Using Reserved Special Powers of Appointment in Medicaid Planning
(Note: this is an update of an article of mine published in NAELA Quarterly in 1992.)
Due to their concerns about possible impact of nursing home costs (and the Medicaid disqualification period) on their assets, many aging clients feel under pressure to make transfers of their assets earlier than may otherwise be advisable. One relatively simple way to make such a transfer more palatable to a client is to suggest that the client reserve a power which is known as a non-general power of appointment or a “special power of appointment” (SPA).
What is an SPA?
An SPA is a power which allows someone at a later date to alter the disposition planned under the original instrument of conveyance. This power can be reserved by the client in the original instrument making the transfer.
By virtue of the existence of the SPA, the disposition planned in the original instrument of conveyance amounts to nothing more than a vested or contingent interest subject to divestment. If the SPA is never exercised, however, the property will eventually be inherited by the persons or entities (and in the proportions) originally planned.
The possible alternate recipients of the property named or described in the SPA can be any person or entity. For tax reasons, it seems advisable that the SPA exclude the client, the client’s creditors, the client’s estate, and the creditors of the client’s estate. A power which includes any of this group could be treated as a general power of appointment under Internal Revenue Code sections 2041 and 2514 and saddle the holder of the power with unintended tax consequences. For Medicaid purposes, this group should be excluded, as well as the client’s spouse.
Why does a reserved SPA work?
Two key elements in Medicaid planning are that the property not be reachable by a creditor (such as the state Medicaid program), either (1) during the client’s lifetime or (2) after the client’s death. A transfer which is subject to a reserved SPA can meet both of these tests. As long as the property is vested, albeit defeasibly, in entities or persons other than the client and his spouse, and as long as neither of them have any power to revest the property in themselves, the property should be deemed transferred for purposes of beginning the running of the Medicaid disqualification period. If nursing home care is not needed during the disqualification period, the property is protected in case the need for nursing home care should subsequently arise (unless, of course, Medicaid laws change retroactively, an occurrence which is always a risk in Medicaid planning).
Since the Medicaid disqualification period would begin to run upon the original transfer, any later exercise of the SPA should not cause any additional period of Medicaid disqualification.
Non-tax benefits of reserved SPA to client.
One key benefit of a reserved SPA is that a client who holds such a power maintains a great deal of control over the asset despite the conveyance. An SPA reserved in a deed can amount to a power to change who will eventually inherit the real estate. An SPA reserved in an irrevocable trust can amount to a power not only to change who will eventually inherit the remaining assets of the trust fund, but also to make gifts out of the trust.
A reserved SPA in a deed or irrevocable trust allows an appreciative client the later opportunity to compensate or reward the members of his family who take care of the client and keep the client out of or postpone entry into a nursing home. For example, part or all of the assets of an irrevocable trust with a reserved SPA could be used to build an addition or otherwise revamp the caring child’s home.
If the reserved SPA were banned in the Medicaid planning context, clients would probably resort to making outright gifts, and would have no flexibility to deal with future changes in circumstances. A caring child could then be left in a much worse financial position than another child who takes a share of the client’s assets and later bears no responsibility for the client’s continuing care.
Tax benefits of reserved SPA to client.
The control afforded by the SPA has tax ramifications. For deaths before 2010 and after 2010, at the client’s death, Internal Revenue Code section 2038 will treat the transferred assets as if they had not been transferred, and the full fair market value of the assets as of the client’s date of death will be includible in his federal gross estate. If the assets had appreciated in value during the time of the client’s ownership, this result will often be advantageous to the transferees, as Internal Revenue Code section 1014 then gives each asset a “stepped-up basis.” This means that the value at which each asset is includible in the client’s federal gross estate will then become the asset’s new basis (i.e., the figure above which federal capital gains taxes would later be assessed upon a sale of the asset).
For deaths that occurred during 2010, there are two choices of law, with the default provision being 2011 law, so powers of appointment would receive the treatment described above. If 2010 law is elected by the executor of the estate, the tax law is unclear, but my opinion is that a reserved power of appointment receives similar tax treatment. See my blog post Which Powers of Appointment Are Eligible for a Step-up in Basis in 2010 under the Modified Carryover Basis Rules?
In a Medicaid trust, a reserved SPA which allows the client and/or the client’s spouse to make lifetime gifts out of the trust fund invokes the grantor trust rules (found in Internal Revenue Code sections 671 through 678). Upon a future sale of the home, the use of the client’s $250,000.00 capital gains exclusion under Internal Revenue Code section 121 may thus be preserved.
Example of use of reserved SPA in deed.
Consider the following use of a reserved SPA in a deed: “John Smith hereby grants to his daughters, Mary Smith, Jeanne Smith, and Cheryl Jones, as joint tenants with right of survivorship, the following premises……John Smith reserves the power, exercisable as often as he may choose, by an instrument recorded at this registry of deeds during his lifetime, to appoint these premises, outright or upon trusts, conditions or limitations, to any one or more of his issue or their then current or surviving spouses.”
If Mary, Jeanne or Cheryl are sued, file for bankruptcy, file for divorce, marry a man for whom John feels little affection, become disabled or incompetent, have a falling out with John, or undergo some other change in circumstances or character, John can eliminate the daughter’s interest, can set it up in trust for the daughter and/or her husband, widower or issue, or can make it subject to a right of first refusal.
The SPA may also be of great utility if a daughter predeceases John. By exercising the SPA he could eliminate her interest and the need for probate of her estate. If in the absence of the exercise of the SPA he were to inherit her share of the home, however, a new Medicaid disqualification period may thus begin to run. If this gift had been made to the daughters as tenants in common, upon a daughter’s death John could be revested with the daughter’s share, and an exercise of the SPA could thus begin the running of a new Medicaid disqualification period.
In the above example of a gift to Mary, Jeanne or Cheryl as joint tenants with a reserved SPA in John, the deed could be recorded and the running of the Medicaid disqualification period could begin without time being spent in reviewing or altering the estate plans of John’s daughters. Upon a daughter’s death where the daughters hold title as joint tenants, and upon John’s later exercise of his SPA, he would not begin the running of a new Medicaid disqualification period because he would not have inherited any interest. (If his testamentary wish were per stirpes, however, the possibility of his later becoming incompetent to exercise the SPA makes this maneuver risky, even if it were meant to be temporary.)
Example of use of reserved SPA in irrevocable trust.
Consider the following use of a reserved SPA in an irrevocable trust: “John Smith reserves the power, exercisable during his lifetime as often as he may choose, to appoint any part or all of the principal and income of the trust fund, outright or upon trusts, conditions, or limitations, to any one or more of his issue or their then current or surviving spouses, or to charitable organizations.”
Much of the above discussion regarding deeds also applies here, except that in a trust the remainder interest would not become vested until John’s death, so that a per stirpes testamentary disposition can be initially established without concern for any daughter’s estate plan, or lack thereof.
If changes in the law adversely affect the trust, it may then be advisable to place all of its assets directly into the hands of the daughters. To get assets out of the trust and into their hands, he could use the gifting aspect of the SPA to make outright gifts to them. The SPA thus can amount to a power to terminate the trust.
Can an SPA be used less aggressively?
Clients and their advisors may feel that a reserved SPA in an irrevocable trust as described above may be too aggressive an approach and may someday be deemed to cause Medicaid disqualification on the grounds of excessive control or indirect access to the trust fund. One less aggressive approach would be to eliminate the aspect of the reserved SPA which would allow the client to make lifetime gifts from the trust to other persons. Since a gifting aspect of the SPA may be required in order to activate the grantor trust rules as to principal, the client could instead reserve an SPA which allows him to make unlimited lifetime gifts to charitable organizations. Under this approach the client could not be deemed to have indirect access to the trust fund. In order to maintain the flexibility to terminate the trust in light of future changes in the law, someone other than the client and his/her spouse could be given an SPA under this less aggressive approach.
A future complication could be caused by use of a simple SPA, for a meticulous conveyancing lawyer may require proof that the SPA was not exercised by will. In such a case the transferor’s will may have to be probated, perhaps solely for this reason. This complication can be eliminated by language in the deed which causes a conclusion presumption of the failure to exercise the power by will or codicil if notice of the establishment of probate proceedings is not recorded in the chain of title within a certain time frame after the transferor’s death.
At the same time at which any such deed is executed, the transferor may also wish to execute a durable power of attorney under which one or more of the transferees could release the transferor’s life estate or SPA. Such a power would allow a transferee whom the transferor does not wish to favor financially, but upon whose judgment the transferor feels secure, to later step into the transferor’s shoes and take corrective action if necessary or desirable under future changes in family circumstances or in federal or state law.
By use of the SPA, each remainderperson would have a vested remainder subject to divestment. If a sibling has such an interest and lives in the home for one (1) year, it is possible that one of the permissible transfers under federal Medicaid law could be utilized. Thus, the transferor may wish to give a partial remainder interest to a sibling who could later be persuaded, if feasible, to live in the home for one year prior to the transferor’s institutionalization in order to preserve it for the transferor’s family. At the same time the deed is executed, or thereafter, the transferor could execute a will which exercises the SPA to remove the sibling’s interest; since such a testamentary exercise of the SPA would not be effective until the transferor’s death, the sibling’s “equity interest” would thus remain part of the record title and intact during the transferor’s lifetime.
It should be noted here that, despite the opinion of one legal commentator, any transfer described herein does not necessarily allow the transferor to make full use of the transferor’s $250,000.00 capital gains exclusion under Internal Revenue Code section 121. If the transferor wishes to move in the future to a smaller, less expensive home, the lawyer should consider placing the home into an irrevocable grantor trust in order to preserve this exclusion.