A recent article in NAELA Journal addressed the problem of how to maximize Medicaid benefits and minimize the tax burden for an institutionalized spouse who has a substantial individual retirement account (IRA) in a state where the account is not exempt. The primary problem is that most strategies require that the IRA be cashed out, triggering income tax liability for the entire withdrawal for that tax year. Once the IRA is cashed out, the proceeds can be spent down in any number of ways; one option is for the community spouse to purchase a Medicaid qualified annuity (MQA).
The proposed solution is creative — annuitize the IRA itself but make it irrevocably payable to the community spouse. The success of this strategy depends on favorable answers to two distinct legal questions.
First, as a matter of Medicaid law, this strategy works only if the income is recognized as that of the community spouse for Medicaid purposes rather than as income of the institutionalized spouse. If the income is the institutionalized spouse’s, the community spouse benefits only to the extent that his or her income is low enough compared with his or her minimum monthly maintenance needs allowance (MMMNA) to be eligible to receive a community spouse monthly income allowance (CSMIA). But if the income is the community spouse’s, he or she gets to keep all of it since this income is never deemed available to the institutionalized spouse.Second, purchasing an annuity inside an IRA but making it payable to the community spouse improves the cash-out option only if the income tax liability is deferred over the term the annuity payments are made. That, of course, is how an IRA operates when it is used to purchase an annuity payable to the IRA owner. The savings can be considerable.
For example, a $480,000 IRA distributed in 2020 for a couple filing jointly with other taxable income of $200,000 would incur a tax liability of $188,749 on the total $680,000 in taxable income, throwing the couple into the top 37 percent tax bracket and resulting in $152,589 more in taxes than the $36,159 in taxes that would be incurred on the $200,000 in income without the IRA. If the couple were to purchase an annuity with a 4-year term in January to enable $120,000 to be distributed in each of 4 years, the couple would pay taxes at a much lower rate of 24 percent each year instead of at the 37 percent rate if the $480,000 were paid all at once.
The Krause and Engstrom article addresses the Medicaid issue but not the tax issue. The authors’ argument that the income should be treated as that of the community spouse for Medicaid purposes is not well grounded. The policy cited by the authors, on examination, rests on a condition that makes the policy inapplicable to the IRA case. Nonetheless, a closer look shows that there is other authority for using the strategy as a matter of Medicaid law and that purchase of such an annuity should transfer that income to the community spouse, avoiding the limitations of the CSMIA benefit. That other authority is reasonable, if not entirely unassailable.
But whether the strategy solves the tax problem, its primary raison d’etre, is problematic. An attorney advising a client to use this strategy should caution the client that it might result in the client being taxed on the full amount of the IRA in the year the annuity was purchased. Putting aside penalties and interest for underpayment of taxes, this strategy is no worse than the case it is trying to improve — distributing the income, paying the income tax due, and transferring the balance to the spouse, who then purchases the annuity. It presents other problems as well — primarily the client not having the cash to pay the tax bill when substantial funds are tied up in an irrevocable annuity. And no client will be pleased if this unfortunate result occurs and the client was not warned of the risk.
II. The Medicaid Issue
The strategy of annuitizing the IRA but making it irrevocably payable to the community spouse works as a matter of Medicaid law and practice only if the annuity payments are treated as the income of the community spouse in determining the institutionalized spouse’s post-eligibility patient pay obligations. The argument in the Krause and Engstrom article turns on the name on the check rule concerning trust income: “If payment of income is made solely to the institutionalized spouse or the community spouse, the income shall be considered available only to that respective spouse.”But there is a condition. The name on the check rule only comes into play “in the absence of a specific provision in the trust,” otherwise, “income shall be considered available to each spouse as provided in the trust … .” The State Medicaid Manual, published by the Centers for Medicare & Medicaid Services (CMS), brings that home. The name on the check rule applies only “[w]hen a trust instrument is not specific as to couples’ ownership interest in income.”That proviso is fatal to relying on the name on the check rule.
The “instrument providing the income” is the IRA, and IRAs plainly provide income only for their owners (i.e., institutionalized spouses). Even if the underlying asset is community property under state law, the income and distributions are taxed solely as those of the IRA owner. The ownership of the source of the income trumps the name on the check rule; no amount of irrevocability of the annuity solves that problem since application of the rule turns on the underlying instrument of ownership, not to whom the money goes. The name on the check comes into play only when the ownership of the income is unclear or the source is silent. That is not the case with an IRA.
But the fact remains that the annuity is irrevocably payable only to the community spouse. If the institutionalized spouse has the power to change ownership of the income stream, notwithstanding — indeed because of — his or her ownership of the underlying asset, the spousal impoverishment policy, as well as Medicaid policy generally, would accept that power and apply its rules to the resulting ownership. State Medicaid agencies have argued that the duty under federal law to obtain all income and assets to which an applicant is entitled supersedes ownership in this instance. The obligation extends to filing suit where appropriate, the duty being relieved only if “the cost of obtaining the assets may be greater than the assets are worth.” If an asset can be had for the asking, such as the elective share, failure to ask for it is considered a transfer:A claimant/recipient is not eligible for SSI [Supplemental Security Income] if … he does not … file for and, if eligible, obtain any … other benefit [or] payments … includ[ing] annuities, pensions, Title II benefits (e.g., retirement, disability, widow’s, parent’s benefits), and payments to which he is entitled.These benefits or payments include pensions and retirement benefits. Income is considered available when it is available as a matter of fact and the Medicaid applicant has a legal interest in it and “the ability to make it available for support and maintenance.” Thus, the question is not, “Whose name is on the check?,” but rather, “Who has the power to control whose name is on the check?”
Having purchased the annuity, does the institutionalized spouse nonetheless have the power to take it back? Notwithstanding its nominal irrevocability, an annuity purchased with funds that cannot be assigned to another would remain the property of, or at least be available on the demand of, the institutionalized spouse. The irrevocable annuity is necessary, but not sufficient, to effect transfer to the community spouse if the IRA is inalienable.
Most retirement benefits — Social Security, most state retirement plans, and Employee Retirement Income Security Act (ERISA) plans — are not assignable. Closer to home, individual retirement annuities are not assignable; Congress put in a specific provision prohibiting transfer by the annuitant. There is no such limitation in the parallel provision establishing individual retirement accounts. Assignability has secondary consequences in another area, bankruptcy, in which assets subject to limitations on alienation under non-bankruptcy law are not available to trustees in bankruptcy. ERISA benefits are excludable from the reach of trustees in bankruptcy.IRAs are not so excludable. Congress’ concern with IRAs is not whether they are assigned, but that they not be used like cash or other available assets (e.g., as security). Thus, if an IRA is pledged in whole or part as security, “the portion so used is treated as distributed to that individual.” And in specifying what constitutes a distribution, the Internal Revenue Service (IRS) elaborated on that provision:
[A]n assignment of an individual’s rights under an individual retirement account … shall … be deemed a distribution to such individual from such account … of the amount assigned.”Having defined the tax effect of assigning an IRA, Congress plainly assumed that the IRA could be irrevocably assigned.
Thus, an institutionalized spouse’s assignment of his or her annuity to the community spouse by purchase of an irrevocable, nonassignable annuity is an irrevocable act that the institutionalized spouse has the power to consummate. It is a transfer to the spouse, exempt under the Medicaid transfer rules. Whether considered an asset or income at the moment of transfer does not matter; both are subject to the transfer rules under 42 U.S.C. § 1396p(h)(1) and thus enjoy the exemption.
What makes the strategy effective for Medicaid purposes is not the formality of whose name appears on the check but the transfer of the underlying rights by an irrevocable contract that the institutionalized spouse has the legal authority to make. A recent decision of the Indiana Court of Appeals, Hotmer v. Indiana Family and Social Services Administration, confirms that approach. There, the agency argued that the applicant’s duty to collect income or assets to which he was entitled precluded treating the assigned payments as belonging to the spouse. The court swept that aside. The two contracts were unalterable. There was no argument that the original transaction was not exempt from the antitransfer rules. The court assumed, correctly, that IRA distributions could be irrevocably assigned, which resolved whose income it was for Medicaid purposes.III. The Tax IssueTax treatment is, of course, distinct from Medicaid treatment. Just as a gift permitted for tax reasons (e.g., annual exclusion gifts) may still be subject to penalty under the Medicaid antitransfer rules, the shift of income from one spouse to another, though effective for Medicaid reasons, may have adverse tax consequences. Here, there is a serious risk that the purchase of an annuity irrevocably payable to the spouse will trigger the assignment of income doctrine, resulting in the IRA’s value at the time of the annuity’s purchase being fully taxed in the year of purchase and not taxed ratably over the life of the annuity. The Kraus and Engstrom article assumed, without discussion, that tax liability would follow payments, but that is a risky proposition.
Assignment of income is a judicially created doctrine of ancient vintage. Because the doctrine is judicially created, it generally has not been affected by changes in the Internal Revenue Code over the years. The leading and still controlling case law is very old. The doctrine does not establish whether an item is subject to tax; rather, it determines who is the appropriate taxpayer and when the item is subject to tax.Being judicially created, the doctrine can best be understood by examining how the courts have handled similar fact patterns. A search did not find any judicial precedent addressing whether the doctrine applies to the assignment of an interest in an employee benefit plan or IRA, but the regulation quoted, supra note 27, that an assignment results in a deemed distribution, suggests there is regulatory authority. This lack of judicial authority should not be surprising. As discussed earlier in this article, assignment of an interest in an employee benefit plan is prohibited under ERISA. In addition, assignment of an IRA, while legally permissible, is certainly rare.
The issue, therefore, must be addressed by looking at analogous fact patterns. Perhaps the best way to begin is to state a general principle derived from the case law and IRS rulings. That principle can be stated as follows: If income that has been realized (i.e., earned or accrued) is transferred to another before that income has been recognized (i.e., reported on a tax return), that income is immediately taxed to the transferor as of the date of the transfer even though it is actually payable to the transferee at a later date. This principle, not always this clearly stated, has been applied by the courts and the IRS in numerous analogous fact patterns. For example, interest accrued but not yet paid on an endowment insurance policy is taxed to the transferor, not the transferee, if the policy is transferred to a charity prior to the interest payment date. Similarly, interest accrued on bonds transferred to a trust is taxed to the transferor of the bonds even though the interest is subsequently received by the trust.Perhaps a better analogy is the treatment of Series E and EE savings bonds. Similar to an IRA, in which taxation does not normally occur until a withdrawal is made, the reporting of interest earned on a Series E or EE bond is usually deferred until the interest is actually paid. But there is an exception. If a Series E or EE bond is transferred, interest earned on the bond until the date of transfer is immediately taxable to the transferor even though is the interest is paid to the transferee at a later date.A leading assignment-of-income case is Blair v. Commissioner. Blair might suggest a different principle upon a quick read, but upon closer examination, it is fully consistent with the savings bond and other tax authority cited above. In Blair, which predates the widespread use of spendthrift provisions, a son, who had an income interest in a trust created by his father, assigned a portion of that income interest to his own children. The court held that the son’s children, not the trust beneficiary’s son, were subject to income tax on the transferred income interest. However, in Blair, the income at issue and on which the children were taxed was the income earned by the trust after the date of the transfer. The courts have held that income that accrues prior to the date of a trust beneficiary’s transfer is taxed to the transferor even though it is not paid out until a later date.Another issue that should be addressed is whether it makes any difference whether the IRA is being irrevocably assigned to the spouse of the IRA owner as opposed to someone else. The Internal Revenue Code in many respects treats a married couple as a single taxpaying unit. This philosophy is confirmed by Internal Revenue Code § 1041, which provides that “[n]o gain or loss shall be recognized on a transfer of property from an individual to … a spouse. Consequently, if one spouse sells a stock or bond to the other spouse, no gain or loss is recognized on the sale and the transferee spouse takes over the transferor’s tax basis.
The IRS has ruled, however, that § 1041 and its negation of tax liability does not apply to a transfer to the spouse that triggers the assignment-of-income doctrine. In Internal Revenue Ruling 87-112, which involved the transfer of Series E savings bonds to the other spouse, the IRS stated, “Although section 1041(a) of the Code shields from recognition gain that would ordinarily be recognized on a sale or exchange of property, it does not shield from recognition income that is ordinarily recognized upon the assignment of that income to another taxpayer.” Consequently, the transferring spouse was taxed on the interest that had accrued on the savings bonds up to the date of transfer.
In Revenue Ruling 87-112, the IRS noted that the transferee’s basis in the bonds would be increased by the amount of the interest income required to be recognized on the transfer. Applying this principle by analogy to the assignment of an IRA, the community spouse would only need to include in gross income any income earned on the annuity following the date of the transfer. But that will not likely provide much comfort to the institutionalized spouse who, under the weight of authority, will be immediately taxed on the full value of the IRA as of the date of the transfer.
The rigidity of tax law in frustrating effective Medicaid strategies is an old and familiar tale. To be sure, the increasing societal reliance on IRAs and 401(k)s in lieu of old-fashioned pension plans facilitates, if anything, more Medicaid planning than it forecloses. But the tax impediment to effective Medicaid planning remains a fact of life. The “IRA MQA to community spouse” strategy, though creative for Medicaid purposes, runs into longstanding tax policy that deprives it of its most important reason for being. Attorneys considering this strategy need to be aware of, and disclose to clients, the potential for adverse tax treatment.