Calling all trust experts !

[LCP]

Can a grantor trust be irrevocable?

A new client came in the other day wondering about her mom's irrevocable trust that was set up in 2005 for the purposes of qulifying her for medicaid.

Her house is in the trust and they started renting it out at the end of 2007. They feared that renting the property would adversely affect her medicaid situation as she's in a home for the elderly.

My initial reaction was that the main issue at this point was to properly show the rental activity on a 1041 and it shouldn't be a problem.

Now that I see the doc though, this irrevecoble trust is a grantor trust and taxes are to be paid by the tustmaker

[Koss]

Grantor Trust

The following text is from the instructions for Form 1041:

Grantor Type Trust

A grantor type trust is a legal trust under applicable state law that is not recognized as a separate taxable entity for income tax purposes because the grantor or other substantial owners have not relinquished complete dominion and control over the trust.

Generally, for transfers made in trust after March 1, 1986, the grantor is treated as the owner of any portion of a trust in which he or she has a reversionary interest in either the income or corpus therefrom, if, as of the inception of that portion of the trust, the value of the reversionary interest is more than 5% of the value of that portion. Also, the grantor is treated as holding any power or interest that was held by either the grantor's spouse at the time that the power or interest was created or who became the grantor's spouse after the creation of that power or interest.

The fact that the trust is irrevocable, in and of itself, does not determine whether it is a grantor trust. The key question is whether the grantor is also a beneficiary. There's certainly more to it than that, but if she put her own house into the trust, then she is a grantor, and if she is named as a beneficiary, then she probably has a reversionary interest.

Just a couple observations:

The trust may or may not hold up as an instrument designed to shield the house from Medicaid recovery by the state. It depends on when the trust was established, when she ran out of money to pay the nursing home, the language and structure of the trust instrument, and other factors that vary from state to state. You need to get an attorney involved.

Even though it may in fact be a grantor trust, the trustee may still be able to choose to obtain an EIN and file a 1041. The problem is that based on the terms of the trust, the rental income may bleed over to the individual taxpayer on Schedule K-1. Here again, it depends on the language of the trust instrument. Is the trustee allowed to retain income within the trust, or is the trustee required to distribute income to the current beneficiaries?

The treatment of the trust under state law is an entirely separate question from its treatment under federal tax law. The state will look at the language of the trust instrument, and apply certain statutory and regulatory principles of state law, to determine whether the assets of the trust are subject to medicaid recovery. They won't care how the trust is treated under federal tax law.

If the trust isn't set up properly, the state can pierce the veil and get to the house. If it's set up correctly, they can't. How you report the trust's income doesn't matter.

If the trust is not set up in a way that will shield the assets, you may be correct that filing a 1041 might allow the trust, and its assets and income, to "fly under the radar."

But if the state really wants to get to those assets, all they have to do is ask whether the elderly woman in question has a beneficial interest in a trust, partnership or other entity. If she answers truthfully, they will ask for a copy of the trust instrument to determine whether the assets or income are subject to medicaid recovery. If she lies and says no, then she's committing fraud. Not tax fraud, but medicaid fraud.

As I have said in many other posts:

It is not the reporting documents and information returns that determine the tax treatment of an item; rather, it is the nature and character of the income that determine the appropriate treatment.

And the same holds true for the question of medicaid recovery.

[Koss]

Further thoughts

If the trust is not set up correctly, it may be possible to modify the terms of the trust, even though it is irrevocable.

The process for doing so involves petitioning a court to authorize changes to the terms of the trust. Sometimes courts can do this if the petition is properly supported by the grantor, trustee, and beneficiaries, and if the reason they want to modify the trust is because...

well, it depends on the state law. Obviously you need to get an attorney involved. The court can order modifications to an irrevocable trust based on clerical errors in the instrument, or changes in the law that occurred after the trust was established. The basic concept is that the terms of an irrevocable trust can be modified if they need to be modified in order to accomplish the original intent of the grantor.