TAX AND ESTATE RECOVERY ISSUES IN CONNECTION WITH INCOME ONLY TRUSTS
by: Begley Law Group
by Thomas D. Begley, Jr., CELA
An Income Only Trust can be designed as a grantor trust. The trust assets are unavailable for Medicaid, but there are some potentially significant tax benefits to the grantor. The Internal Revenue Code contains certain requirements for a grantor trust.
Income Tax. Income is taxed at the grantor’s individual tax rate, which is usually less than the trust’s compressed tax rate.
Capital Gains Tax. Capital gains tax treatment is maintained. This is particularly important if the trust is funded with a primary residence. The §121 exclusion from capital gains tax can be maintained. The trust must contain a provision that the trustee must allocate the gain on the sale of the home to principal and not to income.
The benefit of the capital gains tax can be achieved for non-home appreciated assets as well.
Gift Tax. An Income Only Trust can be designed in such a way that a transfer into a trust can be either a gift or not a gift. If the grantor desires that the transfer be considered a gift for tax purposes, a gift tax return would be filed based on the present value of the gift. This would be the value of the assets transferred, less the value of the grantor’s retained interest in the income stream.
Estate Tax. Since the trust is a grantor trust, the entire value of the estate would be included in the grantor’s estate for federal estate tax purposes.
Because the assets are included in the estate of the grantor, the estate should receive a step up in tax basis as to trust assets to the fair market value of the assets as of the grantor’s death. To achieve the step up in basis, the trust should contain a limited power of appointment on death. In many cases, this is a significant advantage over outright transfers to children.
Estate Recovery. The assets in the Income Only Trust would not be subject to estate recovery in states having a probate definition of estate, but would be included in states having a broad definition of estate for estate recovery purposes.
 I.R.C. §§ 673–677.
 I.R.C. §§ 1014, 2036, 2038; Treas. Reg. §§ 1.1014-2(a)(3), (b).