OCTOBER 2009

DRA Update. The State of Indiana has now published its final rule concerning DRA implementation [LSA Document # 08-325(F)], which amends the Indiana Administrative Code, 405 IAC 2, et seq., to conform to the Deficit Reduction Act of 2005. Although the effective date of the new rule is to be 30 days after publication, it is contemplated to be effective as of November 1, 2009. As a consequence, trusts and other transfers which are implemented before November 1, 2009, will be subject to Indiana's current rules, which means that the Medicaid penalty period will commence to run in the month following the transfer, rather than be subject to the harsh DRA requirements. Please refer to previous issues of this newsletter for a general explanation of the implications of the DRA and Indiana's proposed rule. The next issue of this newsletter will report any subsequent changes or developments which may impact Indiana's DRA implementation.

Use of the Irrevocable Income-Only Trust ("IIOT"). One of the devices that I use quite frequently for asset protection and other planning purposes is the so-called Irrevocable Income-Only Trust ("IIOT"). An IIOT is an irrevocable trust that an individual creates, which accomplishes the same probate-avoidance goals of a revocable trust, but which will also protect assets after the applicable Medicaid penalty period has expired, and may also protect assets against the claims of other creditors. Revocable trusts which are commonly used for general planning and probate-avoidance purposes will not accomplish asset protection and will not save taxes, although trusts of various types can be used to save taxes if they are implemented properly. In the case of an IIOT, the grantor retains the right to income, and so the individual's income does not change. The grantor has no right to the principal, although the grantor will typically retain a testamentary power of appointment (i.e., the power to specify under the grantor's last will and testament how the assets ultimately may be distributed among a limited class of beneficiaries, such as children and grandchildren, at the time of the grantor' s death). These retained rights will cause the trust to be a "grantor trust" for income tax purposes, which means that, in general, the grantor will be taxed on the income, including capital gain, and will be entitled to receive the income, although generally the grantor will not be entitled to receive capital gains from sales inside the trust. Because a grantor trust is generally ignored for income-tax purposes, if the grantor transfers a residence to the trust, the same residence exclusion rules would apply as if the grantor had retained ownership of the home and then sold the home. Likewise, at death, when the assets in the trust are distributed to children or other beneficiaries, they will receive a "stepped-up" basis to fair market value at the time of death, thus avoiding any capital gain tax on the sale of the appreciated property subsequent to the death of the grantor except to the extent that the property has appreciated in value after the death of the grantor.

An IIOT is a type of intentionally defective grantor trust ("IDGT"), which is often used for tax purposes as a means of avoiding taxes inside the trust or in respect of trust transactions. The IIOT also provides a means of protecting assets under the Medicaid rules. It is one of the few arrangements which will allow a grantor to come very close to "having his cake and eating it too." While it is not a panacea, it is a very useful mechanism that I use very frequently in my practice and that most clients find to be beneficial. Neither the DRA nor Indiana's implementation of the DRA will have any impact on IIOTs except that the Medicaid penalty period attributable to the establishment of the IIOT may not commence to run until certain other requirements are met. After the five-year "look-back" period has expired, however, irrespective of the potential penalty, the assets in the trust will be "safe" for Medicaid and perhaps other asset protection purposes.

LLC Recognized For Gift Tax Purposes. The Tax Court, in Suzanne Pierre (2009), 133 TC No. 2, held that transfers of interests in a single member limited liability company ("LLC") that was treated as a disregarded entity under the check-the-box regulations were to be valued for gift tax purposes as transfers of interests in the LLC. The IRS took the position that the transfers should be valued based on the underlying assets, which the Tax Court rejected. In Pierre, the transferor transferred more than $4 million in cash and publicly traded securities to an LLC in exchange for a 100% interest which she then transferred to trusts established for the benefit of certain descendants. In valuing the transfers for gift tax purposes, Ms. Pierre applied substantial discounts for lack of marketability and control which reduced the gift tax effect of the transfers. The Tax Court held that the transfers should be valued as transfers of interests in the LLC. The LLC was not disregarded so as to treat the transfers as gifts of a proportional interest in the underlying assets. It should be noted that in transactions involving gifts of LLC interests as well as family limited partnership interests, it is very important to comply with all legal requirements and to document all transfers and related transactions.

Post-Death IRA Planning Options. Many non-spouse beneficiaries who inherit an IRA are surprised to learn that they may be able to minimize the income tax by spreading the inherited account over several years, perhaps even the beneficiary's entire life expectancy. In the case of a deceased IRA owner who is age 70½ or older, the last required minimum distribution must be withdrawn before December 31 of the year of death by the designated beneficiary or beneficiaries. This amount cannot be "stretched." It is withdrawn and taxed in respect of the beneficiary's social security number. After the owner's death, the beneficiary can elect to disclaim the IRA as long as a proper disclaimer is made within nine months of the date of death, but in order to do so, the beneficiary cannot receive any funds before disclaiming, including the year-of-death required minimum distribution. If the beneficiary disclaims, the IRA will then pass to the contingent beneficiary or beneficiaries. In general, the foregoing decision should be made no later than September 30 of the year after death. A surviving spouse has the option of taking a rollover into the surviving spouse's own name, or to elect a five-year rule payout (all funds must be withdrawn within five years), or to elect a life expectancy stretch, in which event all funds are withdrawn over the spouse's life expectancy. A non-spouse beneficiary can elect either a five-year rule payout or a life expectancy stretch. However, the beneficiary must meet the requirements of a "beneficiary" in order to elect the stretch payout or be stuck with a payout under the five-year rule (if the owner died before 70½) or over the owner's life expectancy (if the owner died after age 70½). The date of September 30 after the year of death is sometimes referred to as the beneficiary designation date, as it identifies who will be the official beneficiaries for figuring life expectancies. During this "shake out" period until the September 30 beneficiary designation date, certain beneficiaries, such as charities, or older persons, can be cashed out or can disclaim, so that "undesirable beneficiaries" are eliminated. The remaining beneficiaries can then elect the inherited IRA "stretch payout" without being impacted by the taint of undesirable beneficiaries such as charities or other non-individual beneficiaries. There are special issues involving a trust as a beneficiary, which will be addressed in the next newsletter.

Additional Information. Future issues of this Newsletter will address other issues of current interest. Please contact my office with any questions that you might have.

Previous Newsletter - August 2009