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The Use of Irrevocable Trusts in Long-Term Care Planning

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The Use of Irrevocable Trusts in Long-Term Care Planning

The Use of Irrevocable Trusts in Long-Term Care Planning

In Revenue Ruling 2023-2 the IRS has ruled that assets held in a trust that is a “grantor trust” (a trust that is treated for income tax purposes as the alter ego of the grantor to the trust because of the application of certain retained interests under IRC 671, et. seq.) at the passing of the trust grantor do not qualify for the special adjustment (or “step up”) in income tax basis. While this ruling had a substantial impact on Estate Planning, and in particular, on the use of irrevocable trusts, it also has an effect on long term care (sometimes called “Medicaid” planning.)

As background, certain trusts, known as “grantor trusts,” are popular in the estate planning context because of, among other things, their income tax treatment. Since 1985, in Revenue Ruling 85-13, the IRS has held that assets in a grantor trust are the alter ego of the grantor. As a result the trust is ignored for income tax purposes, and the income generated by the assets in the trust is taxed to the grantor. There is a series of statutes under the Internal Revenue Code which detail when this “grantor trust” treatment is triggered for a trust, and the statutes were designed to prevent the shifting of taxable income to a lower income tax bracket by having the income taxed to the grantor. These statutes have been with us for decades, but the idea of shifting income had become irrelevant since 1993 when the income tax bracket on trusts was raised to the nearly highest bracket.

Previously, some tax practitioners believed that assets gifted to a grantor trust would be eligible for a step-up in basis at the grantor’s death since the assets are still taxable to the grantor for income tax purposes. Under IRC § 1014 and 26 CFR § 1.1014-2, step-up in basis is a rule that can apply to capital gains tax on inherited assets. For an inherited asset, the fair market value of the property on the date of death is used instead of the purchase price from decades earlier. This produces the result that no capital gains tax is due on the property’s appreciation, which would otherwise have been subject to this tax.

With respect to grantor trusts, some practitioners had long hoped that there was support for the position that assets held in a grantor trust are excluded from the grantor’s estate at his or her death for estate tax purposes, while simultaneously receiving a step-up in basis at the grantor’s death for income tax purposes. For other practitioners, this seemed too good to be true—would the IRS really allow capital gains taxes to be eliminated on the death of the grantor, while at the same time allowing the asset to be excluded from his estate, thereby saving both income and estate taxes?

Revenue Ruling 2023-2 issued by the Internal Revenue Service (“IRS”) finally addresses this issue, holding that assets in a grantor trust on the death of the grantor are not provided a ‘step-up” in basis, where the assets are not includible in the grantor’s estate. This would also apply to a step-down in basis.

The IRS’s decision is likely intended (and certainly results) in as many people as possible paying income tax when the assets in the trust are eventually sold. However, there is also a possible unintended impact on some estate planning for long-term care needs. Many taxpayers seek out long-term care (“LTC”) planning as a way to pass down assets without the possibility of LTC costs depleting their estates.

According to the World Health Organization (“WHO”), the number of persons aged 80 years or older is expected to triple between 2020 and 2050 to reach 426 million people.[1]  In America alone, by 2030, individuals age 60 and older will account for 21% of the population.[2]

Longer years after retirement may also mean a greater likelihood of needing long-term care provided at home or in an institution. Life expectancy has increased rapidly, while aging in place has become difficult for many older individuals due to increased social isolation, cognitive decline, and the loss of physical abilities over a greater period of time.[3]

According to the American Association of Retired Persons (“AARP”)[4], the average cost of long-term care in New Jersey was $12,151 a month for nursing home care in a private room for one individual. The average national cost of care ranges from $9,000 to $15,000 a month for long-term care.[5]

As Medicare offers no long-term care benefits, many families are planning their estates around the cost of long-term care over five years and then applying for Medicaid for long-term care services through the New Jersey Family Care program thereafter.

A common strategy in Medicaid Planning is to use a Medicaid Asset Protection Trust (“MAPT”), which is a uniquely designed irrevocable trust to protect and transfer assets in order to qualify for Medicaid while retaining a step-up in basis for those assets. . A MAPT is a grantor trust for income tax purposes. MAPT’s allow an individual or a couple to qualify for Medicaid after the five-year lookback period on transfers. The assets remain in the MAPT until the grantor(s) death and then are generally distributed outright to beneficiaries. A properly designed MAPT allows the asset to be non-countable for Medicaid purposes while remaining taxable to the grantor for income tax purposes and ultimately achieving a step-up in basis while remaining in the grantor(s) estate.  As such, assets held within a MAPT should never be designed as a completed gift and must remain in the grantor(s) estate in order to receive the step-up in basis.

An improperly designed MAPT could now fail to achieve the step-up in basis if the asset is not includable in the estate. Therefore, despite the impact of Revenue Ruling 2023-2, where Medicaid Planning using an irrevocable trust is done properly, it is still possible to achieve both Medicaid qualification and a step-up in basis at death for the appreciating assets.

[1] https://www.who.int/news-room/fact-sheets/detail/ageing-and-health

[2] https://www.census.gov/library/stories/2018/03/graying-america.html

[3] https://www.healthline.com/health/aging-in-place

[4] aarp.org

[5] aarp.org

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