properly designed MAPT and certain other irrevocable gifting trusts.
Grantor trust status by itself does not create a step-up in basis. In fact, the IRS has specifically confirmed that an asset in a grantor trust that is not included in the grantor's gross estate does not receive a basis adjustment merely because the trust was a grantor trust for income tax purposes.
A Medicaid trust can instead be intentionally structured to preserve estate inclusion—and therefore the potential basis adjustment—while still accomplishing the desired Medicaid planning.
That distinction can have significant tax consequences for highly appreciated homes, brokerage accounts and other assets.
Real Estate Tax Benefits Can Often Be Preserved
For many clients, the most valuable asset being transferred to a Medicaid Asset Protection Trust is the family home. Understandably, they are often concerned that transferring title to a trust will cause them to lose valuable property-tax benefits.
Fortunately, New York law recognizes beneficial ownership under a trust for purposes of several real-property tax exemptions.
For example, New York expressly provides that when a homeowner transfers a residence to a trust but remains a beneficiary and continues to live in the home, the beneficiary may continue to be treated as the homeowner for purposes of the STAR benefit. The State's guidance specifically recognizes trust beneficiaries as owners for this purpose.
New York has similarly recognized trust-beneficiary eligibility in connection with certain senior citizen and veterans exemptions. Importantly, the State has stated that, for these purposes, the fact that a trust is irrevocable rather than revocable does not, by itself, eliminate eligibility.
Eligibility for any particular exemption still depends upon the applicable program, the terms of the trust, the homeowner's circumstances and local requirements. But transferring a residence into an irrevocable Medicaid trust does not automatically mean giving up the property's existing tax benefits.
“Irrevocable” Does Not Mean the Same Thing for Every Purpose
This is one of the most important concepts to understand about Medicaid Asset Protection Trusts.
An asset can be treated one way for Medicaid eligibility, another way for income tax purposes, and still another way for estate tax and basis purposes.
A properly drafted MAPT may therefore be designed so that:
- the grantor cannot simply take the principal back, which is fundamental to the Medicaid asset-protection strategy;
- the grantor continues to be treated as the owner for income tax purposes;
- appreciated assets remain includible in the grantor's estate so that they may qualify for a step-up in basis at death; and
- a residence transferred to the trust can continue to qualify for applicable real-property tax benefits when the statutory requirements are satisfied.
This is why it can be misleading to compare a Medicaid Asset Protection Trust to an irrevocable trust designed primarily to make completed gifts or remove appreciating assets from a taxable estate. They may both be called “irrevocable trusts,” but their tax objectives—and their tax consequences—can be very different.
The Drafting Matters
A Medicaid Asset Protection Trust is not simply an asset-protection document. The provisions included in the trust can affect income taxes, capital gains taxes, estate taxes, basis and real-property tax exemptions.
That is why Medicaid planning should not focus solely on getting assets “out of your name.” The goal should be to protect assets without unnecessarily sacrificing valuable tax benefits along the way.
When properly designed, a Medicaid Asset Protection Trust can accomplish both.