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Nicholas Souliotis

ESTATE TAX AND MEDICAID PLANNING

When it comes to estate planning to reduce potential estate taxes upon death, or to limit exposure of assets when nursing home care is required, there are still some strategies that can be utilized to accomplish a client’s goals. Now that the Federal Estate Tax Unified Credit has been increased to $5,430,000 per person, and to $10,860,000 per couple, (if a Bypass Will or Married AB Trust is in place) most clients do not need to worry about paying a federal estate tax upon death. However, for Pennsylvania residents there still remains the PA Inheritance tax, which is based on the relationship of the decedent and the beneficiary and not on the value of the estate, and of course the difficulties when a spouse or parent needs nursing home care near the end of life.

 PENNSYLVANIA INHERITANCE TAX:

 The Pennsylvania Inheritance Tax is a tax that must be paid by the executor or successor trustee within 9 months of a Pennsylvania resident’s death. Property passing from parent to children is taxed at 4.5% regardless of its value, with the tax topping out at 15% for assets passing to non-children, non-siblings. The tax is assessed on the entire net estate.  No exemptions for the PA Inheritance Tax exist; the tax is based on the “first dollar”.  Any asset that is given away or transferred within one year of the transferor’s date of death (otherwise known as a “one year look-back period”) is still subject to this tax. In other words, the transferor must survive the transfer by at least one year for the tax not to apply to said asset. However, transferring an asset directly to one’s children may have its own concerns, such as liability regarding the children’s creditors, or potential divorce issues. 

 NURSING HOMES AND MEDICAID ELIGIBILITY:

 The other main concern for clients in their 50s and 60s, and their adult children, is the possible need for future nursing home care, which can cost on average $10,000 per month for full in home care. Long-term care insurance is clearly the best approach to dealing with nursing home contingencies, but many clients cannot afford the cost of long-term care insurance. Many clients depend on Medicaid paying the cost of nursing home care, but Medicaid does not begin to pay until almost all non-exempt assets have been used to pay for one’s care. As with the PA Inheritance Tax above, there is a look-back period when gifting or transferring assets, but it is five (5) years, not one (1) year, so planning for future  nursing home care is even more difficult.  

 TRANSFERS TO A TRUST:

 Many people either have or have heard of Revocable Living Trusts (RLT), which is only a substitute for a Last Will & Testament, and the only unique benefit is that assets titled to a RLT do not go through the Probate process. Assets in a RLT are still subject to the Inheritance tax and provide no protection when applying for Medicaid. Irrevocable Trusts do provide protection after the look-back periods discussed above have expired, but most irrevocable trusts require obtaining a new Tax ID number from the IRS, as well as filing separate 1041 Income tax returns every year, plus possibly paying a higher tax rate.

 THE INCOME-ONLY TRUST:

 One strategy that is still popular for some clients is the creation and funding of what is known as an “Income-Only Trust”, also known by some as an “Intentionally Defective Grantor Trust”, or IDGT. What makes this trust attractive to planners is that it is an Irrevocable Trust for the assets transferred to it, but any income generated by said assets is treated as income to the grantor, not the Trust, so there is no requirement to obtain a new Tax ID number from the IRS, or file any tax form other than the standard 1040 income tax return, with the income subject to individual tax rates, not the higher Trust tax rates. In other words, federal income tax laws disregard the existence of the Trust for federal income tax purposes, thereby imposing the federal income tax obligations associated with the asset upon the grantor as opposed to the trust. Although this may seem undesirable for certain clients, it can actually enable the asset owner to transfer significant wealth to beneficiaries, tax-free.

 For example, if client owns an asset (such as a stocks or bonds) that generates income, he/she can transfer the asset to an Income-Only Trust for the benefit of his/her heirs, which will allow the trust to receive the income generated by the asset free of federal income tax because the client will be required to pay such tax at individual tax rates. Not only does this allow the income to be received by the trust free of federal income tax, it also decreases the value of the client's estate by reducing any federal estate and/or gift tax obligations associated with his/her estate.

 Like a direct transfer to an adult child, a transfer of an asset to an Income-Only Trust is still subject to the one-year look-back for the PA Inheritance tax, and the five year look-back period for applying for Medicaid. Once the look-back period expires, however the assets is protected as it is titled to a trust that is Irrevocable, and this also provides asset protection from the grantor’s potential creditors, as well as protection from the children’s creditors and/or spouses.           

SUMMARY 

1.    Transferring assets to an Income-Only Trust protects the assets from the grantor’s creditors, since the assets are owned by an Irrevocable Trust. 

2.    Any income/capital gains generated by the assets can be used by the grantor for any reason, and the income will be taxed at the grantor’s individual tax rate, not the higher Trust tax rate. 

3.    There is no requirement to file a Trust 1041 Income tax return every April 15th, as all income is reported on the individual’s 1040 income tax return. 

4.    Once the prospective look-back period has passed, the assets are not subject to the Pennsylvania Inheritance Tax, and are also not counted as an asset when applying for Medicaid to cover long-term Nursing Home care costs. 

5.    Assets transferred to an Income-Only Trust receive a stepped-up basis upon death, meaning beneficiaries will likely not have to pay any capital gains taxes upon the sale of the assets. 

6.    Although the Trust usually names the grantor’s children as the ultimate beneficiaries of the trust assets, the children’s creditors or spouses cannot attach the assets to satisfy any judgments, since the Trust, and not the children, own the assets. 

7.    However, like any Irrevocable Trust, once an asset is transferred, it is considered irrevocably owned by the Trust. The grantor can make changes to trust terms, but the assets must remain owned by the Trust.    

 

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 IMPORTANT DISCLOSURES

Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances.

To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

This communication is strictly intended for individuals residing in the state(s) of PA. No offers may be made or accepted from any resident outside the specific states referenced.
 


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