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Articles

When Worlds Collide - The Intersection of Traditional Estate Planning With the Protection of Assets From Nursing Home Costs

By Michael T. Lahti on May 14, 2020
A good general definition of estate planning might be “getting what you have (your estate), to whom you want (your loved ones), when you want (now, upon death, or after death), efficiently (reducing taxation, avoiding probate, protecting assets), while keeping control to the extent possible.” That’s simple enough. What is not so simple is how aspects of the planning can change depending on one’s situation and goals. Very often, what seems quite ordinary has layers of issues that need to be peeled away to arrive at the appropriate strategy. Often what one might consider regular estate planning conflicts with what needs to be done to protect assets. This article follows a relatively normal estate planning situation. It then amplifies how trying to protect assets from nursing home spend-downs might affect the common goals of tax reduction and probate avoidance while keeping control.

To begin, we will assume we have a Massachusetts family with an “estate” of $2 million that consists of:
  • a house worth $600,000
  • brokerage accounts of $400,000
  • IRAs totaling $600,000
  • term life insurance of $400,000
When the clients’ children were young, the parents completed simple “I love you” type estate plans that left everything to each other, and then to their children. Now that their children and assets have grown, they want to have their estate plan reviewed and updated, if needed.

During the interview, the clients expressed their desire to make things pass from them to their children as efficiently as possible, and said they want their children to have their respective shares from the parents immediately. We will assume everyone in the family gets along, is responsible and trustworthy, and is healthy. This family might benefit significantly from typical estate planning, discussed below:

Typical Revocable Living Trust Planning

Revocable (Living1) Trust Planning for Estate Taxation
Without further planning, when the surviving client is deceased, there would be an “estate” tax due to Massachusetts in the amount of $99,600.2 Fortunately, this tax exposure could be totally eliminated with the use of revocable trusts that contain “Credit Shelter Trusts”3 which, when properly implemented, allow the use of both spouses’ $1 million Massachusetts estate tax exemption to shelter estate taxes.

Revocable (Living) Trust Planning for Probate Avoidance
Revocable living trusts would keep our clients “out of probate” upon their deaths. Appropriate assets could be titled into trust ownership, and would consequently avoid probate.4 Avoiding probate allows assets to pass quickly, privately, and at a lower cost.

Revocable (Living) Trust Planning for Income Taxation
Revocable living trusts would allow our clients’ assets they placed into their revocable trusts to receive a new income tax “basis” upon death. This can be extremely helpful: for instance, if one has a property that was purchased for a low price, and it has grown substantially since the time of purchase, then, upon death such property will get a new stepped-up basis to the fair market value of the property as of the date of death. After the first spouse’s death, assets that continue upon trust for the benefit of the surviving spouse typically can, if desired, be distributed out of the trust back to the surviving spouse to obtain another stepped-up basis upon his or her death.5 (The decision of whether to do this subsequent transfer requires careful consideration of what estate and income taxes might have to be paid.)

Furthermore, revocable trusts are “grantor trusts.” A grantor trust is a trust in which the person creating the trust is considered to be the “owner” of the trust for income tax purposes. Grantor trust status is significant if the trust is to hold one’s primary residence. If the house is sold, the grantor trust status preserves the favorable capital gains tax treatment upon sale.6

Revocable (Living) Trust Planning for Control
Revocable living trusts would allow our clients to have complete control of assets inside the trust.

After the death of the first client, his or her trust would continue for the benefit of the surviving spouse. Without jeopardizing the tax-protective qualities, this continuing trust could be written so that the surviving spouse controls it: that spouse has the ability to choose investments, has income generated, has the ability to take supportive principal distributions, and can even change the distribution of the assets upon his or her subsequent death.

Irrevocable Living Trust Planning

But what if our clients were not so healthy? What if, during the meeting, they told us that one has a debilitating chronic illness and wants to shelter assets from devastating health care expenditures? Asset protection requires different planning techniques that can be implemented with, or in lieu of, traditional trust planning. Let’s look at some of these strategies and see how they affect planning.

Irrevocable (Living) Trust Planning
Our clients could use irrevocable living trusts to protect assets. Each state has its own nuances as to how such trusts must be prepared, and as a result, such trusts need to be carefully drafted. For our clients, such trusts could be used to protect their real estate from being spent down for nursing home care.7 Our clients could retain the “income” from their property placed in an irrevocable living trust. (So, for instance, if their residence is placed in an irrevocable trust they can still live in it.) Assets put into an adequately crafted irrevocable living trust five years before a nursing home admission will not have to be spent down for care. Because medical costs can be devastating, irrevocable living trust planning has become widely used in estate planning.

Irrevocable (Living) Trust Planning for Estate Taxation
Our clients could use irrevocable living trusts for estate tax planning. For instance, an irrevocable living trust could be created by one spouse who reserves an income right for both spouses. When the first spouse deceases, the surviving spouse can benefit from the income interest in the irrevocable living trust. Yet, the property remains excluded from the surviving spouse’s estate for estate tax purposes. In this way, an irrevocable living trust can be drafted to accomplish some of the estate tax objectives discussed above. An irrevocable living trust can be dovetailed with the use of a revocable living trust – assets that the client wants control over are placed in a revocable living trust. In contrast, assets to be protected are placed in the irrevocable living trust.

Irrevocable (Living) Trust Planning for Probate Avoidance
Irrevocable living trusts would keep our clients “out of probate” upon their deaths. Appropriate assets could be titled into trust ownership and would consequently avoid probate.8 Avoiding probate allows assets to pass quickly, privately, and at a lower cost.

Irrevocable (Living) Trust Planning for Income Taxation
Irrevocable living trusts could allow the assets that our clients placed into their irrevocable trusts to receive a new income tax “basis” upon death. As discussed above, this can be extremely helpful.

Furthermore, irrevocable trusts are often structured as “grantor trusts.” As discussed above, this can be important if the trust is to hold one’s primary residence. If the house is sold, the “grantor trust” status preserves the favorable capital gains tax treatment upon sale.9

Irrevocable (Living) Trust Planning for Control
There is much confusion over “control” with respect to irrevocable trusts, and the topic deserves discussion. The fact that the trust is irrevocable does not mean that one gives up all rights. Actually, quite the opposite is true, as irrevocable trusts designed to protect property from nursing home expenditures typically reserve the “income” for the person creating the trust. Income can be the “use” of the property, rents, dividends, and interest. (Consider this: If one has a typical “buy and hold” portfolio and does not intend to spend the principal, then this asset could be put into an irrevocable trust --and protected-- while income is retained. Similarly, if one has a house in an irrevocable trust, the house can be protected concurrently with one’s reserved rights to live in the house.)

The house can be sold when held in an irrevocable trust,10 and, nothing prevents assets from being distributed out of the irrevocable trust to others (typically children and grandchildren), so assets can be distributed from the trust to such others as distributions from the trust (without triggering another five-year “lookback” period for gifts that would have resulted if gifts were made by the parents individually).11

Testamentary Trust Planning

Testamentary Trust Planning
But what if our clients were so sick that there was serious doubt that both could stay healthy for another five years to make it beyond the “Lookback” period for nursing home purposes? Absent the irrevocable trust, is there another strategy our clients might consider? A Will containing a “Testamentary Trust” might be considered.

A “Testamentary Trust” is a trust created from within the language of a Will and which comes into existence after death. It’s the counterpart to the “living” trust, in that instead of avoiding probate, assets intentionally pass through the probate process, so that the Will can set up the assets within the Testamentary Trust.

So, if we usually are trying to avoid probate, why might we intentionally pass assets into the probate process? The answer is asset protection. The Testamentary Trust allows assets that one dies with, that pass under the terms of the Will, and hence devolve into the Testamentary Trust, to be left in a continuing trust for the surviving spouse that is totally protected from nursing home expenditures. The protection is immediate, and there is no five-year Lookback Period.12

To show the power of this strategy, let’s assume we have a crystal ball, and we know that one of our clients is going to pass away in two weeks. Further assume that the other spouse (the spouse who is to live on) has a chronic illness that has weakened him or her to the point that without the soon-to-be-deceased-spouse’s help, a continuing nursing home stay will occur. With these facts, we might intentionally (1) have the soon-to-be-deceased-spouse sign a Will that creates a Testamentary Trust for the surviving spouse, (2) move assets into the soon-to-be-deceased-spouse’s name, and (3) check to make sure that these newly-moved assets intentionally pass through probate.13 Of course, we do not have a crystal ball, so there is always an element of risk with this planning because we do not know which spouse will decease first.

Despite this, the Testamentary Trust plan is powerful and could be a good strategy for our clients on its own, or as a strategy to fall back upon in the event that our clients did not stay nursing-home-free for five years and thus did not make it beyond the five-year Lookback Period.

The Testamentary Trust is fundamentally different from the “living” trusts, discussed above, and its differences are noted below.

Testamentary Trust Planning for Estate Taxation
Our clients could use Testamentary trusts for estate tax planning. For instance, when one spouse deceases, assets that he or she deceased with could be managed under the terms of the Testamentary Trust for the benefit of the surviving spouse. The trustee (the person in control of the trust), who in this instance should not be the surviving spouse, could be given considerable latitude to make distributions for the surviving spouse’s comfort. Despite the trustee’s ability to make distributions for the benefit of the surviving spouse, the trust assets will not be taxed in the surviving spouse’s estate when he or she subsequently deceases.

Testamentary Trust Planning for Probate Avoidance
The Testamentary Trust is mutually exclusive with probate avoidance. This is a drawback with this type of planning – assets must be probated. That being said, oftentimes the cost and inconvenience of going through probate is far surpassed by the asset protection that Testamentary Trusts provide.

Testamentary Trust Planning for Income Taxation
When the first spouse deceases, assets he or she owns that subsequently are administered by the Testamentary Trust receive a new income tax “basis” upon death.14 As discussed above, this can be extremely helpful.

Testamentary Trust Planning for Control
As mentioned above, even though the Testamentary Trust provisions can be quite generous to the surviving spouse, the surviving spouse should not be the “trustee” in charge of the trust. Typically a child or children assume the role of trustee of such a trust and can make distributions from the trust for their parent’s needs. Some clients bristle at the thought of having to “ask” their children for distributions. For other clients, it’s of little concern.

Conclusion

Sometimes the clients with modest estates have the greatest number of choices to make. It’s always nice if probate can be avoided, thereby reducing costs and time when a client deceases. In states like Massachusetts and Rhode Island, where the estate tax thresholds are so low, planning to minimize estate taxes is essential. Capital gains can be expensive, and strategies to reduce income taxation are important too. And, lastly, it is always important, if possible, to keep control of assets. This maelstrom of issues is enough to make one’s head spin and is why an experienced practitioner who knows taxation and elder law issues is so important. Should you have any questions, please do not hesitate to contact us.




FOOTNOTES:

1 In this article the term “Living” indicates the trust was created during the person’s lifetime, in contrast to the term “Testamentary,” which indicates the trust was created upon death.

2 If our couple lived in Rhode Island, the exposure would be reduced to $30,085, and if they lived and owned the property in Florida, their exposure would be $0.

3Sometimes called “Family” Trusts or A-B Trusts.

4Avoiding probate simply means that assets pass upon death without court supervision.

5Of course, assets placed back into the surviving spouse’s name would be subject to possible estate taxation, so this would need to be appropriately analyzed and quantified prior to distributing assets from an otherwise tax-protected Credit Shelter Trust.

6Per person, $250,000 capital gains tax exclusion.

7Irrevocable living trust planning is not limited to just real estate. Often clients will contribute assets that they do not need to live on into an irrevocable living trust that they consider to be “low-lying fruit” that might otherwise be spent down on nursing home care.

8Avoiding probate simply means that assets pass upon death without court supervision.

9Per person, $250,000 capital gains tax exclusion.

10Upon sale, if the irrevocable trust is a “grantor” trust for income tax purposes, then the grantor will report any gain from the sale on his or her personal return as if he or she sold it (thus preserving possible favorable capital gains tax treatment). Furthermore, assets from the sale stay in the trust and continue to be protected within the irrevocable trust. Clients often ask whether the sale of the house inside the irrevocable trust “triggers” a new five-year Lookback Period for nursing home planning purposes. It does not, and the sales proceeds remain protected.

11This ability for the trust to distribute assets to others can even be used to terminate the trust (if all assets are distributed to children). The children, if they choose, could then transfer assets back to the parents. This ability to prematurely terminate an irrevocable trust is often loosely called an “escape hatch.”

12Of course, one has to decease for the protection to take effect.

13This means that such assets should not be jointly owned or have a beneficiary listed; we want assets to fall into the decedent’s “estate” so that the Will (and Testamentary Trust) will administer such assets.

14But not IRAs, 401k assets, 403b assets, and other “retirement” assets that have not been taxed for income tax purposes.



©2020. This material is intended to offer general information to clients, and potential clients, of the firm, which information is current to the best of our knowledge on the date indicated below. The information is general and should not be treated as specific legal advice applicable to a particular situation. Fletcher Tilton PC assumes no responsibility for any individual’s reliance on the information disseminated unless, of course, that reliance is as a result of the firm’s specific recommendation made to a client as part of our representation of the client. Please note that changes in the law occur and that information contained herein may need to be reverified from time to time to ensure it is still current. This information was last updated May 2020.



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