Using Reserved Special Powers of Appointment in Deeds and/or Irrevocable Trusts in MassHealth Planning

Due to their concerns about possible impact of nursing home costs 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 non-general power of appointment, also known as a limited or special power of appointment (“SPA”), in a deed or irrevocable trust.

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, or granted to somebody else. In 2017, the Massachusetts Appeals Court ruled that such a SPA in a deed is a valid transfer; see Reservation of Special Power of Appointment in Deed Is Approved by Massachusetts Appeals Court in 2017 Case of Skye v. Hession. 

By use of the SPA, each remainderperson (the persons inheriting the remainder of an irrevocable trust, or the persons to whom real estate was deeded) would have a vested remainder subject to divestment.  If the SPA is never exercised, however, the property will eventually be owned 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, but for tax and MassHealth reasons, the SPA should exclude the client, the client’s creditors, the client’s estate, and the creditors of the client’s estate. (If the SPA limits the appointment power to a group, under settled law the power automatically excludes 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 MassHealth consequences. For MassHealth purposes, the client’s spouse should also be excluded.

Why does a reserved SPA work in MassHealth planning?

Two key elements in MassHealth planning are that the property not be reachable by a creditor (such as the state MassHealth 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 the client’s 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 MassHealth disqualification period. If nursing home care is not needed during the MassHealth disqualification period, the property is protected in case the need for nursing home care should subsequently arise (unless, of course, federal Medicaid laws change retroactively, an occurrence which is always a risk in MassHealth planning).

Since the MassHealth disqualification period would begin to run upon the original transfer, any later exercise of the SPA should not cause any additional period of MassHealth disqualification.

Tax benefits of reserved SPA to the client

The control afforded by the SPA has tax ramifications. 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 the client’s 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).

The SPA prevents a completed gift from being made for gift tax and capital gains tax purposes.  Under Treasury Regulation Section 25.2511-2(b), the funding of an irrevocable trust or deeding of real estate with an SPA would be considered an incomplete gift.

In an irrevocable 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 679). 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. Since a gifting aspect of the SPA may be required in order to activate the grantor trust rules as to principal, the client could reserve an SPA which allows him to make unlimited lifetime gifts to charitable organizations. Under this approach the client should not be deemed to have even indirect access to the trust fund, but be leery of the Supreme Judicial Court’s shockingly ignorant comment in the 2017 Daley case about a power of appointment that allowed gifts to nonprofit organizations. Because the SJC’s dicta will undoubtedly be considered to be an educated comment (although the issue had not been briefed or even mentioned by the parties), it may be advisable in drafting to take pains to specify that the powerholder cannot make a gift to pay a debt; somehow the SJC justices did not seem to consider that basic concept  when issuing its kneejerk comment.

It should be noted here that, despite the opinion of one legal commentator, an SPA in a deed 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 drafting lawyer should consider placing the home into an irrevocable grantor trust in order to preserve this exclusion.

Example of use of reserved SPA in a 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 MassHealth 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 MassHealth 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 MassHealth 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 MassHealth 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 an 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.

Should an SPA have self-destructing language?

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 or trust 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.

Is the insertion of a life estate and/or an SPA in a deed a better overall move than the establishment of an irrevocable trust?

Irrevocable trusts have for a few years now been under attack from lawyers at the Office of Medicaid, and as one elder law attorney once said to me, no client wants to be a test case. The inclusion of an irrevocable trust in a MassHealth application right now is practically a guaranteed denial, and the outcome of the fair hearing appeal is often based on which hearing officer is assigned to your case.  See www.irrevocabletrust.info for over 200 recent fair hearing appeals regarding irrevocable trusts, with the Office of Medicaid Board of Hearing’s appalling lack of knowledge of trust law and utter disregard for administrative consistency being the main points one can take from a close reading of the hearing decisions.

The combination of a life estate and a SPA usually has the same estate tax result as an irrevocable trust, with a step-up in basis received by the remainderpersons, but does not have the same capital gains tax result upon a lifetime sale, where an irrevocable trust would often not be subject to capital gains taxes but the remainderpersons would be subject to them. These lifetime capital gains tax issues, centralized management and the fiduciary duties of a trustee may be the main advantages of an irrevocable trust, but other issues may be of greater importance to the client.

The nonexistence of fiduciary duties on the part of the remainderpersons in a deed with a life estate and/or SPA would prevent the deed from being treated as a trust under Medicaid law. Further, an SPA reserved by the client should not be subject to a lifetime lien or post-death estate recovery because it is not a property interest.  (See Restatement 3rd Property (Wills and Donative Transfers) §22.1 Comment a (“a nongeneral power of appointment is not an ownership-equivalent power.” Also, see Restatement 2nd (Donative Transfers) 13.6, Comment b (“Where a non-general power has been created, the donee is not in the position of an owner either as a matter of common law doctrine or the practicalities of the situation.) )  Still, proposed regulations issued but he Office of Medicaid in November of 2016 treated a deed with both a life estate and an SPA as a trust, so it is probably best for long-term planning purposes not to have both of them in the same deed.

Besides the capital gains tax ramifications for a sale during the client’s lifetime, there are significant reasons that an irrevocable trust may not be the better move. An irrevocable trust is set in stone, whereas persons to whom the real estate is transferred could choose to adapt to changing circumstances.  For example, an irrevocable trust could not ever participate in a reverse annuity mortgage due to the prohibition of principal to its settlor, but the remainderpersons in a deed could someday choose to expose their own established personal financial interests in order to obtain such a mortgage. In addition, for the first 5 years after a transfer, a life estate or an SPA would actually be better than an irrevocable trust, because the remainderpersons could choose to transfer the real estate back to the client and cure the disqualifying transfer, whereas the funding of an irrevocable trust would doom the client to the consequences of waiting 5 years and a day before applying for MassHealth.

Under the Rule 1.4(b) of the Massachusetts Rules of Professional Conduct, a “lawyer shall explain a matter to the extent reasonably necessary to permit the client to make informed decisions regarding the representation.”  Under Rule 1.0(f), the term “informed consent” is defined as “the agreement by a person to a proposed course of conduct after the lawyer has communicated adequate information and explanation about the material risks of and reasonably available alternatives to the proposed course of conduct.”  The recommendation of an irrevocable trust to a client when there are other, simpler ways to accomplish the client’s primary goals may fall short of that standard.