IRREVOCABLE TRUSTS AND TAXES
Grantor TrustIRC §677(a) provides in part that the grantor shall be treated as the owner of any portion of a trust whose income, without the approval or consent of any adverse party, is or may be, in the discretion of the grantor or a non-adverse party or both, either (1) distributed to the grantor or the grantor’s spouse, or (2) held or accumulated for future distribution to the grantor or the grantor’s spouse.
- There are four possibilities, all assuming no approval or consent of an adverse party:
- Income is distributed to the grantor or the grantor’s spouse;
- In the discretion of the grantor, or non-adverse parties, income may be distributed to the grantor or the grantor’s spouse;
- Income is accumulated for future distribution to the grantor or the grantor’s spouse; and
- In the discretion of the grantor, or non-adverse parties, income may be accumulated for future distribution to the grantor or the grantor’s spouse.
The foregoing subsection, therefore, results in an IIOT, or "Wyoming Trust" , being classified as a Grantor Trust. As a grantor trust, all income from the trust is reportable on the grantor’s Form 1040 and a separate Form 1041 for the trust need not be filed.
Capital Gains Exclusion of Principal Residence
: IRC §121(a) allows you to exclude, regardless of age, gain on the disposition of your home if you owned and occupied the property as a principal residence for two of the five years immediately before the sale even if ownership and occupancy are not concurrent. The maximum gain exclusion is $250,000 for an individual and $500,000 for married couples filing jointly).
You are considered to have owned and used a home as a principal residence during the time you or your deceased spouse used the home as a principal residence. This rule applies as long as on the day the home is sold your spouse is deceased and you have not remarried. Divorced spouses can also benefit from the ownership and use periods of former spouses to satisfy the exclusion requirements.
Generally, the ownership test will require you to own the property directly and not through an entity. For example, the IRS has refused to allow a taxpayer to satisfy the ownership test if the principal residence was owned by a family limited partnership or partnership. PLR 200119014, revoking PLR 20004022. If the home is owned by a trust, the exclusion will be available only to the extent the taxpayer is considered an owner of the trust under the grantor trust rules. Rev.Rul. 85-45, 1985-1 C.B. 183.
Thus, the §121 exclusion is available to the settlor of a revocable living trust (Rev. Rul. 66-159, C.B. 162) and to the surviving spouse of a marital trust established under the living rust (Rev. Rul. 85-45, 1985-1 C.B. 183). However, the IRS ruled in PLR 200104005 that the exclusion from gain from the sale of a personal residence is available to the beneficiary of a nonmarital bypass trust only to the extent the beneficiary has a right to withdraw trust corpus (PLR 200104005 (September 11, 2000)). Consider a 5&5 power for this purpose.
Interest Mortgage Deduction
You may generally deduct under IRC §163 two types of debt secured by your home: “acquisition indebtedness,” which is debt that is used to acquire, construct or substantially improve a residence, and “home equity indebtedness,” which is any other debt secured by the home. Acquisition indebtedness cannot exceed $1 million and home equity indebtedness cannot exceed $100,000.
The same analysis for capital gain exclusion on the sale of your home applies to the deductibility of interest on a home within a grantor trust, including an IIOT.
Under IRC §2511(a), gift tax applies whether a transfer is in trust or otherwise; whether a gift is direct or indirect; and whether the property is real, personal, tangible or intangible. Treas. Regs. §25.2511-2(b) provides that a gift is complete when a donor parts with dominion and control so as to leave him or her with no power to change the disposition of the property transferred. If a donor reserves any power of the disposition of property, the gift may be incomplete, partially complete or partially incomplete, depending on the facts of the case. Gift tax applies when the gift is complete.
A gift is incomplete in every instance in which a donor reserves power to revest beneficial title in him or herself; it’s also incomplete when a donor reserves power to name new beneficiaries or change the interests of the beneficiaries, unless that power is a fiduciary one, limited by a fixed or ascertainable standard (Treas. Regs. §25.2511-2(c)). A donor possesses power over transferred property if such power is exercisable with any person not having a substantial adverse interest in the disposition of the transferred property (Treas. Regs. §25.2511-2(e)). Under Treas. Regs. Section 25.2511-2(g), if a donor transfers property to himself as trustee (or to him/herself and another person who lacks a substantial adverse interest, as trustee) and retains no beneficial interest in the property except for fiduciary powers, the exercise/nonexercise of which is limited by a fixed or ascertainable standard, the donor has made a completed gift. As such, gift tax will apply to the value of the transferred property.
The issue is whether the transfer to an IIOT as a grantor trust would be subject to the gift tax imposed by the IRC. A transfer to a wholly-owned grantor trust is an incomplete gift. The gift becomes complete on the death of the grantors and the subsequent transfer to beneficiaries; albeit that transfer is then subject to estate tax rules. IRS Notice 2010-19.
If the grantor-trust is not wholly-owned, such as the case with an IIOT since the principal is not available to the grantors, gift tax would apply on transfer absent an intervening factor. If a grantor retains a limited power of appointment under IRC §2041, this would be an intervening event.
The key to understanding the transfer rules pertaining to trusts for this purpose is to understand when the transfer has taken place. Medicaid is different than gift tax. If there is a transfer from an individual to a trust under conditions by which the trust assets are still available to the individual, for Medicaid purposes there has been no transfer. Therefore, where the trust is revocable, the assets are still available to the individual after the trust is funded so there is no transfer at this point.
If the trust is irrevocable, the transfer is considered to have been made as of the date the trust was established, or upon such later date that payment to the settlor was foreclosed. However, if the settlor can still benefit from the assets with which the trust is funded, those assets are still available, and there is no deemed transfer. If and when those assets are paid out to a third party, the transfer occurs for Medicaid claw-back purposes. If the settlor places assets in an irrevocable trust and can no longer benefit from any of the trust corpus, there has been a transfer of assets when the trust is funded. 42 U.S.C. §1396p(c)(1)(B); HCFA Transmittal 64 § 3258.4E. A LPOA under IRC §2041 would not mean a transfer has not occurred.
Step-Up in Basis
LPOA means there is an incomplete gift and, therefore, no gift tax. Further, IRC §1014 would step up the basis in the trust assets on death of the grantor since the grantor reserved the right to income and the entire value of the estate would be included in the grantor’s estate for federal estate tax purposes. I.R.C. §1014, 2036, 2038; Treas. Reg. §§1.1014-2(a)(3), (b).LPOA means there is an incomplete gift and, therefore, no gift tax. Further, IRC §1014 would step up the basis in the trust assets on death of the grantor since the grantor reserved the right to income and the entire value of the estate would be included in the grantor’s estate for federal estate tax purposes. I.R.C. §1014, 2036, 2038; Treas. Reg. §§1.1014-2(a)(3), (b).
You should structure the IIOT as a grantor trust to avoid the detrimental tax aspects of trust tax. Further, as a grantor trust, the beneficial aspects of IRC 121 and 163 are not lost. Finally, a LPOA retained by the grantor and his/her spouse will result in no gift tax at the time of establishment since the gift is not complete, while meeting the definition of transfer for Medicaid purposes. If properly structured, you should be able to protect your home.