By Attorney Suzanne R. Sayward (December 2010)

Continuing with our three-part series on understanding Trusts, this month’s column discusses reasons why someone might create an Irrevocable Trust. (If you missed last month’s column on Revocable Trusts, visit our website at www.ssbllc.com.) An Irrevocable Trust is a trust that cannot be changed once it is created. Further, once you transfer an asset into an Irrevocable Trust, you usually cannot remove it from the Trust. Irrevocable Trusts are used for very specific reasons. Here are five reasons why you might consider using an Irrevocable Trust as a part of your estate plan.

1. You want to protect assets from having to be spent down on long-term care costs.

The cost of nursing home care in Massachusetts is about $10,000 per month. There are essentially three ways to pay for nursing home care: 1) long-term care insurance; 2) private pay (that is you just write a check each month for your care); or, 3) Medicaid. Medicaid is the state and federally-funded program that pays for long-term nursing home care if a person is both medically and financially eligible. In order to be financially eligible, a person cannot have more than $2,000 in so-called countable assets. To prevent people from giving away their assets in order to qualify for benefits, Medicaid imposes a period of ineligibility following the gratuitous transfer of an asset. In most cases, the ineligibility period for giving away assets is five years from the date of the gift. For people who feel confident that nursing home care will not be needed for more than five years, or who have other sufficient assets or long-term care insurance to pay for their care during the five-year ineligibility period, transferring assets to an Irrevocable Trust can be an effective way to preserve assets for children.

2. You want to keep life insurance proceeds from being taxable in your estate.

Although the new federal tax law enacted on December 17, 2010, exempts estates valued at less than $5 million from federal estate tax (for the next two years), Massachusetts imposes an estate tax on estates valued at $1 million or more. One common estate tax planning strategy is to buy life insurance so that surviving family members do not have to liquidate real estate or borrow money to pay the estate tax. While life insurance proceeds are not taxable income to the person who receives them, life insurance is a taxable asset in the estate of the insured if the insured was also the owner of the policy. If instead an Irrevocable Life Insurance Trust (often referred to as an ILIT) owns the life insurance policy, the proceeds are not part of the insured’s estate.

3. You want to transfer your home or vacation home to your children in a tax favorable manner.

There is a special type of Irrevocable Trust permitted under the Internal Revenue Code that can be used to gift a primary residence or a vacation home to children at a reduced value. This type of trust is called a Qualified Personal Residence Trust (QPRT). Here’s how it works:

Say, for example, Mom owns a primary residence or vacation home worth $600,000 that she wants to gift to her three children. She could transfer it directly to the children; however, this is not the most ‘tax-wise’ way to gift the property. Instead, Mom could transfer the property to a QPRT. Mom would be the beneficiary of the QPRT for a certain number of years. While Mom is the beneficiary she would have exclusive use of the property. At the end of that specific time period, the property belongs to the children and it is not part of Mom’s taxable estate.

Although the transfer of the residence to the QPRT is a taxable gift, it is not a gift of the full fair market value of the property since Mom has kept the right to use the property for a predetermined period of time. The value of the gift is determined using a formula that includes the value of the property and the number of years the parent retains the right to use the property. If, in this example, Mom was 72 years old and kept the right to use the property under the QPRT for eight years, the value of the gift would be about $370,000. The QPRT would allow Mom to gift a $600,000 home to her children for a gift and estate tax ‘cost’ of just $370,000. The ‘catch’ with using a QPRT is that if the parent dies prior to the expiration of the term, the full value of the property at the time of her death is included in her taxable estate.

4. You want to make qualifying annual exclusion gifts to minors.

Many people know they can make annual gifts of a certain amount each calendar year to any number of people without estate or gift tax consequences. The current annual exclusion gift is $13,000 per calendar year per person. In order to qualify as an annual exclusion gift, it must be a “present interest” gift. That is, the recipient must have immediate access to and control over the gift. Parents and grandparents may want to make gifts to minor children or grandchildren, but do not necessarily want the child to have access to the funds at a young age. There is a special type of Irrevocable Trust allowed under the Internal Revenue Code which addresses this issue. If the Trust is properly drafted, then gifts to the Trust will qualify for the annual gift tax exclusion, but the Trust beneficiary’s right to gain access to the funds is restricted until the beneficiary reaches age 21.

5. You want to protect governmental benefits for a person with disabilities.

Individuals with disabilities may be eligible for a variety of governmental benefits that provide income and medical care. Many of these benefits are needs-based, meaning that in order to qualify, a person may not have assets in excess of the program limit, which might be as low as $2,000. There are two situations in which Irrevocable Trusts can be used to protect such benefits. The first is when a disabled individual acquires assets in her own right, such as proceeds from a lawsuit arising from an accident that caused the disability. In that case, assets in excess of the program limit can be transferred to an Irrevocable Trust, sometimes called a Special Needs Trust. Provided the Trust strictly complies with the statutory requirements, the transfer of the assets and the existence of the assets in the Trust will not cause the individual to lose her benefits.

The second situation is when parents or grandparents want to make gifts to a child with disabilities. A Trust can be created for the benefit of an individual with special needs to receive such gifts. In this situation, the Trust may be Revocable or Irrevocable. Such a Trust can receive gifts made for the benefit of the disabled person and the Trustee can use the funds to enrich the beneficiary’s life. Gifts to the Trust would not qualify for the annual gift tax exclusion as noted above. However, for many people this is not an issue, given the new $5 million federal estate and gift tax exemption limits.

There are other reasons why using an Irrevocable Trust may be appropriate for your particular situation. Everyone’s circumstances are unique. Whether or not an Irrevocable Trust is appropriate for your situation depends on your circumstances and goals. In every case, you should consult with a qualified estate planning attorney to review your estate planning needs and develop a plan that meets your family’s goals.

This article is not intended to provide legal advice or create or imply an attorney-client relationship. No information contained herein is a substitute for a personal consultation with an attorney.

Attorney Suzanne Sayward is a partner with the Dedham law firm Samuel, Sayward & Baler LLC and served as the 2009 president of the Massachusetts Chapter of the National Academy of Elder Law Attorneys (MassNAELA). For more information, visit www.ssbllc.com or call (781) 461-1020.