Trusts are very common tools used by individuals in estate planning because they avoid the time and expense of probate. Additionally, properly structured trusts are often used in qualifying individuals for Medicaid benefits. As I have written in previous articles, whether trust assets count for Medicaid purposes is not dependent upon whether the trust is revocable or irrevocable; but rather, on how the trust is structured.
One potential problem is using a trust in estate or Medicaid planning is they can create adverse income tax consequences. In certain situations, trusts are taxed as separate legal entities from the settlor (creator of the trust). Taxing trusts as separate legal entities is usually much less favorable then the tax treatment of the settlor or other people involved with the trust.
For instance, in 2025 trusts only received a $300 exemption deduction while individuals receive a standard deduction of $15,750 if they are single, and $31,500 if married filing jointly. This means certain trusts have to file income tax returns and pay income taxes when their income exceeds $300. Conversely, individuals do not have to file income tax returns or pay income taxes until their incomes exceed $15,750 if single, and $31,500 if married filing jointly.
Also, the marginal income tax rates are much higher for trusts than individuals. For example, a trust is taxed at the rate of 37% when its taxable income reaches only $15,200. Single individuals and married couples are not taxed at the rate of 37% until their taxable incomes reach $626,350 and $731,200; respectively.
In many instances, individuals need the legal protections afforded by a trust being taxed as a separate taxable entity, but they do not want to suffer the adverse tax consequences of using such a trust. Medicaid planning provides a good example of such a case. Using a properly structured irrevocable trust may ensure assets are not counted in determining Medicaid eligibility. However, the typical irrevocable trust is treated as a separate legal entity for income tax purposes, thereby creating adverse tax consequences. A very effective solution in solving this problem is ensuring the trust is treated as a “grantor trust” for income tax purposes.
In a grantor trust, the settlor or other person is treated as the owner of all or a portion of the trust property for federal income tax purposes. As such, all income, deductions and credits attributable to the trust property are included in computing the taxable income of the settlor or other person as if the trust did not exist for tax purposes. The grantor trust rules are designed to prevent taxpayers from avoiding tax by transferring property to a trust while retaining certain powers or interests in the trust.
The grantor trust rules are codified in Sections 671 through 679 of the Internal Revenue Code. If the settlor or other person retains certain powers in the trust, then the trust is considered a grantor trust. Those powers include: (1) retention of a reversionary interest exceeding 5% of the value of the trust; (2) power to control beneficiary enjoyment of trust property; (3) administrative powers exercisable in a nonfiduciary capacity such as the power to reacquire trust property by substituting other property of equivalent value; (4) power to revoke the trust and return the property to the settlor; (5) power to distribute income to the settlor or settlor’s spouse; and (6) power in non-grantor to vest income / corpus in a person.
These grantor trust rules allow an individual to qualify for Medicaid by using a properly structured irrevocable trust while at the same time not creating any adverse tax consequences. By including one or more of these grantor trust provisions in the trust, the irrevocable trust’s income is taxed on the settlor’s or other person’s income tax return at rate much lower than the trust’s income tax rates. However, the question becomes whether the assets lose the protection afforded by the trust if the income is taxed to the settlor or other person. The answer is they do not.
Medicaid is codified in the Social Security Act. As such, many of the Social Security regulations in the Program Operations Manual System (POMS) apply to Medicaid. Pursuant to POMS SI 01120.200(D)(3), a trust may provide for it being taxed as a grantor trust for tax purposes. Such a designation does not necessarily mean the assets of the trust are countable resource for Medicaid purposes. The trust must still be analyzed under the Medicaid trust rules as I have discussed in previous articles. Therefore, a person may still receive the benefits afforded by an irrevocable trust while not suffering the adverse tax consequences of using such a trust.
For more information about Medicaid, Medicare, VA benefits, Social Security disability, estate planning and asset planning, visit the website of Senior Resource & Benefits, LLC (“SRB”) at www.srbllc.com call toll-free 1-800-407-9302. All legal services for SRB are provided by the law firm of Riffel, Riffel & Benham, PLLC having a website of www.westoklaw.com and telephone number of 580-234-8447.
