Tuesday, March 6, 2012

IRS Memo may have implications for Medicaid Trusts

On February 24, 2012 the IRS Office of Chief Counsel issued Memorandum 201208026. The memo deals, in part, with the issue of whether the retention of a testamentary power of appointment over an irrevocable trust makes a donor’s gift to the trust incomplete for purposes of the federal gift tax. The memo may have implications for lawyers who create irrevocable grantor trusts to help clients qualify for public benefits.

Memo 201208026 involves a situation where a couple (Donor A and Donor B) gratuitously transferred property to an irrevocable trust (Trust) and designated their adult child, Child A, as the sole trustee. The Trust beneficiaries are the Donors’ children, other lineal descendants, and their spouses. The Trust will terminate when both Donors have died.

The Donors did not retain any power to determine or control the beneficial enjoyment of Trust income or principal during the term of the trust. However, the Donor’s did retain testamentary limited powers of appointment. (Testamentary limited powers of appointment are exercised via will and take effect at a Donor’s death; they allow a Donor to change the way a trust is to be distributed to the beneficiaries). If the Donors do not exercise their testamentary powers, the property remaining in the Trust at termination will be distributed to Child A and Child B.

The Trust permitted the trustee, Child A, to make distributions from income and principal of the Trust at any time for any purpose to any of the beneficiaries or to a charitable organization.

If the gifts to the Trust were complete, the Donors should have filed a federal gift tax return (Form 709) and paid the gift tax, if any, due as a result of the transfer. The Donors contended that since they had retained testamentary powers of appointment over the Trust, they had not made completed gifts to it.  (Tax regulations provide that a gift is incomplete to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves. See, Treasury Regulation Section 25.2511-2(c)).  

The IRS found that the Donors had made a completed gift to the Trust despite their retention of the testamentary powers of appointment. The Service noted that the Donors did not retain any powers or rights to affect the interests of the beneficiaries during the term of the Trust (the time between funding and the death of both Donors). With respect to those interests, the Donors fully divested themselves of dominion and control of the property when they transferred the property to the Trust and the gift of those interests was complete at that time.

The Donor’s did retain some potential control over the remainder of the Trust (the portion that remains at its termination upon the death of both Donors).  However, the Service notes that, under these circumstances, it feels that the value of retained interest should be treated as zero. As a result the full value of the property transferred to the Trust was subject to gift tax at the time of the transfer.

For reasons specific to the rather untypical terms of the Trust, the service also denied the use of the annual exclusion via the “Crummy power” provisions in the trust.

Implications for Medicaid Trusts

Elder law attorneys may have a number of goals in mind when they set up irrevocable trusts for clients of modest means.  These may include eventual protection of the trust’s assets from loss to health and long term care costs, enhancing the client’s ability to qualify for Medicaid and VA pension benefits, avoiding estate recovery and providing for ongoing management of trust assets. In addition, tax goals may be sought including retention of IRC Section 121 treatment on sale of a residence held by the trust, obtaining a step-up in basis on the trust’s assets at the death of the donor, and avoiding the costs involved in filing a gift tax return.  

Memo 201208026 suggests that lawyers should not rely solely on testamentary powers of appointment to obtain the desired favorable tax treatments.  At the least, counsel should carefully consider including the Donor’s additional retention of income and/or lifetime dominion and control powers to avoid completing the gift. (Note that retention of trust income may be contraindicated depending on the particular client circumstances such as a potential need to apply for VA pension benefits).     


Rich Shapiro said...

Thanks for alerting me to this determination. Do you think including a lifetime power of appointment in the trust would have changed the result? The memo seems to imply that it would.

Jeff Marshall said...

Although the terms of the trust in this case were pretty quirky, I think that retention by the Donor of a lifetime power of appointment coupled with a testamentary power will generally make the gift incomplete.