THE BEST VA BENEFITS TRAINING ANYWHERE CONFERENCE SPECIAL FORCERS DAY

January 7, 2011

VA BENEFITS PLANNING WITH IRREVOCABLE GRANTOR TRUSTS Robert A. Mason, CELA1

Mason Law, PC Asheboro, North Carolina

336-610-6000 ♦ ram@masonlawpc.com

CONTENTS

I. Introduction .................................................................................................................... 2 II. The General Fact Pattern/Benefits of Irrevocable Grantor Trusts ................................ 3

A. Typical Fact Pattern .................................................................................................. 3 B. Why “Giving Everything Away” Is A Bad Idea ....................................................... 4 C. Features of a Properly Designed Asset Protection Trust........................................... 5 D. Overview of Medicaid Issues.................................................................................... 6 E. Overview of Estate Recovery.................................................................................... 6 F. Overview of Tax Issues ............................................................................................. 6 G. Note on legal authorities ........................................................................................... 7

III. Medicaid and Grantor Trusts ....................................................................................... 7 A. General Medicaid Principles..................................................................................... 7 B. Availability Issues ..................................................................................................... 8

1. Revocable Trusts.................................................................................................... 8 2. Irrevocable Trusts .................................................................................................. 8

C. Analysis Under the Medicaid “Self-Settled” Trust Rules......................................... 8 1. Availability ............................................................................................................ 8

(a) Key definitions ................................................................................................. 8 (b) Applicability of Rules ...................................................................................... 9 (c) Key Test.......................................................................................................... 10

2. Transfer Issues ..................................................................................................... 10 D. The Doherty Case: A Warning For Attorneys ........................................................ 12

IV. Tax Issues .................................................................................................................. 13 A. Grantor Trust Status ................................................................................................ 13

1. Generally.............................................................................................................. 13 2. Internal Revenue Code Grantor Trust Rules........................................................ 14 3. Internal Revenue Code – Specific Powers Retained By Grantor ........................ 18

B. Results of Grantor Trust Status ............................................................................... 26 1. General................................................................................................................. 26 2. Sale of residence .................................................................................................. 27 3. Funding Grantor Trusts With Nonqualified Annuities ........................................ 28

C. Basis Issues ............................................................................................................. 29 D. Gross Estate Inclusion............................................................................................. 31

1 Certified by the National Elder Law Foundation

© 2011 Mason Law, PC

F. EINs and Reporting ................................................................................................. 34 1. Single Grantor trust – Option 1: Using Grantor’s EIN........................................ 34 2. Single Grantor trust – Option 2: Using Trust’s EIN............................................ 35 3. Multiple Grantors/Owners – Furnish Trust’s EIN............................................... 35 4. Practical possible steps ........................................................................................ 35

V. VA and Trusts ............................................................................................................. 36 VI. Trust Protector/Advisor ............................................................................................. 43 Appendix A - Richardson Letter....................................................................................... 45 Appendix B - Streimer Letter ........................................................................................... 47 I. Introduction Since the passage of the Deficit Reduction Act of 20052 (“DRA”), elder law practitioners (including those attorneys and other practitioners whose practices involve veterans’ benefits planning) are revisiting the use of grantor trusts as a possible strategy for sheltering assets while retaining partial use of the assets sheltered and avoiding many of the risks that accompany outright transfers of assets. After OBRA ’93 and before DRA, Medicaid rules generally sanctioned transfers of assets for up to thirty-six months, but specifically sanctioned transfers of assets to trusts for sixty months.3 Because of the extra two year sanction period practitioners simply stopped using irrevocable trusts. After DRA, however, all asset transfers are subject to transfer sanctions if an application is filed anytime within sixty months of trust funding. With the principal disadvantage to trust usage now gone, trusts are enjoying a renaissance. Perhaps because of the 12 year hiatus trusts took between OBRA ’93 and DRA, the principal disadvantage to the use of trusts seems to be ignorance and misunderstanding by practitioners and regulators. Because the VA, Medicaid, and tax rules applicable to trusts are not paragons of clarity, few elder law attorneys stray from familiar paths. Nevertheless, for those willing to invest the time and patience to sort through the rules, grantor trusts can be a formidable tool. Much of the confusion centers on a handful of issues. The first issue seems to be a matter of nomenclature and the meaning of “grantor trust.” “Grantor trust” is a rather broad term referring to trusts that are taxable, either wholly or partially, to the settlor under rules specified in Internal Revenue Code of 1986 sections 671 through 678. The general term, “grantor trust” covers garden variety revocable trusts in addition to irrevocable trusts carrying all sorts of labels and acronyms such as income only trusts or “IOTs” and

2 Pub. L. No. 109-171, 120 Stat. 4 (2006). 3 Omnibus Budget Reconciliation Act of 1993(“OBRA ‘93”), Pub. L. No. 103-66, § 13611(a)(1), 107 Stat. 312, 622 (1993) added the present 42 U.S.C. § 1396p(c)(1) which provided a 36 month look-back with respect to most asset transfers but specified an alternative 60 month look-back with respect to transfers to trusts. Prior to OBRA ’93, 42 U.S.C. § 1396p(c)(1) provided a maximum 30 month look-back with respect to all transfers.

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intentionally defective grantor trusts or “IDGTs.” There are many others. 4 They are all, wholly or partially, grantor trusts. Second, the scant guidance offered by the Department of Veterans Affairs has caused much confusion with respect to the use of grantor trusts in the veterans’ benefits planning area (especially to those who have not read the applicable General Counsel Opinions). Third, the Medicaid rules applicable to trusts baffle many (including many regulators). In the VA planning context, many (if not most) cases call for an understanding of the Medicaid rules because Medicaid either is an immediate issue or will be in the foreseeable future of the client. The federal statutes applicable to Medicaid and trusts are skeletal.5 Regulatory guidance provides some flesh, particularly Transmittal 64 issued in 1994 by the Health Care Financing Administration6. Transmittal 64, however, is in need of updating and contains many provisions that are irrelevant in a post-DRA world. Fourth, tax rules spell trouble for many. They are complex. Buried in the complexity are a number of rules that need not defy understanding but which are absolutely essential for a malpractice-free grasp of the grantor trust rules. Chief among those often misunderstood rules are the “portion of” provisions that may result in a grantor being a deemed owner of only a portion of a trust, as opposed to an entire trust. For example, failure to correctly apply that concept in trust drafting can cause considerable consternation if the grantor’s intent was to be a deemed owner of a residence, yet all she (or her attorney) reserved was an income interest. This outline will explore each of the foregoing areas and, I certainly hope, dispel some of the fog of uncertainty that persists in the VA benefits/elder law bar concerning the use of grantor trusts. This is an intermediate-to-advanced topic. I have presumed the practitioner using these materials has a moderate-to-advanced knowledge of VA Improved Pension benefits (housebound, aid & attendance, etc.), Medicaid long term care benefits, general trust law, and at least a basic understanding of personal income tax law. II. The General Fact Pattern/Benefits of Irrevocable Grantor Trusts

A. Typical Fact Pattern

Meet Gladys. Gladys is 79 years old and in good health. Her late husband, Harry, Sr., died ten years ago and served in the US Navy during World War II. Gladys has three sons: Harry, Bob and Jack, all of whom get along well.

4 The best for readers enjoying acronyms is “Intentionally Defective Income Only Trust.” 5 See generally 42 U.S.C. § 1396p(c). 6 The Health Care Financing Administration (“HCFA”) was the predecessor to the current Centers for Medicare and Medicaid Services (“CMS”). Transmittal 64 added §§ 3257-3259 of Chap. 3 of the CMS State Medicaid Manual. The State Medicaid Manual is available online at http://www.cms.gov/Manuals/PBM/itemdetail.asp?filterType=none&filterByDID=-99&sortByDID=1&sortOrder=ascending&itemID=CMS021927&intNumPerPage=10

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Harry is an OBGYN who has been sued three times, Bob is on his fifth wife and a CPA, and Jack is an engineer and demolitions expert, but has not been found responsible for any serious accidents. Gladys inherited a 100 acre farm from her parents in 1963. In 1963, the farm had a fair market value of $50,000 but currently its fair market value is $500,000. Gladys also has a residence with a tax value of $150,000 that she and Harry, Sr., bought in 1968 for $25,000. Gladys has about $250,000 in various liquid investments and $100,000 tied up in a deferred non-qualified annuity. Gladys receives Social Security Retirement Income Benefits of $1,500 a month and $700 a month from other investments.

Gladys is in good health now, although she is concerned about a series of chronic ailments that had affected her parents and her now deceased siblings. Harry, Sr.’s mother died at the age of 98 in a nursing home many years ago, and Gladys has memories of her in-laws spending all of their $200,000 in savings that her mother-in-law had before she eventually became eligible for Medicaid. Because the farm that Gladys owns has been in her family for many generations, she is particularly concerned that she be able to pass it on to her descendants.

Gladys wants to know if you can do anything for her and whether she should “just give her sons everything because they’ll get everything anyway.” Because you attended this seminar and have studied these materials, you immediately think of some sort of grantor trust arrangement.

B. Why “Giving Everything Away” Is A Bad Idea

1. Gladys will transfer her very low basis in her assets to her sons. IRC § 1015(a).7

2. Gladys will shift income tax attributes of transferred assets to her sons (who are likely in higher income tax brackets)

3. By “shielding” her property from the liabilities she fears most, she is simply exposing her property to the liabilities of her sons (children

7 At the time of the preparation of this outline the federal estate tax remains in an uncertain state. As a result of the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. No. 107-16, 115 Stat. 38 (2001) (“EGTRRA”), beginning January 1, 2010, the estate and generation-skipping transfer taxes have been repealed for one year while the gift tax remains in place with a $1 million exemption and 35% maximum rate. The same “one year repeal scheme” contains a “modified carryover basis” that generally denies a step-up in the basis of appreciated assets at death through a repeal of I.R.C. §§ 1014 and 1015. The (presumably) temporary I.R.C. § 1022 replaces those sections with a modified carry over basis scheme that raises tax issues with respect to estates of decedents dying while estate tax repeal and the carry over basis rules are in effect in 2010. Congressional action is impossible to predict. What does seem certain is that either the pre-EGTRRA estate tax scheme will be in effect on January 1, 2011, or Congress will take some action to reenact some sort of estate tax scheme closely resembling the scheme in effect during 2009. In either event the familiar I.R.C. §§ 1014-1015 basis scheme should return soon. Accordingly, this outline will not address any issues relating to (temporary) I.R.C. § 1022, and will proceed under the assumption that the pre-2010 stepped-up basis scheme, or something very closely resembling that scheme, will be in effect on January 1, 2011.

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divorce, get sued, incur tax liabilities, develop drug and alcohol problems, and sometimes die leaving property to in-laws and grandchildren).

4. A large enough transfer to her sons could involve federal gift tax issues (assuming the property was valuable enough; but filing requirements exist in any event with respect to gifts not qualifying for the current annual exclusion under IRC § 2503).

5. Gladys loses complete control and is relying on her pure “trust” (pun intended) of her sons.

6. Potential permanent loss of testamentary intentions (and certainly loss of any future flexibility in that regard).

7. Loss of ad valorem tax exemptions, if any apply.

8. Creating “countable” assets in a parent’s balance sheet for college financial aid purposes.

By transferring some or all of her assets to an irrevocable trust Gladys could very well negate each of the disadvantages noted above associated with direct transfers to her children.

C. Features of a Properly Designed Asset Protection Trust

For purposes of this outline, any trust intended to be an irrevocable grantor trust for the purpose of protecting assets, and as an alternative to outright gifting, will be referred to as an Asset Protection Trust or “APT.”

A properly designed APT will contain the following basic characteristics, each of which will be discussed in much greater detail in these materials:

1. Self-settled, meaning that Gladys will be the grantor/settlor of the trust.

2. Irrevocable, meaning Gladys will have no rights whatsoever to revoke or amend the trust (although careful consideration will be given to trust protector provisions).

3. Contain provisions that will result in tax treatment as a grantor trust under the provisions of Internal Revenue Code of 1986 (“IRC”) Sections 671-679.

4. May or may not reserve a right to income distributions with respect to trust property, depending upon whether future VA benefits are of concern. The term “Irrevocable Income Only Trusts” is often applied to APTs, but in my (developing) opinion, this is a term that describes one variety of APT. The determination to retain a mandatory income interest must be made in view of intended goals.

5. Provide for trustees other than Gladys (although some practitioners may take issue with that position).

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6. Retain a testamentary special power of appointment for Gladys.

7. Retain the right for Gladys to discharge trustees and name successor trustees (other than herself or a spouse).

D. Overview of Medicaid Issues

Because the trust is irrevocable and provides that no distributions of principal may in any event be made to Gladys, the corpus of the trust will be non-countable with respect to Gladys for purposes of the Medicaid rules. On the other hand, because Gladys has irrevocably transferred assets from her name, the transfer upon funding of the trust will be a sanctionable transfer under the Medicaid rules. Five years from the funding of the trust, the transfer should be irrelevant from a Medicaid transfer sanction standpoint. Of course, the retention of the income stream and any distributions of income from the trust to Gladys will be treated as income for Gladys for Medicaid purposes.

E. Overview of Estate Recovery

In states that maintain a “probate assets only” estate recovery scheme, the assets transferred to the trust by Gladys should be beyond the reach of any estate recovery efforts. Retention of income rights, right to occupy the residence, and other named rights within the trust in other states could create estate recovery issues and should be carefully considered in the event that Gladys decides to move to another state.

In states that maintain an “expanded estate recovery” scheme (meaning assets well beyond the probate assets of an estate) it is somewhat debatable whether assets transferred to the trust by Gladys are completely beyond the reach of any estate recovery efforts. Retention of income rights, right to occupy the residence, and other named rights within the trust in some states have created estate recovery issues and should be carefully considered. Furthermore, the presence of assets in a thoughtfully designed irrevocable trust (with respect to the applicant/grantor), especially if there are discretionary sprinkle standards with respect to additional beneficiaries, present some extremely difficult obstacles to recovery.

F. Overview of Tax Issues

If properly designed, the Gladys’ APT will have the following tax characteristics (each of which will be discussed in further detail below):

1. Designed as a grantor trust with respect to Gladys, the trust will be of no consequence for purposes of taxation (although there may be some reporting requirements).

2. Gladys will continue to pay income taxes on any trust earnings, which is not a particularly onerous burden because she may likely be receiving income distributions and would be required to address any tax issues without the trust.

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3. If the trustees later elected to sell Gladys’ residence, as a grantor trust, the sale of the residence would continue to qualify for the capital gains exclusion under IRC Section 121.

4. Upon Gladys’ death, and eventual distribution of the farm to her three sons, the family will enjoy a “stepped up basis” pursuant to IRC Section 1014(e).

5. Because Gladys retained an income interest and a testamentary power of appointment over the trust property, the transfer to trust will be an incomplete gift for federal gift tax purposes (and in Gladys’ case, this would relieve her from mere reporting requirements).

G. Note on legal authorities: The following authorities are used throughout this outline and further references to these authorities will use the citation convention noted immediately below.

1. Federal statutory and judicial authorities will use standard citations.

2. References to the State Medicaid Manual or “SMM” refer to sections of the State Medicaid Manual maintained by the Centers for Medicare and Medicaid Services (“CMS”), primarily as contained in transmittal 64 issued by the Health Care Financing Administration (the predecessor to CMS) and effective December 31, 1994. These provisions of the SMM, to the extent not otherwise superseded by the United States Code (particularly as amended by the Deficit Reduction Act of 2005) continue to provide good authority upon which State Medicaid Directors are required to rely in implementing the provisions of their Medicaid plans.

III. Medicaid and Grantor Trusts

A. General Medicaid Principles

A broad analysis of any Medicaid issue is best addressed methodically. Many practitioners tend to confuse issues relating to resource availability with issues relating to transfer of resources and ensuing application of sanctions. The distinction is particularly applicable when dealing with trusts and Medicaid.

Medicaid rules apply classification systems to assets to determine whether assets should be recognizable assets for purposes of applying rather strict asset limitation tests. An applicant who is the beneficiary of a trust will subject the trust to the application of various rules to determine whether the trust assets are available for purposes of Medicaid’s asset limitations. For purposes of an APT, the analysis turns on whether the trust was funded with an applicant’s (or his spouse’s) assets and whether (or to what extent) the distribution standard of the trust provides for discretionary distributions to the applicant/beneficiary.

If application of those rules determines that the assets of a trust are totally (or in part) unavailable to the Medicaid applicant, then it will be necessary to

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analyze the funding of the trust to determine whether the Medicaid transfer sanction rules present any issues.

B. Availability Issues

1. Revocable Trusts.

Revocable trusts established by a Medicaid applicant or his or her spouse are available resources. SMM § 3259.6 A. Such a conclusion does not defy common sense because, of course, the assets are readily accessible by the applicant.

2. Irrevocable Trusts.

The analysis of whether the assets in an irrevocable trust established for the benefit of a Medicaid applicant begins with a determination of whose assets were used to fund the trust and who established the trust.

(a) Third Party Trusts. An applicant who is the beneficiary of an irrevocable trust established by a third party (other than a spouse or the agent of the beneficiary) may or may not need to include the assets of the trust for purposes of determining eligibility: it depends upon the distribution standard the applies to the trust and whether there are any circumstances under which the trustee is required to make distributions to the applicant. It could very well be that a trustee subject to a completely discretionary distribution standard under which the trust beneficiary could not legally enforce any sort of distribution may be an unavailable asset for Medicaid qualification purposes. Third party trusts are an incredibly valuable planning technique available to friends and family of recipients of governmental benefits and competent practitioners should have at least a passing understanding of these trusts. Third party trusts, however, will not be discussed any further under this outline.

(b) Self-Settled Trusts. An applicant (or certain persons close to the applicant) who established a trust for his own benefit will be subject to an entirely different set of rules discussed further below.

C. Analysis Under the Medicaid “Self-Settled” Trust Rules When an “individual” has established an irrevocable trust using his or her assets and those assets form all or at least part of the corpus of the trust (the typical grantor trust scenario), an analysis must be undertaken to determine to what extent the assets are “available” and countable for Medicaid purposes. To the extent not available, then the transaction will be viewed under the transfer sanctions provisions.

1. Availability

(a) Key definitions:

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(1) “Individual” includes not only the individual himself, but also his spouse if she is acting on his behalf, or any court or other body or person acting on behalf of the individual or his spouse. 42 USC § 1396p(d)(2)(A); SMM 3257.B.1

(2) “Grantor” is the person who creates the trust and, with respect to the individual, will include his spouse. 42 USC 1396p(d)(2)(A); SMM § 3259.1.A.4.

(3) “Irrevocable Trust” is a trust that cannot be changed by the grantor, SMM § 3259.1.A.6.

(4) “Individual’s Assets” will include her assets and those of her spouse. 42 USC § 1396p(d)(2)(A); SMM § 3259.3.

(b) Applicability of Rules The rules apply to any individual who establishes a trust with his or her assets and applies for Medicaid, the purposes behind the creation of the trust are totally disregarded, as well as the existence of any trustee discretion, exculpatory clauses, or any restrictions on trustee discretion regarding distributions. 42 USC § 1396p(d)(2)(C); SMM § 3259.5. IMPORTANT DISTINCTION/EXCEPTION: The rules described herein do not apply to testamentary trusts. 42 USC § 1396p(d)(2)(A); SMM § 3259.3. A discussion of testamentary trusts is yet another topic beyond the scope of this outline; nevertheless, for Medicaid purposes the availability of assets in a testamentary trust to a trust beneficiary turns on the trustee’s distribution standard under applicable trust law and, under a developing line of cases and, the testator’s intent that the trust be a fund supplemental to public benefits. See, e.g., White v. Kansas Health Policy Auth., 40 Kan. App. 2d 971, 979, 198 P.3d 172 (2008) (interpreting Kansas statutory requirement that an inter vivos third-party trust or testamentary trust must contain explicitly stated intent that trust assets are supplemental to Medicaid); Pohlmann v. Nebraska Dep’t of Health & Human Servs., 271 Neb. 272, 279, 710 N.W.2d 639 (2006) (excellent discussion of testator’s intent that trust be purely discretionary, thus excluding assets from Medicaid availability); Corcoran v. Dep’t Soc. Servs., 271 Conn. 679, 698-703, 859 A. 2d 533 (2004) (assets available; extensively cited and contrasted the court’s earlier decision in Zeoli v. Comm’r Soc. Servs., 179 Conn. 83, 425 A. 2d 553 (1979) in which testamentary trust assets were deemed unavailable for Medicaid purposes); Estate of Rosenberg v. Dep’t Pub. Welfare, 545 Pa. 27, 31-33, 679 A. 2d 767 (1996) (testamentary trust assets

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unavailable).

(c) Key Test: Existence of Circumstances Under Which Distributions Could Be Made

(1) If there are any circumstances in which all or a portion of a trust can be made to the individual:

(a) Payments of income from any portion are considered monthly income

(b) Any portion of the corpus that could be paid, under any circumstances to the individual, are available assets

(c) Any income or corpus paid to other individuals that could have been paid to the individual are deemed transfers of assets.

See 42 USC § 1396p(d)(3)(B); SMM § 3259.6.B.

(2) If there are NO circumstances in which distributions of corpus can be made to the individual; analyze for transfer of assets as of “the date the trust was established” or transfer to the individual was foreclosed. SMM § 3259.6.C.

2. Transfer Issues If an irrevocable trust is established, the transfer of assets issue must be addressed. As mentioned above, if the assets are deemed available, there is no transfer sanction. Assets that are not available, incur transfer sanctions. The additional issue has also been raised concerning subsequent transfer from trust to beneficiaries or individuals other than the grantor.

(a) A 1993 HCFA letter from confirmed that transfer of assets to an irrevocable trust that prohibited distributions of principal to the grantor, but in which the grantor retained income interest, would be deemed a transfer of assets and the corpus of the trust would “never [be] considered an available resource to the grantor.” Letter from Sally K. Richardson, Director, Medicaid Bureau, Health Care Financing Admin, to Ellice Fatoullah, Alzheimer’s Dis. & Related Disorders Ass’n, Inc. (Dec. 23, 1993) (attached as Appendix A). The letter did not, however, address the issue of when a sanction would begin, whether at funding or at later distribution from the trust.

(b) Eleven months after the Richardson letter, HCFA issued Transmittal 64. The SMM clarified the issue:

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In treating these portions as a transfer of assets, the date of the transfer is considered to be:

• The date the trust was established; or, • If later, the date on which payment to the individual was foreclosed.

In determining for transfer of assets purposes the value of the portion of the trust which cannot be paid to the individual, do not subtract from the value of the trust any payments made, for whatever purpose, after the date the trust was established or, if later, the date payment to the individual was foreclosed. If the trustee or the grantor adds funds to that portion of the trust after these dates, the addition of those funds is considered to be a new transfer of assets, effective on the date the funds are added to that portion of the trust.

(c) Three years after Transmittal 64 HCFA clarified a number of points in a now somewhat famous letter. Letter from Robert A. Streimer, Director, Disabled & Elderly Health Programs Group, Center for Medicaid & State Operations, Health Care Financing Admin to Dana E. Rozansky, Begley, Begley & Fendrick (Feb. 25, 1998) (the “Streimer Letter” attached as Appendix B):

(1) Any portion of trust funds in an irrevocable trust that “can be made available” will be treated “as appropriate” as either income or resources. Streimer Letter item 3.

(2) Assets in a trust that cannot be made available incur a penalty “when the funds were placed in the trust.” Id. item 4.

(3) Later transfers to an individual other than the “beneficiary” do not incur a separate transfer penalty. Id.

(4) Transfers to trust with a mere retained income interest are available “only to the extent of the income earned.” Id., item 5.

(d) Does a distribution of assets that results in a reduction of income to the beneficiary count as a sanctionable transfer? Some commentators have raised the issue of whether the distribution of principal to other beneficiaries with a resulting reduction of income to the income beneficiary may count as some sort of sanctionable transfer. The idea animating such concerns seems to be that if a grantor trust has a mandatory, retained income interest, a transfer of the underlying assets is tantamount to a transfer (at least partially) of the income stream, which should have a value.

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This concern has lead some to recommend a discretionary income distribution standard only, a recommendation that may have merit. These concerns can be addressed and perhaps managed. First, when the trust is funded it may8 have a discretionary sprinkle standard with respect to principal to some class of beneficiaries. If so, the income was always subject to trustee discretion regarding principal distributions. For that matter the income could vary depending upon trust investment (a mix that the trustee is presumably free to alter)9. Second, various authorities consistently treat the corpus and the income separately for purposes of calculating availability and potential sanctions. See 42 USC § 1396p(d)(3)(B)(ii); SMM § 3259.6 B and C; Streimer Letter items 4 & 5 (penalty assessed when funded; in the case of a retained income interest, only to extent of income earned).

D. The Doherty Case: A Warning For Attorneys Doherty v. Dir. Off. Of Medicaid, (Mass. App. Ct., Essex, No. 08-P-939) (March 2009), will provide no binding, and very little persuasive, authority outside Massachusetts. Nevertheless it could be a big case because it provides an excellent legal template for a state agency to successfully mount a challenge to an irrevocable income only trust. Practitioners would be wise to heed the case carefully.

1. Facts: Muriel Doherty established an irrevocable trust naming her niece and nephew trustees. She reserved a lifetime income interest and the trust contained the usual admonition that under no conditions would any distributions of principal be made to her or on her behalf. Unfortunately, the trust contained a number of boilerplate provisions common to many form trusts.

(a) The trustee had the right “in its sole discretion and notwithstanding any other provisions” to terminate the trust in the event the trust became too small for practical administration and distribute to the beneficiaries (in general terms – no specification of remainder beneficiaries).

(b) The trustee had exclusive right to determine all allocations of principal and income.

(c) The trust also contained unfortunate language describing the “unforeseeability” of Muriel’s future needs and to accumulate principal “to the extent feasible.”

8 In fact, perhaps it should contain such a standard, especially in the VA benefits context, for reasons discussed further below in the section of this outline discussing VA benefits. 9 Far from being “boilerplate”, trustee authority provisions may need to contain some authority with respect to income and principal notwithstanding the Principal and Income Act.

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(d) Muriel retained a special power to appoint principal to any of Muriel’s descendants or siblings.

(e) She specifically retained a right to remain in the home, giving her, as the court observed, a veto power over any potential sale.

2. Law: The court mentioned that the trust was subject to the “post-1993 statutory scheme” (a nod to OBRA ’93) and specified that its task was to determine whether any portion of the principal of this self-settled trust could “under any circumstances” be paid to or for the benefit of Muriel.

3. Held: The trust vehicle “considered as a whole” evidenced Muriel’s intent that the trustees would invade the principal as necessary to insure her comfort. The court characterized the trust as a ”remarkably fluid legal vehicle” structured to provide maximum flexibility to respond to Muriel’s changing needs. Implicit (by mentioning the trustee’s power to allocate between principal and income) was the conclusion that the trustees could distribute “principal” to Muriel simply by recharacterizing it as “income.”

4. Lessons: Eliminate the right to terminate a small trust. Lock the trustee into definitions of principal and income. Avoid inter vivos special powers of appointment (stick with testamentary powers). Allow the beneficiary to remain in the home at the sufferance of the trustee and perhaps subject to an occupancy agreement (perhaps obligating the beneficiary to cover carrying costs of the residence). And by all means avoid recitals describing the grantor’s future or current needs! Finally, many scriveners employing trust advisor/trust protector language grant the advisor/protector authority to terminate the trust under certain circumstances and distribute trust assets to some or all beneficiaries, but care should be taken to insure the grantor is not a member of the class of beneficiaries eligible for a potential distribution.

5. Conclusion: On the bright side, the court said that it had “no doubt that self-settled, irrevocable trusts may, if so structured, so insulate assets that those assets will be deemed unavailable to the settlor.”

IV. Tax Issues

A. Grantor Trust Status

1. Generally. All or any portion of an irrevocable trust drafted to be “defective” for both income tax and transfer tax purposes (or either) is classified as a “grantor” trust with respect to that portion of the trust. In the context of income taxation, the settlor (or other designated individual depending upon planning objectives) is the deemed owner of the portion of the trust that triggers the grantor trust rules and is responsible for income tax liabilities associated with that portion of the trust.

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The courts and Congress throughout the 1940s and 1950s devised the grantor trust rules years ago to impede the ability of individuals to shift tax burdens to lower-bracket taxpayers (e.g., children); the idea was to essentially nullify the transfer to trust (for tax purposes) if the transferor retained too much control. After the adoption of those rules, drafting an “unintentionally defective” trust might have created an undesirable result - thus, the term “defective.” Long a staple of estate tax planning, a defective grantor trust can be a powerful tool in the elder lawyer’s arsenal. When “defective” with respect to transfer taxation as well (discussed below), the results can be dramatic. A trust gains “grantor” status by “failing” one of the rules enumerated in IRC §§ 673 through 678. Those sections provide a menu of options for designing an intentionally defective grantor trust. Generally they involve some sort of right or benefit retained by the grantor over the trust assets or beneficiaries. IRC §§ 671 and 672 provide, respectively, general rules and definitions. 2. Internal Revenue Code Grantor Trust Rules – The Meaning of “Any Portion”.

(a) General Rule Regarding Grantors (and Others) as Owners; Definition of “Adverse Party” A grantor (or another person, for that matter) deemed the “owner” of any portion of a trust under the Grantor Trust Rules is required to include in computing his or her taxable income those items of income, deductions, and credits that are attributable to that portion of the trust. Remaining items of income, deductions and credits (i.e., those attributable to other portions of the trust) are taxed to the trust, or beneficiary, as applicable, under the usual trust taxation rules of subchapter J of the IRC (IRC §§ 641 – 692). A critical definitional issue pertains to who is treated as the “grantor”. Particularly in the context of so-called “self-settled trusts” established by a parent, grandparent, guardian or court the identity may be somewhat unclear. See, generally, 42 U.S.C. § 1396p(d)(4)(A). Generally, the regulations under Code section 671 deem any person who creates or funds a trust to be a grantor of the trust. Treas. Reg. § 1.671-2(e)(1). A grantor, however, may not necessarily be the tax owner. A person may create a trust or fund a trust, but if that person made no gratuitous transfer to the trust or is directly reimbursed for a transfer to the trust, he or she may be the

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grantor of the trust, but not the owner. Id. The converse may apply in certain limited cases. For example, a person who is not the grantor with respect to a trust (i.e., she neither created nor funded any portion of the trust) may nevertheless be the tax owner with respect to any portion of the trust over which she has a withdrawal power that could benefit herself. 10 Id. 1.671-2(e)(6) Ex. 4 and I.R.C. § 678(a)(1). The concepts of tax owner and grantor are related but different. Any of the grantor trust tax rules must be read carefully to determine whether the rule applies to a grantor, an owner, or perhaps some other person such as a nonadverse party.11 There may be more than one grantor and one owner. The regulations provide an example that could easily be read in the third party special needs trusts context. Brother creates a Trust for Sibling and transfers $50,000 worth of Acme Stock to the Trust. The Acme Stock appreciates in value to $100,000. Uncle transfers property worth $1,000,000 to the Trust in exchange for the $100,000 Acme Stock shares. Brother is grantor with respect to the trust portion valued at $100,000; Uncle is grantor with respect to the $900,000 portion. Brother and Uncle will also be the tax owners of the respective portions to the extent the Trust document grants them any of the powers enumerated in the rules under Code sections 673 through 677. Treas. Reg. § 1.671-2(e)(6) Ex. 7. It should also be clear, in the context of a self-settled or d4A trust, 42 U.S.C. § 1396p(d)(4)(A), that a trust “established” by a parent or grandparent may nevertheless be a grantor trust with respect to the disabled beneficiary to the extent the beneficiary’s assets have been transferred to the trust and the scrivener selects some triggering rule under Code sections 673 through 677 and drafts the appropriate power into the document.12 “Adverse Party” is a key definition to master. The concept is important not because adverse parties are essential, but rather

10 As discussed further herein, many grantor trusts drafted in the Medicaid-Veterans benefits asset protection context grant a trustee the authority to make distributions of principal to members of a class that may include the trustee. E.g., the trust permits the trustee to distribute to any of grantors descendants and the trustee is a child of the grantor. If the trustee’s powers are unfettered that individual will be the deemed owner of the trust and many of the tax benefits sought with respect to the grantor may be lost. Addressing this issue should be of critical concern to a scrivener. 11 Nonadverse parties are discussed in this Section. 12 If sound benefits and tax planning indicate that grantor trust status with respect to the beneficiary is advisable, there are any number of provisions that can be inserted that should not create difficulties from a Medicaid or SSI standpoint. This outline discusses a number of those provisions further below.

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because “nonadverse parties” are so useful.13 An "adverse party" is any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust. A general power of appointment over trust property constitutes a beneficial interest in the trust, along with countless other possible interests. I.R.C. § 672(a). It logically follows that any individual who is not an adverse party is a nonadverse party. Id. § 672(b). (b) Determining “Portions” A tremendous amount of confusion exists with respect to the meaning of “a portion of a trust” and the applicability of that phrase to the grantor trust rules. Many elder law attorneys do not understand that a trust may be a grantor trust as to a portion only, and not a grantor trust with respect to other portions (i.e., subject to the “usual” trust tax rules of Subparts A through E of Part 1 of Subchapter J of Chapter 1 of Subtitle A of Title 26 – translation: IRC § 641 et seq.). A trust portion can appear in one of three ways. Short of being the deemed owner of an entire trust, a grantor could be the deemed owner of the principal or the income, the owner of a pecuniary or fractional share of all trust income, deductions and credits, or the owner of income, deductions and credits attributable to a specific trust asset. Elder law attorneys are most likely to encounter apportionment in the context of principal and income. To determine what items of income, deduction and credit are apportioned to income and principal, the regulations use the distributable net income (“DNI”) rules under IRC 643(a). Treas. Reg. § 1.671-3(c). Calculation of DNI can be complex and a thorough treatment is beyond the scope of this Outline. At the outset, it is important to understand that DNI is not he same as fiduciary accounting income (“FAI”) under most states’ Principal and Income Act. The purpose of FAI is to allocate equitably receipts between current and remainder beneficiaries. The purpose of DNI is to determine, as between beneficiaries and the trust, who should bear the tax burden.

13 As will be discussed further below, some of the retained grantor trust powers are not “retained” at all, but rather vested in someone other than the grantor who is a nonadverse party. The nonadverse party actually becomes quite an ally if the intent is to create a grantor trust without vesting troublesome powers in the grantor/beneficiary that could create Medicaid/SSI/Veterans benefits issues.

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DNI allocates tax burden by acting as a limit on what would otherwise be an unlimited deduction available to trusts for distributions to beneficiaries. With respect to simple trusts (trusts required to distribute all income – and nothing else - to beneficiaries) and complex trusts (trusts that are not simple trusts) IRC §§ 651 and 661 allow deductions from gross income for distributions to beneficiaries for purposes of calculating taxable income. IRC §§ 651(b) and 661(c), however, disallow deductions in excess of DNI. As a “rule of thumb,” for most trusts DNI will equal taxable income determined without regard to the IRC §§ 651 and 661 distribution deductions (which makes sense since DNI is limiting those deductions) and any personal exemption (which also makes sense because allowing a trust’s exemption with regard to amounts passing to a beneficiary and exposed to her personal exemption would allow for “double exemption dipping”). From the resulting figure, deduct net capital gains (which are usually – not always – allocated to principal) and add tax-exempt income (reduced by administrative expenses allocated to the tax-exempt income). (c) CAVEAT: Practical Impact of “Any Portion” Items of capital gain are not included in the “income” portion of a grantor trust. The most likely area for an elder law attorney to run afoul of the “any portion of” rules of IRC § 671 is in the area of reserved income interests. For example, a cursory review of the literature available in seminar materials and on the internet gives the impression that a grantor, by reserving an income interest, has created a grantor trust that will preserve favorable attributes of grantor trust status with respect to corpus – notably a preservation of the capital gains exclusion on sale of a principal residence under Code section 121. Unfortunately, the reservation of a power that will result in grantor trust status with respect to income may not create the desired result with respect to corpus unless some other reserved power triggers grantor trust status with respect to corpus. In such a case, the grantor will be treated as owner of only those items of trust income, deduction, and credit allocated to income and not to principal. Treas. Regs. §§ 1.677(a)-1(g) (example 1); 1.671-3(b). For an interesting case on point see Goldsby v. Comm’r, T.C. Memo 2006-274 (trust income beneficiary denied pass through of items attributable to corpus). From a VA planning standpoint, the “any portion” rules should work to an advantage if wisely used. Think of it as the “reverse” income only trust. The vet/grantor conveys a highly appreciated

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asset (perhaps a residence) to a grantor trust designed such that no portion of the income is deemed owned by him, but he is deemed the owner of principal for grantor trust purposes. The grantor will retain the income tax attributes of the residence and preserve a possible Code section 121 exclusion and avoid having the trust count for VA purposes (because he has retained no income interest that will be reportable and be revealed in a VA/IRS match, if that is a concern). See discussion below concerning VA benefits.

3. Internal Revenue Code – Specific Powers Retained By Grantor

(a) IRC § 673 Reversionary Interests The grantor is treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of that portion of the trust, the value of such interest exceeds five percent (5%) of the value of such portion. In the elder law or special needs context a significant reversionary interest in a grantor with asset protection motives is not attractive . (b) IRC § 674 Power to Control Beneficial Enjoyment – TRICKY Generally, a grantor is treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party. IRC § 674(a). There are eight major exceptions: Five are powers the grantor or any other person may hold, two are powers an independent, nonadverse trustee may exercise, and one is a power a nonindependent, nonadverse trustee (other than the grantor or the grantor's spouse) may exercise, without causing the grantor to be taxable as the owner of the trust. Accordingly, reliance on a simple power to affect the beneficial enjoyment of a trust without verifying whether the power falls within one of the following exceptions is not a good practice.

(1) A grantor is not taxable as the trust's owner if, in a fiduciary capacity as trustee or co-trustee, he may use trust income to discharge a legal support obligation of the grantor. IRC § 674(b)(1); Regs. § 1.674(b)(-1(b)(1). The grantor is taxable as the trust's owner to the extent the trust income is in fact used to discharge the support obligation

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described in IRC § 677(b) (see below). Regs. § 1.677(b)-1. (2) A “postponed power” (i.e., a power to affect a trust's beneficial enjoyment that is subject to the occurrence of an event) will create a grantor trust unless it is postponed for a period which, were it a reversionary interest, would cause it to have a value less than five percent (5%) of the value of the trust or portion of the trust. IRC § 674(b)(2). The analysis is the same as one would perform under IRC § 673 with respect to reversionary interests. (3) A testamentary power of appointment does not create a grantor trust, even if the grantor or a nonadverse person (or both) holds the power and the power is exercisable without an adverse person's approval or consent. IRC § 674(b)(3). That being said, there are two important limitations that take much of the force out of the general rule. First, the regulations provide that, with respect to a trust that provides an income interest to another for life, a grantor who holds a power exercisable without an adverse person's approval or consent to appoint the trust remainder by her will is taxed as the owner of those items of trust income, deduction, and credit properly allocated to the trust principal. Regs. § 1.674(b)-1(b)(3). Second, the statute carves out an additional exception. If the trust provides that the grantor or another nonadverse party may elect to accumulate income for disposition by the grantor or the other nonadverse party, the trust will be a grantor trust. Regs. § 1.674(b)-1(b)(3) further provides that if trust income is to be accumulated during the grantor’s life and is subject to a testamentary power of appointment, then “the grantor is treated as the owner of the trust.” What is not clear (as if anything to this point is) is whether the grantor is treated as the owner of the income or the entire trust. The better reading seems to be that the grantor would be treated as owner of the income portion of the trust. This is because IRC § 674(a) says the grantor is treated as owner of a portion of a trust with respect to which the “beneficial enjoyment of the corpus or the income is subject to a power of disposition” in the grantor or a nonadverse person. Here, the power of disposition (in this case, “accumulating”) applies to a portion (i.e., the income). The regulations bear this out (“this exception

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does not apply to income accumulations”). Caution should be exercised if relying on one of these “exceptions” to establish grantor trust status if any adverse parties hold a right to force or make trust distributions (perhaps without the consent of a nonadverse party) during the term of the trust. Many practitioners give a trustee (perhaps one who is an adverse party) a power to make distributions during the trust term to a class of beneficiaries other than the grantor. Many will add the necessary consent of another beneficiary, perhaps a sibling, in order to provide some safety and to avoid problems under Code section 678 (deeming person who has sole discretion to distribute as owner of trust and destroying grantor trust status with respect to grantor). That only solves one problem. If both “consentors” are adverse and can distribute at any time, they will destroy grantor trust status if that status is dependent upon Code section 674(b)(3) and Treasury regulations section 1.674(b)-1(b)(3) testamentary powers of appointment. See, e.g., Priv. Ltr. Rul. 200637025. Finally, a general power of appointment could also be viewed as a reversionary interest in the trust, causing the trust to be a grantor trust under IRC § 677(a). (4) A grantor is not taxed as a trust's owner if the grantor simply retains a power to allocate the beneficial enjoyment of trust corpus or income among charitable beneficiaries. I.R.C. § 674(b)(4); Treas. Reg. § 1.674(b)-1(b)(4). (5) A grantor is not taxed as a trust's owner simply because she or a nonadverse person (or both) has a power to distribute corpus among one or more beneficiaries if the power is limited by a “reasonably definite standard” (i.e., similar to the ascertainable “health, education, maintenance or support” under IRC §§ 2041 and 2514). IRC § 674(b)(5)(A); Regs. § 1.674(b)-1(b)(5)(i). ** A couple of noteworthy points in the elder law context: First grantor trust status will result if the power in the grantor or a nonadverse person to distribute corpus to or among beneficiaries is not limited by a reasonably definite standard. Second, pursuant to flush language at the end of IRC § 674(b)(5), if the grantor or a nonadverse party retain the right to add a beneficiary or to a class of beneficiaries,

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the result will be grantor trust status. Both of these could be extremely useful powers of the intent is to create a grantor trust with respect to principal without retaining additional powers that could create Medicaid “asset retention” issues, particularly if a nonadverse party is the powerholder. (6) A grantor is not taxed as a trust's owner if he or a nonadverse person (or both) has a power to distribute or apply income to or for any current income beneficiary or to accumulate the income for him, provided that any accumulated income must ultimately be payable to that beneficiary, his estate, or to his appointees. IRC § 674(b)(6). This rule goes on to become exceedingly complex. Read it and the underlying regulations if you intend to rely upon it (or avoid it). In any event, this exception does not apply if any person has the power to enlarge the class of beneficiaries (other than to add after-born or adopted children (7) A grantor is not taxed as a trust's owner simply because she or a nonadverse person (or both) reserves a power, exercisable without an adverse person's consent or approval, to withhold income from a current income beneficiary during any legal disability of the beneficiary or until such beneficiary attains age 21. IRC § 674(b)(7). (8) A power held by the grantor or a nonadverse person (or both) to allocate receipts and disbursements as between corpus and income, even though expressed in broad language, does not constituted a power to dispose of the beneficial enjoyment of the trust corpus or income that would cause the grantor to be taxed as the trust owner. IRC § 674(b)(8). (9) Other Noteworthy Elements Under IRC § 674

(a) A grantor is not taxed as a trust's owner if an independent trustee has the power to distribute, apportion, or accumulate income or corpus to or for a beneficiary or beneficiaries. An independent trustee is not the grantor, nor a related or subordinate party. IRC § 674(c). (b) A grantor is not taxed as a trust's owner if a nonadverse trustee holds the power to distribute,

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apportion or accumulate income to or for a beneficiary, if the power is limited by a reasonably definite external standard. The exception to grantor trust treatment for this permissible trustee power is not available if the grantor or the grantor's spouse (if living with the grantor) is a trustee; however, unlike the IRC § 674(c) exception, any of the trustees may be related or subordinate to the grantor. §674(d). (c) Grantor’s power to remove, substitute, or add trustees (other than a power exercisable only upon certain limited conditions such as the death or resignation of, or breach of fiduciary duty by, an existing trustee) may prevent a trust from qualifying under section IRC § 674(c) or (d). For example, if a grantor has an unrestricted power to remove an independent trustee and substitute any person including himself as trustee, the trust will not qualify under section IRC § 674(c) or (d), above. Conversely, if the grantor's power to remove, substitute, or add trustees is limited so that its exercise could not alter the trust in a manner that would disqualify it under section IRC § 674(c) or (d) the power does not cause grantor trust treatment. For example, a power in the grantor to remove or discharge a nonadverse trustee on the condition that he substitute another nonadverse trustee will not prevent a trust from qualifying under section 674(d). Treas. Regs. § 1.674(d)-2(a).

(c) IRC § 675 Administrative Powers (IMPORTANT and EASY) Certain administrative powers exercisable by the grantor or a nonadverse person, or both, for the benefit of the grantor rather than for the trust beneficiaries, or powers exercisable in a nonfiduciary capacity, will cause the trust to be taxable to the grantor as owner of the trust. The first three categories are of no use in the elder law context because they will render trust assets as available resources for Medicaid purposes; the fourth category contains a provision that is much more interesting. Those powers include:

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(1) The power to dealing with trust assets for less than adequate and full consideration, (2) The power to borrow trust assets without adequate interest and security, (3) Actually borrowing trust assets with inadequate security and failing to repay the loan, (4) The power to exercise certain administrative powers in a nonfiduciary capacity without the approval or consent of any person in a fiduciary capacity, including:

(a) a power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; (b) a power to control the investment of the trust funds either by directing investments or reinvestments, or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control (c) a power in the grantor or an adverse person acting in a nonfiduciary capacity (no trustees!) to reacquire the trust corpus by substituting other property of an equivalent value. This particular power could be important to the elder law attorney. CAUTION: One potential line of attack that could be used by a regulator attempting to assert that trust assets are available for Medicaid purposes due to the retention of a power of substitution has surfaced in Colorado. Colorado Medicaid regulations provide that “If there are any circumstances under which payments from the trust could be made to or for the benefit of the individual . . . the portion of the corpus of the trust . . . from which payment to the individual could be made shall be considered as resources available to the individual.” 10 Colo. Code Regs. § 2505-8.110.52.B.4. According to Bradley Frigon, CELA, of Englewood, Colorado, the Colorado Medicaid office interprets the provision to provide that if a trust contains either a

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power of substitution or a right to borrow assets without adequate security the assets will be deemed available. Further, if the trust is amended to remove the power, the “fix” date will be treated as “the date on which payment to the individual from the trust was foreclosed” with respect to assessing a transfer sanction. Id. § B.4.a.4. Given that this is a power of “equal substitution” it is difficult to see how such a retained power is anything but the ability to enter into a fair market exchange (nonsanctionable). Nevertheless, concerns over a “Colorado-like attack” could be avoided by simply vesting a power of substituion in some nonadverse party willing to lend her name to the cause. Admittedly the section refers to “reacquired” and a grantor is the only person capable of “reacquiring” an asset, but the section also refers (applying generally to all “administrative powers”) to the power existing in the grantor or any nonadverse party (there is no limitation with respect to this power). In a closely analogous setting, the IRS published model charitable lead trust language in 2007. Rev. Proc. 2007-45. Section 7 of the ruling provides model language for a grantor lead trust, and in model trust section 11 the IRS chose to structure the trust by giving a nonadverse party the power of substitution under IRC § 675(4). The annotations to the model explain the use and specify that the exercise must be in a nonfiduciary capacity. Rev. Proc. 2007-45, § 8.09(1). The following paragraph even explains that the drafter is free to choose some other power under the grantor trust rules if the power of substitution does not fit client needs. Id. @ § 8.09(2).

(d) IRC § 676 Power of Revocation If a grantor (or grantor's spouse) or any other nonadverse person retains the power to revest the title to the trust assets in the grantor, then the grantor shall be treated as the owner of such portion, even though no other provisions of IRC §§ 671-678 apply. In light of Doherty this is not at all attractive because there is an argument to be made that this was a collusive scheme to hold the assets available to the grantor.

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(e) IRC § 677 Income for the Benefit of Grantor A grantor is taxable as the owner of any trust or trust portion as to which she, or any nonadverse person (or both), has the ability to use (or actually uses, as the case may be) the trust income for the benefit of the grantor or the grantor's spouse in one or more specified ways, without the consent or approval of an adverse person. Statutory ambiguity notwithstanding, the regulations clarify that a grantor who retains an income interest only is treated as owner of only ordinary income items, and not owner of any trust property properly allocable to principal. Treas. Reg. § 1.677(a)-1(g) (ex. 1). IMPORTANT: Do not reserve a simple income interest and expect grantor trust treatment with respect to both income and principal. For example, a grantor who retains an income interest (and no other interest under the grantor trust rules that would treat him as owner of principal) and transfers a principal residence to the trust will not be able to obtain an exclusion from capital gains upon sale of the residence under IRC § 121. The manner in which a grantor may retain an income interest and trigger grantor trust status are:

(1) Actual or constructive distribution of income to the grantor or the grantor's spouse; (2) Accumulation of income for future distribution to the grantor or the grantor's spouse; (3) Application of income, either actually or constructively, to payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse, other than certain charitable policies (this could be interesting in certain circumstances); or (4) actual application or distribution of income to discharge the grantor's or her spouse's legal obligation of support (which is usually the case in an income only trust).

(f) IRC § 678 Person Other Than Grantor Treated As Owner – BE CAREFUL This section is the only provision under which a trust could be a grantor trust as to a person who is not a transferor to the trust (note that each of IRC §§ 673 through 677 begin “The grantor shall be

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treated . . .” and IRC § 678 commences with “[a] person other than the grantor shall . . .”). IRC § 678 provides that a person (which could be a beneficiary) will be treated as the owner of any portion of a trust with respect to which he has the power to vest the corpus or income in himself, or if he previously had such a power and released or modified it and still retained such control as would, under the principles of IRC §§ 671 through 677, treat a grantor of the trust as the owner thereof. Very important: If a trustee is vested with the sole discretion to distribute trust principal to a class that includes the trustee (not at all uncommon given that many APTs grant a trustee the discretion to distribute corpus to descendants of the grantor) the trust will no longer retain grantor trust status with respect to the grantor. IRC § 678(a)(1) provides “A person other than the grantor shall be treated as the owner of any portion of a trust with respect to which . . . such person has a power exercisable solely by himself to vest the corpus or the income thereof in himself . . . .” In such a case consider co-trustees or perhaps require the trustee to secure the written approval of some other individual before making such distributions. Crummey powers and inter vivos powers of appointment will also trigger this section.

B. Results of Grantor Trust Status

1. General A client who has executed a grantor trust under the foregoing rules has likely retained some degree of control over trust assets notwithstanding the irrevocable nature of the trust and the accomplishment of a completed transfer of assets for Medicaid purposes. Many clients are comforted by the fact that they retain a right to alter the ultimate beneficial or direct enjoyment of trust assets. Such a power can do much to encourage a trustee/child/remainder beneficiary to retain a keen sense of his or her fiduciary duty as well as an “extra-fiduciary” sense of fair play toward a beneficiary parent! Of course, the beneficiary/parent is responsible for income taxation, which includes both ordinary and capital gains tax. If the settlor has retained a mandatory income interest, obligation for taxation on ordinary income should not be a burden. Capital gains taxation could produce more interesting issues. Without

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appropriate authority to classify income and principal under the Uniform Principal and Income Act in the event whatever ordinary income distributed to the grantor is not sufficient to cover capital gains tax that might be due on the sale of an asset by the trustee, the grantor may have difficulties meeting his or her tax liabilities. This could be particularly true if a trust has been designed as a grantor trust without the retention of a mandatory income interest (perhaps a discretionary distribution of income standard or even a complete prohibition of any distribution to the grantor – which may be desirable from a veteran’s benefit standpoint as discussed in Section V, below). 2. Sale of residence

(a) IRC § 121 permits a taxpayer to exclude up to $250,000 ($500,000 for married couples filing jointly) of gain realized on the sale or exchange of a principal residence, so long as certain use and ownership requirements are met. The $250,000 exclusion applies if the property has been owned and used by the taxpayer as the taxpayer’s principal residence within the five year period ending on the date of the sale or exchange, for periods aggregating at least two years. The $500,000 amount applies to spouses filing a joint return so long as one spouse meets the above ownership requirement, both spouses meet the use requirement and neither has used the exclusion within two years of the date of the sale or exchange. Even if these requirements are not met for a married couple, the $250,000 exclusion can still be used if one of the spouses meets the ownership and use requirements with respect to the property. (b) Rev. Rul. 66-159, 1966-1 C.B. 162, held the transfer of trust property used by a grantor as his principal residence qualified for tax deferral under IRC § 1034 (the then precursor to IRC § 121; IRC § 1034 allowed rollover of gain on sale of residence to a replacement residence) because the grantor was “treated as the owner of the entire trust” under IRC §§ 671 and 676. (c) Rev. Rul. 85-45, 1985-1 C.B. 183, held sale of residence owned by trust and used by grantor as his residence qualified for exemption under IRC § 121 because the grantor was “treated as the owner of the entire trust” under IRC § 671. (d) See also Priv. Ltr. Rul. 199912026 (taxpayer considered owner of trust under IRC §§ 676(a) and 671, thus treated as owner of residence for purposes of IRC § 121) and Priv. Ltr. Rul. 200124011 (same result; taxpayer treated as owner per IRC §

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677(a)).

3. Funding Grantor Trusts With Nonqualified Annuities In the elder law practice setting, clients with nonqualified annuities are not unusual. Most nonqualified annuities are countable assets under the Medicaid rules, and for many reasons converting those annuities to Medicaid qualifying (noncountable) annuities may not be desirable.

(a) Gratuitous ownership transfers of annuities are generally taxable events. IRC § 72(e)(4)(C). On the other hand, transfers of an annuity to a grantor trust, which will result in alter ego tax treatment for the grantor and the trust, should not result in taxation upon transfer of ownership to the trust. Note that under IRC §§ 673 – 677, “the grantor is treated as the owner . . . .”; accordingly, for Chapter 1 tax purposes, there has been no change of ownership.14 Some insurance companies remain unconvinced. The attorneys’ job is to convince them. (b) The next, closely related, issue is the continued tax-deferred status of the annuity. IRC § 72(u)(1) denies tax deferral to an annuity contract that is not owned by a natural person. On the other hand, the provision further provides that “For purposes of this paragraph, holding by a trust or other entity as an agent for a natural person shall not be taken into account.” The legislative history provides help:

In the case of a contract the nominal owner of which is a person who is not a natural person (e.g., a corporation or a trust), but the beneficial owner of which is a natural person, the contract is treated as held by a natural person. Thus, if a group annuity contract is held by a corporation as an agent for natural persons who are the beneficial owners of the contracts, the contract is treated as an annuity contract for Federal income tax purposes.

H.R. Rep. No. 99-426, at 703 (1986). Further, the Service has issued a string of private letter rulings (mindful that they are mere private letter rulings) providing favorable treatment to irrevocable trust

14 See, also, Rev. Rul. 85-13, 1985-1 C.B. 184 (grantor is deemed owner for all tax purposes with respect to grantor). Notwithstanding my opinion that Rev. Rul. 85-13 is of dubious value in the basis-upon-death context, I believe it is on point here. See discussion of basis issues infra Section IV.C.

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ownership of annuities in a variety of settings. Priv. Ltr. Ruls. 9120024, 9204010, 9204014, 9316018, 9322011, 9752035, 199933033, 200018046, 200449011, 200449013, 200449014, 200440015, 200449016, 200449017, 200720004. Because of the focus on “beneficial” ownership in the legislative history and letter rulings, as well as taxation of annuity distributions (way beyond the scope of this outline), maintaining a retained income right (as opposed to a trustee-discretionary standard) might be a wise choice. Incidental Note: The finest (and most succinct) article on the topic of annuity taxation is Robert C. Anderson, “Estate Planning With Nonqualified Annuities: Navigating The Labyrinth,” 3 NAELA J. 119 (2007). This article is a “must read” for any practitioner contemplating advice concerning annuities. Yet another good reason to join NAELA!

C. Basis Issues

1. The law involving determination of basis in the grantor trust context was rather unsettled through 2010. With the passage and enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“TRA 2010”)15 on December 17, 2010, the treatment of basis issues is settled . . . at least through 2012. As of January 1, 2011, the basis scheme in effect prior to the passage of Economic Growth and Tax Relief Reconciliation Act of 2001, will be in effect. TRA 2010 § 301(a).

2. Generally, transfers by gift result in Donee’s basis being the same as the basis “in the hands of the donor.” IRC § 1015(a). Similarly, basis in property acquired by a transfer in trust (whether held by the trustee or later by a beneficiary) is “as it would be in the hands of the grantor . . .” IRC § 1015(b). 3. Notwithstanding IRC § 1015, however, IRC § 1014(a)(1) provides that “basis in the hands of a person acquiring the property from a decedent” shall be “the fair market value of the property at the date of the decedent’ death.” These are the so-called “stepped up basis” rules. If a gratuitous transfer to trust has been made, upon the death of the grantor basis will be determined under either Code section 1015 (a transfer basis) or Code section 1014 (a stepped up basis).

15 This outline was prepared for printing the day after the enactment; accordingly, no public law or session law citation is available.

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Obviously, if stepped up basis is an important goal, compliance with Code section 1014 is necessary. In fact, as will be seen, the retention by the grantor of all the trust’s income will result in gross estate inclusion under Code section 2036(a)(1) and, pursuant to Code section 1014(b)(9), result in stepped-up basis upon the grantor’s death. That would be the end of the basis question. The question becomes a bit more complex, however, if an income interest is not retained. 4. An important, and unsettled issue, is whether the assets in a grantor trust will enjoy stepped up basis upon the grantor’s death simply by virtue of the trust being a grantor trust with respect to principal. In other words, will grantor trust status ensure stepped up basis? As will be discussed further herein, it is my position that a grantor trust must be includible in the grantor’s gross estate to benefit from stepped-up basis. There are exceptional tax commentators who may disagree.16 All should agree the issue is unsettled. 5. As mentioned above, Code section 1014(a) provides a stepped-up basis to a “person acquiring the property from a decedent.” IRC § 1014(b) fleshes out the term “property acquired from a decedent.”

(a) IRC § 1014(b)(1) applies stepped-up basis to “[p]roperty acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent.” While the provision seems straight forward, it is here that much confusion arises. This will be discussed further below. (b) IRC § 1014(b)(2) provides a stepped up basis for lifetime transfers to trust by a decedent who retained both an income right and the power to revoke the trust. Obviously, this is not an attractive option in the elder law or special needs law setting. (c) IRC § 1014(b)(3) provides a stepped up basis for lifetime transfers to trust by a decedent who retained both an income right and the power to alter, amend or terminate the trust. (d) IRC § 1014(b)(4) applies stepped up basis to property acquired by a donee from trust distribution as a result of the exercise of a

16 See, generally, Blattmachr, Gans & Jacobson, Income Tax Effects of Termination of Grantor Trust Status By Reason of The Grantor’s Death, 97 J. Tax’n 149, 154 (Sep. 2002) (hereinafter “Blattmachr, Gans & Jacobson”). While Blattmachr, Gans & Jacobson argue that I.R.C. § 1014 stepped up basis should be available to a grantor trust that has not been included in the decedent’s gross estate, they acknowledge the novelty of the claim (“We also acknowledge that permitting the trustee to determine basis under Section 1014 is contrary to the conventional understanding of the section that it should apply only where the asset is included in the gross estate.”). Id. at 159.

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testamentary power of appointment. (e) IRC § 1014(b)(9) provides stepped up basis with respect to property that was “required to be included in determining the value of the decedent’s gross estate under” the estate tax rules (this has nothing to do with whether there is any estate tax liability). The rules applicable to determining a gross estate are found at IRC §§ 2031 through 2046. (f) Given planning concerns with respect to retention of certain benefits and powers (e.g., reservation of income rights in a VA planning context (see Section V of this Outline), careful consideration should be given to the “gross estate inclusion” methodology selected if retention of stepped up basis is an important goal.

D. Gross Estate Inclusion The Gross estate rules are codified as Part III of Subchapter A of Chapter 11 of Subtitle B of the Internal revenue Code. In Plain English that refers to IRC §§ 2031 through 2046. Rather than provide a complete tutorial on estate inclusion rules, this outline touches on the most relevant and likely provisions affecting grantor trusts in the elder law or special needs law context.

1. IRC § 2036(a)(1) includes in an estate the value of property with respect to which the decedent retained an income interest or a life time right of possession or enjoyment. IRC § 2036(a)(2) includes property with respect to which the decedent retained a right “to designate the persons who shall possess or enjoy the property or income therefrom.” The statute offers an interesting planning opportunity: the power may be subject to the cooperation of “any person”. The regulations clarify that the other person may be an adverse party and that the capacity of the other person is immaterial (e.g., the person could be the trustee). Treas. Reg. § 20.2036-1(b)(3). If the other person is an adverse party, it should be possible to guarantee gross estate inclusion for basis purposes and avoid grantor trust status if that is a desirable objective (e.g., perhaps for VA benefits planning purposes; see discussion of VA benefits, Section V, below). See discussion of IRC § 674 (power to control beneficial enjoyment subject to approval of an adverse party) at section IV.A.3.b. herein. 2. IRC § 2037 includes property transferred to trust over which the grantor retained a reversionary right the value of which exceeds 5% of the value of the property determined as of the date of death. The provision raises serious Medicaid issues regarding the countability of trust assets.

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3. IRC § 2038 is important. That provision includes in an estate the value of property transferred to trust if the property remains subject to a retained right “to alter, amend, revoke, or terminate” the ultimate enjoyment thereof. 4. IRC § 2041(a)(2) includes in an estate property transferred to trust which remains subject to a general power of appointment in the decedent. The decedent’s right to exercise the power can be subject to exercise in conjunction with another person as long as that other person is a nonadverse party with respect to the property. IRC § 2041(b)(1)(C)(ii).

Is All This Really Necessary? Not if the grantor retains an income interest. However, if the trust involved is a grantor trust that does not trigger one of the provisions of Code section 1014 discussed above, particularly if the trust is not includible in the grantor’s gross estate for estate tax purposes, stepped-up basis may not be available. Recently, the Chief Counsel of Internal Revenue Service agreed with the foregoing position. CCA 200937028 (Nov. 18, 2008, released Sep. 11, 2009). Chief Counsel Advice 200937028 is a model of brevity and one must discern the circumstances giving rise to the letter. Heavily redacted, it is impossible to determine who it is addressed to or many of the particulars of the matter that generated the letter. Nevertheless, the letter is clear that a grantor retained a power of substitution under Code section 675(4)(C) (and apparently no other grantor trust power that would trigger estate tax inclusion), the grantor had died, and the trustee was attempting to assert a Code section 1014 basis step-up. The language of the advisory is clear:

We strongly disagree with taxpayer's contention. In this case, the taxpayer transferred assets into a trust and reserved the power to substitute assets. Section 1014(b)(1)-(10) describes the circumstances under which property is treated as having been acquired from the decedent for purposes of the section 1014 step-up basis rule. Since the decedent transferred the property into trust, section 1014(b)(1) does not apply. Sections 1014(b)(2) and (b)(3) apply to transfers in trust, but do not apply here, because the decedent did not reserve the right to revoke or amend the trust. None of the other provisions appear to apply at all in this case. . . . . Based on my reading of the statute and the regulations, it would seem that the general rule is that property transferred prior to death, even to a grantor trust, would not be subject to section 1014,

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unless the property is included in the gross estate for federal estate tax purposes as per section 1014(b)(9).

Others base their counter arguments on Revenue Ruling 85-13, 1985-1 C.B. 184, and its proposition that a grantor is the deemed owner for federal income tax purposes of the trust assets. If a grantor is the deemed owner and the trust is, in effect, ignored for income tax purposes, then assets in the trust ought to receive a stepped-up basis under Code section 1014(b)(1) (an income tax provision) as if the deceased grantor had owned the assets directly. The best and somewhat intriguing articulation of this argument is Blattmachr, Gans & Jacobson.17 Space does not permit a complete discussion of their finely nuanced rationale, but the article is well worth reading for a complete understanding of the counter argument. Nevertheless, as noted above, Blattmachr, Gans and Jacobson acknowledge the novelty of their argument. Further, it should be noted, both Revenue Ruling 85-13 and Blattmachr, Gans & Jacobson deal with grantor trusts involved in sale transactions in which the grantor exchanged trust assets for an unsecured promissory note. Again, most grantor trust scenarios in the elder law context involve a simple gratuitous transfer of assets to trust as opposed to the often used estate freeze technique involving installment sales transactions between the trust and the grantor. Also, the linchpin to the Blattmachr, Gans & Jacobson reasoning is the understanding that Revenue Ruling 85-13 stands for the proposition “that grantor trusts be disregarded for all income tax purposes.”18 Nevertheless, that may be reading too much into the ruling, especially in the context of basis determinations upon the grantor’s death. First, the broad interpretation of the ruling is based on a single sentence19 that does not say anything about disregarding a trust for all income tax purposes. The ruling has nothing to do with a basis-upon-death determination. It deals with proper classification of items of income (and, yes, basis) in the hands of a very much alive grantor. In the basis-upon-death setting under Code section 1014 a determination is being made with respect to basis in the hands of someone other than the grantor, namely a beneficiary of the grantor’s estate. Further, there has yet to be any clear guidance from the Internal Revenue Service on the income tax treatment of grantor trust assets upon the grantor’s death. The generally held belief is that if upon the grantor’s death the trust is not includible in the grantor’s estate and there is no outstanding note involved in the purchase of trust assets, carry-over basis under Code section 1015(b) is the likely outcome.

17 Blattmachr, Gans & Jacobson at 154. 18 Id. at 155 (emphasis added). 19 “Because A is treated as the owner of the entire trust, A is considered to be the owner of the trust assets for federal income tax purposes. [citations omitted].”

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See, e.g., Lawrence I. Richman, Rev. Rul. 85-13: What We Know, J. of Passthrough Entities, 9, 11 (Mar.-Apr. 2005). In view of the rather vigorous language in Chief Counsel Advice 200937028 (“We strongly disagree with taxpayer’s contention.”) attempting to secure stepped-up basis with respect to grantor trust assets that are not includible in the grantor’s estate may very well invite litigation with the Internal Revenue Service. E. EINs and Reporting Many believe that because a grantor trust is “ignored” for purposes of calculating income taxes, they are “ignored” for reporting purposes.. Not so. Once upon a time, all trusts reported income on Form 1041. In cases of revocable trusts where grantor served as trustee, reporting requirements were dispensed with. Finally, effective January 1, 1996, mandatory regulations were issued which modified and clarified(?) the reporting requirements with respect to irrevocable grantor trusts. Treas. Regs. § 1.671-4. A grantor trust has, essentially, two reporting options: Report on Form 1041 (Estates and Trusts Tax Return) or comply with Treas. Reg. § 1.671-4. Certain foreign trusts, subchapter S trusts, fiscal year grantors, foreign grantors, among others may not use the regulations reporting alternative: Those must use Form 1041. This outline section will provide an overview. First step: Determine how many “grantors” or others are treated as the trust owners. Incidentally, a husband and wife who file a single joint return are considered to be a single grantor for purposes of these rules. Treas. Regs. § 1.671-4(b)(8). In other words, grantor trust established by a husband and wife who file jointly is eligible to be treated under the “Single Grantor” rules described below. Separate rules apply for single grantor/owner trusts (2 options apply) and multiple grantor/owner trusts.

1. Single Grantor trust – Option 1: Using Grantor’s EIN

(a) Trustee must secure W-9 from grantor (including information regarding possible backup withholding regarding interest and dividend payments. Treas. Reg. § 1.671-4(e). (b) Trustee must furnish to all payors grantor’s name and EIN,

backup withholding info (if any), and trust’s address. Treas. Regs. § 1.671-4(b)(2). Securing a separate trust EIN is NOT necessary. Treas. Regs. § 1.301.6109-1(a)(2).

(c) Payors then furnish Forms 1099 to trustee, who furnishes them to grantor.

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(d) If the trustee is the grantor: No further reporting requirements. Treas. Regs. § 1.671-4(b)(2)(i)(A). (e) If the trustee is NOT the grantor, trustee must furnish grantor a statement describing: all payors, all items of income, deduction and credit, other information necessary to report (e.g., basis), and the grantor’s necessity of including all tax items on her tax return. Treas. Regs. § 1.671-4(b)(2)(ii).

2. Single Grantor trust – Option 2: Using Trust’s EIN

(a) Trustee must furnish to all payors the trust’s name, EIN, and address. Treas. Regs. § 1.671-4(b)(2)(i)(B) (b) Each payor furnishes trustee with a Form 1099. (c) Trustee files Forms 1099 with IRS in form described at Treas. Regs. § 1.671-4(b)(2)(iii). The additional requirements impose a significant commitment of time and knowledge and may likely involve the need for a CPA. (d) If the trustee is the grantor: No further reporting requirements. (e) If the trustee is NOT the grantor, information described immediately above at 1(e) must be furnished the grantor.

3. Multiple Grantors/Owners – Furnish Trust’s EIN

(a) Trustee does not have the option to furnish to payors grantors’ names and EINs. Trustee must furnish each payor the trust’s name, EIN and address. Treas. Regs. § 1.671-4(b)(3). (b) Each payor issues a Form 1099 to trustee. Treas. Regs. § 1.671-4(b)(3)(ii). (c) Trustee then files Forms 1099 with IRS showing trust as payor and each grantor as payee in proportion to each grantor’s interest. (d) Trustee then MUST furnish each grantor the information described immediately above at 1(e) to enable each grantor to report his or her tax.

4. Practical possible steps to minimize administrative details and reporting may be taken.

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(a) Consider drafting to limit trust to one grantor or owner. (b) Consider naming grantor as a co-trustee. To avoid estate recovery concerns or attachment by creditors consider drastically limiting the powers of the grantor/co-trustee (the regulations do not require fiduciary powers to attach) – perhaps some sort of administrative power to select tax return preparers> (c) Furnish each payor the grantor’s name, address and EIN.

V. VA and Trusts

A. This Outline is not a primer on VA Improved Pension (Aid & Attendance, Homebound) Benefits. The following section assumes a modest understanding of those benefits. Because VA does not at this time20 penalize transfers of assets, nor does it have any look back period, many applicants can transfer assets in excess of the VA’s rather amorphous asset limit (“not more than $80,000 but maybe less”) and qualify for VA benefits immediately after the transfer. For many of the same reasons that outright transfers to children may not make sense for Medicaid purposes, transfers to trusts for VA may be a sound strategy. IMPORTANT: The VA rules applicable to trusts (and grantor trusts) are NOT the same as those encountered in the Medicaid setting. The question is: To what extent will elements of the Medicaid “have my cake and eat it to” strategy survive VA scrutiny? Also, bear in mind that the VA does annual EVRs (eligibility verification reviews) and periodic IVMs (income verification matches, which match tax records with reported income). While a grantor trust can generate reportable income tax consequences for the grantor without the actual receipt of countable income, the result will certainly invite scrutiny of whatever arrangement is in place. Further, application forms issued by the VA in June 2010 explicitly call for the revelation of all transfers. As a result, the practitioner must be prepared to discuss (and perhaps educate) a VA adjudicator who may not be too sophisticated in trust matters as to the nuances of a grantor trust. B. VA General Counsel Precedent Opinions (VAOPGCPREC) (available online at www.va.gov/ogc/precedentopinions.asp) VA General Counsel Precedent Opinions (“VAOPGCPREC”) are VA interpretations of various regulations and statutes and give some indication of how the VA will apply them to issues that arise in the benefits application and qualification context. Often, they are the only authority available for reliance, and

20 Rumor has it that the VA may start to impose limited transfer sanctions in the near future.

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just as often they are poorly written.

1. VAOPGCPREC 72-90 (July 18, 1990) - Testamentary Trust to provide benefits for the “comfort” of the surviving spouse.

(a) The issue addressed in this opinion was whether a testamentary trust directing trustee to provide benefits for the “comfort” of the veteran was an available asset for Improved Pension purposes. The opinion held that the assets and income in a discretionary trust are countable when “actually allocated for the claimant's use” or, if earlier, when the claimant maintains control sufficient to allocate the assets for his use. Further, “[o]nly the portion of the trust property . . . that has actually been made available for the veteran’s use is, at the time of the allocation, countable . . . .” So, what is meant by a “portion”? (b) The opinion’s analysis begins with the recognition that a trust involves the separation of legal title from the beneficial interests. Citing a number of opinions from the 1950’s and 1960’s the opinion then notes that early opinions have “consistently held that property and income therefrom”21 held in trust will not be recognized unless the claimant possesses control sufficient to direct the property to his or her use and the property has “actually been allocated for the use of the claimant”. (c) Finally, and perhaps significantly, the opinion concludes that because the veteran did not hold “legal title to or control of the trust property22 . . . . 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 the allocation, countable . . . .”23

2. VAOPGCPREC 64-91 (Aug. 9, 1991) - Irrevocable Income Only Trust.

(a) Here the general counsel’s office dealt with an irrevocable income only trust. The key holding, citing to VAOPGCPREC 72-90 was that “[w]here the veteran does not hold legal title to or

21 (Emphasis added). 22 Presumably, appearing where they do, the words “control of the trust property” must refer to the particular power to ‘control for the benefit of the veteran’ and not some generalized form of control that might be evident, say, in the context of a special power of appointment. 23 (Emphasis added). While the language might be read in a number of ways, it seems that the opinion recognizes that income is a portion separate from principal. In view of other language in the opinion, this especially may be the case if the trust income is subject to a discretionary sprinkle standard in favor of other beneficiaries (recalling that there are methods of creating grantor trust status with respect to income other than a simple and absolute retention of income).

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control of the trust property, only such portion of the trust property as has been made available for the veteran's use is countable for purposes of the income and net worth provisions . . .". Accordingly, the value of trust assets should not be included in estate valuation under the referenced statutes “unless those funds have been allocated and are available for the veteran’s use.” (b) The opinion giveth, and it taketh away. First it says “only such portion . . . as has been made available”. That may be encouraging to those wishing to retain an income interest while succeeding in keeping the principal out of the veteran’s countable estate. Later, however, it says “unless those funds have been allocated and are available for the veteran’s use.” Perhaps the most frustrating aspect of VAOPGCPREC 64-91 is that the issue to which most elder law attorneys yearn for a concise answer is clearly posed in the opinion, yet not clearly answered. Namely, when a beneficiary receives income as beneficiary of a trust, should the entire value of the trust be included in the veteran’s estate? In other words, is an income right an “allocation” to the veteran’s use of the underlying principal that generates the income? (c) In my opinion, the better answer is that the two are separable, particularly in view of VAOPGCPREC 72-90 and especially if a clever scrivener designs the trust as a grantor trust for ordinary income purposes yet subjects the income rights to a discretionary distribution standard.

3. VAOPGCPREC 73-91- (Dec. 17,1991) - Placement of life insurance proceeds and inheritance by a Veteran into an irrevocable trust for the income benefit of his grandchildren.

(a) If a veteran creates and funds a trust for the benefit of others, the general rule is that the assets are not part of the veteran’s estate for Improved Pension purposes. In the case of VAOPGCPREC 73-91, the veteran funded an irrevocable trust with life insurance and an inheritance for his grandchildren. The opinion held that the assets were not to be part of the veteran's net worth after he established the trust and his only continuing role was trustee. Further, the income paid on behalf of grandchildren was not deemed to be the veteran's income. (b) An interesting question is whether the trust in this particular case was a grantor trust with respect to the veteran, particularly the income portion (notwithstanding the payment of the income to the beneficiary grandchildren). As mentioned above, a nagging issue for many practitioners is the manner in which the VA will respond

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to a grantor trust situation in which income (either or both of ordinary income and capital gains) is taxable to the grantor/veteran under the grantor trust rules (and, thus appearing on the veteran’s tax return), yet not in reality allocated to, or for the benefit of, the veteran who has been required to bear the tax burdens of the income. (c) Also, some language in the opinion implies that assets generating income may, in fact, be deemed available in addition to the income. Whether this is an intentional part of the holding or the result of careless drafting is unclear.24 If, however, the language was intentional the implication would be in contradiction to the thrust of both VAOPGCPREC 72-90 and VAOPGCPREC 64-91, discussed above. (d) Finally, this particular opinion reiterates a clear regulatory exception to the general holding. If in this case the veteran had a legal obligation to support the grandchildren (i.e., they lived with him) the assets in the trust may very well count as part of his estate. See 38 C.F.R. § 3.276(b).

4. VAOPGCPREC 33-97 – (Aug. 29, 1997) - Special Needs Trusts Created for benefit of Veteran’s surviving spouse, naming an adult child as trustee.

(a) This somewhat confusing opinion involved a pre-OBRA ’93 inter vivos trust “created on behalf of the surviving spouse”. The trust allowed the trustee discretion with respect to distributions “to or for the benefit of the surviving spouse only for the surviving spouse’s ‘special needs for health, safety and well being when such requisites are not presently being provided by any public entity . . . .’” (b) The opinion observes that Congress recently expressed concern with rising Medicaid costs by enacting the OBRA ’93 trust provisions, which the General Counsel took as Congressional concern that trusts were negatively impacting “need-based Federal programs.”25

24 “Generally, where a veteran places assets into a valid irrevocable trust . . . and where the veteran . . . 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, the trust assets would not be counted in determining the veteran’s net worth for improved-pension purposes, and the trust income would not be considered income of the veteran.” VAOPGCPREC 73-91, ¶ (b) of the Holding (emphasis added).. 25 The opinion also cites a Washington Post article by Jane Bryant Quinn as authority for the proposition that wealthy seniors were using estate planning to preserve assets for heirs while taking advantage of

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(c) Eventually, the opinion refocused on the issue of veterans’ benefits. The essence of the argument used was that section 3.274(c) of title 38 of the Code of Federal Regulations allows assets to be counted if they are “’such that under all the circumstances . . . it is reasonable that some part of the corpus of . . . the estate be consumed for the surviving spouse’s maintenance.’” Recognizing that there are no regulations that address trust assets, the opinion notes that the central issue is whether “the surviving spouse’s transfer of assets to the trust effectively resulted in divestiture of ownership of the assets such that they cannot be reasonably expected to be used for the surviving spouse’s care.” The fact that the surviving spouse or her fiduciary establishing the trust granted the trustee any discretion to use the assets for the benefit of the surviving spouse under any circumstances would be enough to count the trust assets as available for VA benefit purposes. (d) Of course, the foregoing leaves open the question of whether generating and distributing income rises to the level of ‘using trust assets’ for the beneficiary’s benefit. Footnote 2 of the opinion is puzzling, observing that the trust in issue was similar to a life estate in that remainder beneficiaries would be forced to wait until the death of the grantor to realize any “possession or enjoyment of the property” in the trust. “Significantly,” the opinion added, “both the beneficiary of the trust . . . and the holder of the life estate . . . retained a distinct interest in property having an ascertainable value until death.” Presumably then, a trust containing a discretionary sprinkle standard with respect to principal for the benefit of various beneficiaries would cure this “significant” factor.

5. Summary of Opinions - Obviously, as the name implies and as successive opinions are applied, a VAOPGCPREC has some precedential value. If so, the opinions, particularly opinions 72-90 and 64-91, should give comfort that in theory construction of a grantor trust with an income interest of some sort to the grantor/veteran and a divestiture by the veteran of title to the principal is possible. A number of concerns are apparent. First the opinions are bearing some age, and the intuitive belief of many is that VA will attempt to tighten eligibility restrictions as time passes. Second, because of the lack of clarity in the opinions, many believe that the use of a clear “income only trust” will entail the real possibility of engaging the VA in battle, a battle that may be winnable, but a battle nevertheless. As of the date of the preparation of this article, no one has

Medicaid. Jane Bryant Quinn, Paring Loopholes That Let the Well-off into Medicaid, Wash. Post, Oct. 3, 1993, at H3.

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seen this sort of combat. As mentioned, I would avoid retention of a mandatory income right. Early portions of this article discuss other methods that may be employed to retain a discretionary income right yet achieve grantor trust status if that is an important goal. There has been considerable debate concerning the ability use an income only trust in the VA benefits context. Even among those that advocate the use of such a trust, no one has been able to offer me a single case in which the VA has approved benefits in a situation in which such a trust has been used. Conceptually, however, retention of an income right to an irrevocable trust with absolutely no retention of rights with respect to principal should be no different than an irrevocable immediate annuity. In the latter situation, the VA will of course count the income stream, but not the currently unavailable funds that were used to fund the annuity. Recently, in an active client matter of mine, a Georgia probate court approved the use of an irrevocable trust for the benefit of an incompetent ward. The approval was conditioned, however, on the ward retaining a mandatory income right. The ward is the surviving spouse of a veteran, and an application for aid and attendance benefits will soon be submitted. This will be interesting, and I will publicize the results when they are available.

C. Key Regulation

1. 38 CFR § 3.276(b) says “A gift of property to someone other than a relative residing in the grantor's household will not be recognized as reducing the corpus of the grantor's estate unless it is clear that a grantor has relinquished all rights of ownership, including the right of control of the property." (emphasis added). 2. Many believe the retention of income rights does not exhibit the requisite relinquishment of ownership rights. I agree.

D. Strategies offered by some include:

1. Some recommend: Income Only Trust for the benefit of the Veteran/Grantor

(a) Income payments completely discretionary, not mandatory (b) Income countable toward eligibility

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(c) NOT recommended: This runs afoul of the “made available to or allocated to” reasoning of each general Counsel Opinion cited, above

2. Income Only Trust for the benefit of a third party, not Grantor

(a) No access to principal (b) Use of Trust Protectors (c) Provides greatest protection from all creditors (d) Provides greatest flexibility to access principal and reverse the gift if necessary for Medicaid qualification purposes (e) Sound strategy; use Trust Protector to “blow up” trust if necessary to roll asset out to avoid later Medicaid transfer sanction (may result in loss of VA benefits, which may be acceptable)

3. Hybrid VA Trust A Hybrid VA Trust is one designed to protect the tax advantages of owning a house, selling the house without capital gains, and preserving the assets upon the sale of the house so that they are not counted as an asset for VA eligibility purposes.

(a) Characteristics of the Trust

(1) Veteran is grantor of irrevocable trust (2) Veteran deeds the property to the trust, retains the right to live in the property for his life (perhaps an occupancy agreement or lease) (3) maintains homestead exemption and reduced taxes for age or disability (4) Upon the sale of the property, the beneficiary of the sale proceeds is a third party (including a possible a separate irrevocable trust naming a third party beneficiary). If the trust is a grantor trust with respect to the veteran in order to preserve IRC § 121 capital gains exclusion, the ensuing capital gains should not show up on an IVM or EVR because the gain was excluded from income.

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(a) The Veteran gives up all ownership and control (b) The proceeds do not terminate VA benefits because they are not countable assets. (c) Medicaid Benefits

(i) the initial transfer of the house into the irrevocable trust triggered the sanction (ii) thus, the sale proceeds should not trigger a separate look back period (iii)the use of the Trust Protector can cure a gift if necessary to qualify for Medicaid (take the house out of the trust) (iv) Due to it being an irrevocable trust, the house or the proceeds from the house should avoid estate recovery

4. Intentionally Defective Grantor Trust

(a) Transfer to an APT. (b) 3rd party beneficiary/trustee (c) Grantor retains a carefully selected power to secure grantor trust status with respect to either or both of principal and income without actually triggering the receipt of principal or income (perhaps special powers of appointment, the authority to substitute assets, the power in trustee to apply trust income to the payment of premiums on insurance policies on the veteran’s life). (d) Theoretically, should work for VA purposes because grantor has no control over the actual assets, assets are not allocated for his use. Be prepared, however, to advocate that the income or assets were not allocated for the use of the veteran notwithstanding that the VA catches the reported income on an IVM or EVR. Of course, with disclosures of transfers at application for benefits the trust could be submitted for review. Frankly, I am waiting for a case in which the veteran is willing to take the chance of a delay in benefits to enable a testing of this strategy.

VI. Trust Protector/Advisor

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Given the uncertainties of the law and the perceived certainties of “irrevocability” the use of Trust Protectors or Trust Advisors (a term used in Delaware which many prefer; see Del. Code Ann. tit. 12, § 3570). A Trust Advisor is an individual to whom the trust instrument has granted any number of discretionary powers. With proper planning, the concept can add an extraordinary level of flexibility to an otherwise inflexible situation. Trust Advisors may be used, among other purposes, to amend or terminate the trust, select successor trustees, and direct distributions. Caution may be warranted to select a Trust Advisor who is not a unrelated or subordinate party, so as to avoid any allegation that the arrangement is a sham by the grantor to retain an unacceptable degree of control (and to perhaps trigger resource availability).

State trust law concerning the use of trust advisors varies and should carefully be consulted.

APPENDIX A

Dept. of Health & Human Services, Health Care Financing Admin. 8325 Security Boulevard Baltimore, MD 21207

December 23, 1993 Ms. Ellice Fatoullah Alzheimer's Disease and Related Disorders Association, Inc. 420 Lexington Avenue Suite 610 New York, New York 10170 Dear Ms. Fatoullah: I am responding to your letter asking us to confirm your understanding of the meaning of Section 13611(b) of OBRA 93, as codified in section 1917(d)(3)(B)(i) of the Social Security Act (the Act). This section discusses treatment of irrevocable trusts for purposes of determining eligibility for Medicaid. Briefly, the cited section provides that if there are any circumstances under which payment from an irrevocable trust could be made to or for the benefit of the individual, actual payments made are considered to be income to the individual. Payments that could be made, but are not, are considered resources to the individual. Payments made for any purpose other than to or for the benefit of the individual are treated as a transfer of assets under section 1917(c) of the Act. You interpret this part of the statute as meaning that, if a person establishes an irrevocable trust guaranteeing the income of the trust to him or herself for life, but excluding distribution of the trust corpus to him or herself, the corpus of the trust will not be considered an available resource to the individual after the applicable transfer of assets waiting period (which you believe to be 60 months). You have asked us to confirm your interpretation. Your understanding of the statutory requirements is essentially correct. However, as a technical point, we would note that the appropriate statutory reference dealing with the situation you describe is section 1917(d)(3)(B)(ii), rather than subsection (I). Subsection (ii) deals specifically with trusts where there is some portion of the trust from which distributions cannot, for any reason, be made to or for the benefit of the grantor. In this situation, the 60 month transfer of assets waiting period to which you refer applies. The

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APPENDIX A

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section you referenced in your letter actually deals with trusts where some distribution can be made to or for the benefit of the grantor. In such situations, the portion that could be distributed is counted as a resource to the individual. Where distributions can be made, the waiting period for treatment as transfers of assets of distributions made to or for someone other than the grantor is 36 months. Also, you should understand that where a portion of a trust cannot, under any circumstances, be distributed to or for the benefit of the grantor, that portion is never considered an available resource to the grantor. Rather, the value of that portion of the trust is treated as a transfer of assets for less than fair market value. An individual who transfers assets for less than fair market value can still be eligible for Medicaid. However, the Medicaid program will not pay for the cost of various long term care services, including nursing facility care. The length of time for which payment for services would be denied would depend on the value of the transferred asset (or, in the situation you describe, the value of that portion of the trust which cannot be paid to or for the benefit of the grantor). I hope this information is useful to you.

Sincerely, Sally K. Richardson Director Medicaid Bureau

APPENDIX B

Dana E. Rozansky Begley, Begley & Fendrick 40 East Main Street, P.O. Box 827 Moorestown, New Jersey 08057

25 February, 1998 Dear Ms. Rozansky: I am responding to your letter requesting confirmation of your understanding of certain aspects concerning treatment of trusts under Medicaid. The specific items you mentioned, with our comments, are as follows. 1. Assets in a revocable trust are considered available as if no transfer of assets has taken

place. This is correct. Assets placed in a revocable trust are not treated as a transfer of assets for less than fair market value, but rather are considered available resources.

2. Transfers from a revocable trust to individuals other than the trust beneficiary are considered to be transfers to a trust subject to a 5-year lookback period. Transfers from a revocable trust to or for the benefit of someone other than the trust beneficiary is [sic] subject to a 5-year lookback period. However, such transfers are not a transfer to a trust unless the funds are actually transferred to another trust. Any transfer to another individual that does not involve placing the funds in another trust is simply a transfer of assets for less than fair market value.

3. Transfers to an irrevocable trust have a 5-year lookback. This is not correct. Transfers to an irrevocable trust can be subject to a 5-year lookback period, but only to the extent that after transfer to the trust some portion, or all, of the funds cannot, in any way, be made available to the trust beneficiary. Only the portion of the funds which cannot be made available to the beneficiary is subject to the 5-year lookback. Any portion of funds placed in an irrevocable trust that can be made available to the beneficiary is treated as countable income or resources, as appropriate. Any portion of .those funds transferred from the trust to or for the benefit of someone other than the beneficiary is treated as a transfer of assets subject to a standard 3-year lookback period.

4. Transfers from an irrevocable trust to individuals other than the beneficiary incurs [sic] no additional penalties. (No double jeopardy.) This is only partially correct. As explained in 3. above, a transfer to or for the benefit of someone other than the beneficiary from a portion of an irrevocable trust which can be made available to the beneficiary is subject to a 3-year lookback period, and thus a transfer penalty. This is not "double jeopardy" because no transfer penalty was imposed on the funds when they were placed in the trust. However, where assets in a trust cannot be made available to the beneficiary, transfer of those assets to or for the benefit of someone other than the beneficiary does not incur a separate transfer penalty. Any penalty would have been assessed when the funds were placed in the trust.

5. Transfers to an irrevocable trust with a retained income only interests [sic] are considered available only to the extent of the income earned. Otherwise, the assets are considered to have been transferred with a 5-year lookback period.

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APPENDIX B

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This is correct. 6. Where assets in an irrevocable trust can be distributed to the beneficiary but are

transferred to someone else, the lookback for the transfer is 36 months. This is correct.

I hope this information is useful to you. If you have any questions, please contact Roy Trudel of my staff at 410-786-3417.

Sincerely, Robert A. Streimer Director, Disabled and Elderly Health Programs Group Center for Medicaid and State Operations