By Meghan M. Teigen, Esq., and Mark T. Johnson, CELA
In an effort to encourage comprehensive analysis of this planning strategy, this article highlights the pitfalls of a 5-year trust, along with some solutions to the pitfalls.
A recent article in NAELA News entitled “Understanding and Marketing the Five-Year Trust” (Apr/May/Jun 2019) describes the tax and nontax benefits of an irrevocable trust as a tool for Medicaid planning by transferring assets in advance of a potential 5-year lookback. In addition, that article presents several marketing strategies for promoting such a trust with clients and potential clients.
In an effort to encourage comprehensive analysis of this planning strategy, this article highlights the pitfalls of a 5-year trust, along with some solutions to the pitfalls. In all cases, the authors recommend that the advising attorney discuss all options and risks with clients, including that the benefits of a 5-year trust, versus an outright gift or no gifting at all, will be enjoyed by both the settlor as well as the remainder beneficiaries after the settlor has divested themselves of their asset(s). For example, creditor protection as well as the remainder beneficiaries’ use of the assets in the future to benefit the settlors, benefits both the settlor and remainder beneficiaries, however, stepped-up cost basis for capital gains tax purposes benefits only the principal/remainder beneficiaries of such a trust. In some cases, when clients propose to transfer property for Medicaid planning, an outright gift is easier to understand, easier to accomplish, and easier to undo if needed. In all cases however, whether assets are transferred to trust or outright, clients need to clearly understand that they have relinquished ownership of the property and cannot get it back, unless the beneficiaries or recipients are willing and able to return the assets.
Pitfalls and Solutions
Pitfall #1: Family members are confused about who the attorney represents. In many of these cases, the settlor of the trust is the client, but may choose to include other family members in the meetings and discussion. In some cases, the other family members (often children) may be the client or think they are the client. Difference of opinions may lead to competing or conflicting goals.
Solution #1: The advising attorney needs to be clear from the start who the client is. In some cases, it may be more than one individual, such as married settlors. In other cases, perhaps the settlor and one or more other family members (proposed trustees, perhaps) are the clients. The NAELA Aspirational Standards recognize that an attorney may be advising and representing more than one family member in a common matter, so, with careful consideration, communication, and consent, the attorney can move forward with such representation.
Before undertaking joint representation, the advising attorney should consult applicable state ethics rules concerning conflicts of interest. Furthermore, if the trustee engages the same attorney for future advice about the trust, the attorney will need to obtain conflict of interest waivers from the parties, plus an engagement letter with the trustee defining the scope of advice. All of this assumes that the conflicts of interest are permissible and waivable under state ethics rules. Finally, if the advising attorney is including other individuals who are not clients in a meeting or other communication, the attorney will need to observe all relevant ethics rules regarding confidentiality and communication, with applicable consent or waivers.
Pitfall #2: The settlor adds assets to the trust after initial funding, which extends the start of the 5-year lookback. This may occur if a client later transfers an additional asset to the trust without advice from the attorney. In situations where real estate is the primary asset of the trust, the settlor may pay for improvements of the property, adding to the equity of the property. In either case, the additional gift causes a delayed start for 5-year lookback, which may be applied to the entire trust corpus if the later additions cannot be traced adequately. This situation may vary from state to state.
Solution #2: Clear communication to the settlor and to the trustee is imperative, so that everyone knows the significance of a firm start date for the 5 years to run. When real estate is an asset of the trust, the client must have a plan for cash flow for property taxes, maintenance, and insurance, whether through cash assets of the trust or rental income. If the settlor resides in the property, with an occupancy agreement or lease, the attorney will need to draft the agreement carefully to memorialize accurately the parties’ intentions for the amount of rent or expenses paid in lieu of rent, to avoid such payments being deemed new divestments.
Pitfall #3: Property needs to be sold before the settlor’s death, and thus the step-up in cost basis is lost. This may occur when real estate is transferred to the trust, with reserved grantor power to accomplish the step-up in basis at the settlor’s death, but there is insufficient cash flow to maintain the expenses of the property.
Solution #3: At the initial advising stage, the attorney and client should analyze whether the property can be held long-term, including sufficient cash flow to cover carrying costs (such as those described in Solution #2). If the settlor has reserved the right to reside in the property and satisfies the other requirements for IRC Section 121 exclusion of gain for sale of principal residence, some or all of the gain may avoid taxation. Keep in mind that if the property had never been transferred to the trust and had to be sold prior to the settlor’s death, step-up in basis would be lost as well.
Pitfall #4: The settlor needs Medicaid benefits before the 5 years run, and early termination of the trust to undo the gift may be cumbersome or expensive to accomplish. Also, the settlor may subsequently lose his or her capacity.
Solution #4: Settlors cannot expect a guaranteed return of trust property to themselves if they end up needing Medicaid benefits before the 5 years run. The advising attorney and the client should have a solid Plan A or a fallback Plan B in mind from the start. For example, Plan A could include long-term care insurance or cash reserves sufficient to cover 5 years of care. Plan B could be a general family consensus to provide for the settlor to cover the remaining lookback period, or dissolve the trust and engage in crisis Medicaid planning. Further, the drafting attorney must fully understand their state’s rules governing early termination of this trust. In some states, an irrevocable trust can be terminated through the use of a nonjudicial settlement agreement, which may require the consent of many, possibly remote, individuals. In large families with multiple beneficiaries, this can make terminating the trust a risky and expensive endeavor.
Clients need to be fully informed of these risks based on their individual situation. In addition, to hedge against subsequent incapacity of the settlor, the attorney should ensure that the settlor’s durable power of attorney for finance includes the authority required to act on behalf of the settlor in matters related to the trust going forward. Another solution to this problem is to grant the trustee power during the settlor’s lifetime to distribute assets to some or all of the principal beneficiaries. This may provide an inexpensive way to terminate the trust if Medicaid is needed and return the assets to the settlor for crisis planning.
Pitfall #5: The trustee does not understand how to administer the trust and reports income incorrectly or makes inappropriate distribution decisions.
Solution #5: In cases where income or capital gains during the settlor’s lifetime are to be distributed or attributed to the settlor for income tax purposes, the advising attorney may wish to draft clear provisions in the trust instrument, prepare detailed instructions about preparation of tax returns, and to communicate with the trustee’s tax advisor from the start. Furthermore, clear drafting can guide a trustee in knowing when distributions may or should be made. In addition, naming co-trustees may provide a safeguard against one trustee “going rogue” and making inappropriate distributions. If the trustee seeks advice from the original attorney, the attorney will need to address conflicts of interest, as noted in Solution #1 above.
Pitfall #6: If a 5-year trust is not suitable for particular clients, they may feel that they “missed out” because acquaintances of theirs have such a trust. Clients should never agree to any type of legal planning, including the 5-year trust, as a result of marketing alone.
Solution #6: Attorneys serve their clients well by customizing advice to each client’s goals and circumstances. No one solution fits all clients. Therefore, attorneys should carefully market their services to avoid any “one-size-fits-all” sales pitch or “product.” Even when such a trust is suitable, clients need to be fully informed about the limits on their access to trust assets (e.g., no access to trust principal, and access to income only if allowed by the trust, which also will likely expose the trust to Medicaid scrutiny even after the 5 years run).
Pitfall #7: Parties are not suitable or assets are not suitable for a 5-year trust. This may arise when there are numerous (perhaps disputing) family members or assets that are not suitable to transfer (e.g., real estate subject to an existing mortgage, annuities, retirement assets, or cash the settlor needs). A fair number of clients may inquire about a trust for asset protection, but they can no longer be reasonably confident of making it 5 years without needing Medicaid.
“Solution” #7: Not all legal planning is right for every client. A 5-year trust may not be an appropriate option for your client. The advising attorney may need to turn to other options, such as robust and flexible financial powers of attorney, leveraging spousal impoverishment protections, and other crisis planning tools.
Even though the authors present solutions to most of the pitfalls described, as with any legal planning, if a pitfall cannot be sufficiently addressed for a particular client, it often means that the attorney’s suggested planning idea, such as a 5-year trust, is not a good choice for that client. When advising clients regarding Medicaid planning, elder law attorneys will excel in serving their clients and marketing their practice with customized advice and services, including advice about the best use of 5-year trusts when appropriate.
About the Authors
Meghan M. Teigen, Esq., is a partner with the Fitchburg, Wisconsin firm Johnson Teigen, LLC. She previously served as the Associate Executive Director of Wispact, Inc., a pooled special needs trust serving individuals with disabilities throughout Wisconsin. She serves on the board of directors for The Arc-Dane County.
Mark T. Johnson, CELA, is a partner with the Fitchburg, Wisconsin firm Johnson Teigen, LLC. He is currently the President of the Wisconsin Chapter of NAELA. He is a member of the Special Needs Alliance.