But What About Revenue Ruling 2023-2 and Medicaid Trusts?
In simplistic terms, estate planning is about transferring wealth from one generation to the next, while minimizing transfer taxes. Some call it tax avoidance; others refer to it as tax evasion. Your choice of nomenclature is largely dependent on your political ideologies. The debate, however, as to the ultra-wealthy’s ability to access competent legal counsel and implement sophisticated estate planning techniques resulting in the minimization of transfer taxes has been ongoing for years. It will continue.
Some estate planning techniques can be quite aggressive. Aggressiveness often garners attention. In prior years continuing into the earlier part of this year, there has been heightened pressure on the Treasury to curtail alleged abuses committed by the ultra-wealthy, largely demanding that action be taken to eliminate an aggressive position asserted by practitioners using intentionally defective grantor trusts (IDGTs).
That position, as more fully discussed below, involves advocating for a step-up in basis on assets of an IDGT upon the death of the grantor where the assets are also excluded from the grantor’s estate for estate tax purposes.
On March 29, 2023, the IRS issued Revenue Ruling 2023-2 concluding that there is no basis adjustment under § 1014 of the Internal Revenue Code (Code) to the assets of an IDGT upon the death of the grantor, if the trust assets are not also includable in the grantor’s gross estate for estate tax purposes.
The client calls and emails started soon thereafter. How does this affect my Medicaid trust? Do I need to revoke my Medicaid trust? But you told me that my children would get a step-up in basis?
Spoiler Alert: Rev. Rul 2023-2 Does Not Apply to Medicaid Trusts
The Fact Pattern
Grantor creates an irrevocable trust and makes a completed gift to the trust of certain assets. Grantor does not retain any powers that would cause estate tax inclusion under the Code. For income tax purposes, grantor retained certain powers under the Code allowing grantor to be treated as the owner of the trust under § 671 of the Code for income tax purposes; thus, the trust is considered an IDGT. Upon grantor’s death, the assets of the trust had significantly appreciated in value. Neither grantor nor the trustee of the trust held a note on which the other was the obligor.
Issue
Is there a basis adjustment under § 1014 of the Code to the assets of a trust on the death of a grantor who is treated as the owner of the trust for income tax purposes, if the trust assets are not includible in the grantor’s gross estate for estate tax purposes?
Basis Adjustment Rules
Section 1014(a)(1) of the Code allows for an adjustment to the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent. The basis adjustment is generally adjusted to the fair market value as of the decedent’s date of death (stepped-up basis).
There are seven types of property that are considered to have been acquired from or to have passed from the decedent for purposes of § 1014(a)(1). For purposes of the fact pattern in Revenue Ruling 2023-2, only two of the seven are relevant here:
- Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent.1
- Property acquired from the decedent by reason of death, form of ownership, or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof, the property must be included in determining the value of the decedent’s gross estate.2
The Mechanics of the IDGT
When properly utilized, an IDGT is an effective estate planning tool used to transfer wealth without utilizing one’s estate tax exemption and without incurring an income tax liability.
As mentioned above, where a grantor is treated as the owner of a trust for income tax purposes under § 671 of the Code, all of the income, deductions and credits of the trust will be included in the grantor’s income. A taxpayer is treated as the owner of a trust by retaining certain powers under §§ 671-679 of the Code. For instance, if the grantor of a trust retains the right to receive the income of the trust, the trust will be treated as a grantor trust for income tax purposes.
Transactions between a grantor and an IDGT are disregarded for tax purposes. For instance, assume a taxpayer transfers an asset to an IDGT in exchange for a promissory note. Unlike a traditional sale of the asset to an unrelated third party where gain will be realized, there is no recognition of gain upon sale of the asset to the IDGT since the transaction is disregarded for income tax purposes.3
The taxpayer will receive, via the note payments, the fair market value of the transferred asset, leaving the appreciation after the date of the transfer inside the trust, to be transferred to subsequent generations without utilizing any estate tax exemption.
The important takeaway from the foregoing, and the connection to Revenue Ruling 2023-2, is that since the grantor is treated as the owner of the trust for income tax purposes, there has been no transfer of assets to the trust.
The Argument
The narrow issue in dispute, prior to the issuance of the ruling, was, “When did the transfer of assets occur?”
If the transfer was an inter vivos transfer, then there is no basis adjustment (carry-over basis). This, of course, is the position of the IRS.
Citing Bacciocco v. United States, 286 F.2d 551 (6th Cir. 1961), the IRS held that the assets of the trust were not bequeathed, devised or inherited since they did not pass by will or intestacy. According to the IRS, and notwithstanding the grantor trust rules, the IRS concluded that the transfer occurred at the time the assets were transferred to the trust. Since the transfer occurred during the grantor’s lifetime, the assets of the trust did not fall within any of the seven types of property enumerated in § 1014(b) of the Code and therefore was not acquired from a decedent or passed from a decedent unless includable in the decedent’s estate for estate tax purposes. Since the grantor retained no powers to cause estate inclusion, no basis adjustment was allowed.
Although not authoritative, the IRS took a contrary position in PLR 201245006. In PLR 201245006, a taxpayer, who was a citizen and resident of a foreign country, created an irrevocable trust and funded such trust with certain assets. Taxpayer retained the right to receive all income from the trust while also retaining a lifetime and testamentary power of appointment. The trust was treated as a grantor trust and but for the fact that the taxpayer was not a U.S. citizen, would have been included in the taxpayer’s gross estate for estate tax purposes. Upon the taxpayer’s death, the trust assets were to be paid to a continuing trust for the benefit of the taxpayer’s issue.
Relying on IRC § 1014(b)(1), the IRS concluded that the taxpayer’s issue will acquire, by bequest, devise or inheritance, assets from the decedent’s trust at decedent’s death. As a result, a fair market value basis adjustment was allowed.
“It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so;” Mark Twain got it right.
What about the fact that the grantor is treated as the owner of the trust assets until death for income tax purposes? If the grantor is the owner until death, how could an inter vivos transfer have taken place?
Some of our colleagues have argued that the actual transfer occurs upon termination of grantor trust status, for instance, upon the death of the decedent. In turn, they argue that the trust assets should be viewed as passing by bequest, thereby allowing for a step-up in basis under § 1014(b)(1) of the Code.4
The authors argue “that although IRC § 1014(b)(9) requires estate inclusion, IRC § 1014(b)(1) does not.”5 “Nevertheless, the Regulations, the legislative history, and the statutory language do not affirmatively preclude transfers made under a lifetime trust from qualifying as a bequest or devise.”6 The authors further argue “because a grantor trust’s assets are deemed to be owned by the grantor for income tax purposes, a good argument can be made that assets held in such a trust should be viewed as passing as a bequest or devise when the trust ceases to be a grantor trust at the moment of death.”
Can a successful argument be made that upon the decedent’s death, grantor trust status terminated, and the decedent’s estate constructively transferred (bequeathed) the assets to the trustee of the trust? What about the inconsistency in PLR 201245006?
Revenue Ruling 2023-2 appears, on its face, to answer the long-standing debate, but perhaps not. Perhaps time, and litigation, will tell.
Our Typical Medicaid Trusts
Revenue Ruling 2023-2 has no impact on our typical Medicaid trusts, most of which are drafted as incomplete gifts for transfer tax purposes. In most circumstances, clients who are planning for Medicaid eligibility will not have taxable estates.
The following powers are commonly retained by our clients to cause them to be treated as the owner for income tax purposes (achieving grantor trust status):
- A power to determine the beneficial enjoyment of the corpus or the income therefrom if the corpus or income is irrevocably payable for a purpose specified in § 170(c) (relating to definition of charitable contributions) or to an employee stock ownership plan (as defined in § 4975(e)(7)) in a qualified gratuitous transfer (as defined in § 664(g)(1)).7
- A power to distribute corpus either to or for a beneficiary or beneficiaries or to or for a class of beneficiaries (whether or not income beneficiaries) provided that the power is limited by a reasonably definite standard which is set forth in the trust instrument.8
- The grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under § 674, whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a non-adverse party, or both, may be distributed to the grantor or the grantor’s spouse.9
The following retained interests are commonly used in our Medicaid trusts to cause estate tax inclusion:
- the possession or enjoyment of, or the right to the income from, the property.10
- the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom (power of appointment).11
- An unfettered power to remove and replace a trustee.12
Clients who create Medicaid trusts generally transfer enough ownership and control to the trust so the trust assets are not countable for Medicaid eligibility purposes (subject to a five-year look back) while remaining treated as the owners of the trust for income tax purposes (achieving grantor trust status). By the grantor retaining certain powers, the Medicaid trust assets will cause estate inclusion under the Code.
Most Medicaid trusts are specifically drafted as an incomplete gift for gift and estate tax purposes, resulting in estate inclusion. Since there is estate inclusion, there is a basis adjustment under § 1014(b)(9) of the Code.
When drafting Medicaid trusts, a limited retained power of appointment (a power to change the beneficiaries of the trust either during lifetime or at death) is typically included.
A gift is incomplete if the donor retains a testamentary power of appointment. Treasury Reg. § 25.2511-2(b) provides in part,
As to any property, or part thereof or interest therein, of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another, the gift is complete. But if upon a transfer of property (whether in trust or otherwise) the donor reserves any power over its disposition, the gift may be wholly incomplete, or may be partially complete and partially incomplete, depending upon all the facts in the particular case.
Conclusion
IDGTs have their place. Usually, their place is with clients who are attempting to remove the appreciation of assets from their taxable estates. Not our clients. Our clients typically want to preserve the equity in their homes and maybe some non-qualified savings from the potential cost of nursing home care. Our clients are comfortable with retaining sufficient powers within the trust to cause estate tax inclusion because, realistically, the client’s estate will not be subject to estate tax. Careful drafting will ensure that Revenue Ruling 2023-2 will not apply to our Medicaid trusts.
Salvatore M. Di Costanzo is a partner with the firm of Maker, Fragale & Di Costanzo, LLP located in Rye, New York and Yorktown Heights, New York. Mr. Di Costanzo is an attorney and accountant whose main area of practice is elder law and special needs planning, which consists of wills, trusts, probate and administration of estates, Medicaid planning, asset preservation, nursing home and home care planning and planning for individuals with special needs. Prior to being a partner with Maker, Fragale & Di Costanzo, LLP, Mr. Di Costanzo was a partner with McMillan, Constabile, Maker & Perone, LLP.
Patricia Shevy is an active member of the New York State Bar Association, serving as chair of the Continuing Legal Education Committee, officer of the Trusts and Estates Section and Elder Law and Special Needs Section. She is a former co-chair of the Board of Editors of the Elder and Special Needs Law Journal. Patricia is also a member of the American College of Trust and Estate Counsel and the Albany County Bar Association.
