Understanding and Marketing the Five-Year Trust

Understanding and Marketing the Five-Year Trust

By Donna Jackson, LLM, and Leonard E. Mondschein, LLM, CELA, CAP


The five-year trust, or Medicaid asset protection trust as it is sometimes called, is an irrevocable trust designed to hold and preserve assets and either accumulate or distribute income. An individual transfers his or her assets to the trust and usually retains a lifetime income interest in the trust. The ultimate purpose of this trust is for an individual(s) to qualify for Medicaid after five years from the creation and transfer of assets to the trust. Upon the death of the income beneficiary of the trust, the remaining assets may be held for the benefit of a surviving spouse or pass to the remainder beneficiaries, thus avoiding Medicaid estate recovery.

Prior to the Deficit Reduction Act of 2005 (the DRA), the look-back period for transfers of assets was three years for a direct transfer to a beneficiary and five years to a trust. After passage of the DRA, the look-back period for a direct transfer to a beneficiary became five years as well. By creating parity between direct transfers to a beneficiary or to a trust, the DRA had the effect of expanding the market of potential clients for the five-year trust. This article will discuss non-tax and tax issues, as well as suggested ways of marketing the five-year trust.

Non-Tax Considerations

When an individual or couple decide to transfer some or all of their assets to their beneficiaries in order to qualify for Medicaid in the future, a direct transfer to those beneficiaries will subject the assets to the creditors of the beneficiaries. In addition, if the assets are commingled with the beneficiary’s spouse, the assets could be lost in the event of a future divorce action. If the beneficiary dies prior to the death of the transferor, the assets may be inherited by the beneficiary’s spouse and/or children. In all of the above cases, the assets of the transferor(s) could be completely or partially lost. As a result, the assets may not be available to the transferor(s) if needed in the future. In comparison, when assets are transferred to a five-year trust, the assets are protected from the claims of the beneficiaries’ creditors, divorce actions, and premature death of the beneficiaries. 

Other important advantages of a five-year trust over a direct transfer to a beneficiary include the selection of trustees to ensure proper asset management, preservation of family harmony, as well as probate and guardianship avoidance. In addition, the drafting of a five-year trust allows for successor trustees, contingent beneficiaries, and provisions for beneficiaries with substance abuse and/or special needs.

Tax Considerations

For income tax and estate tax purposes, the irrevocable five-year trust, or Medicaid asset protection trust, is drafted to be a grantor trust. A grantor trust is a trust in which the grantor, sometimes called a settlor or trustor, is taxed on the income from the trust because the grantor has retained an interest in the trust. One particular type of grantor trust, called an intentionally defective grantor trust (IDGT), leverages disparities in federal income and estate taxes to provide opportunities for tax, Medicaid, and asset protection planning. The interests that cause a trust to be a grantor trust are set forth under Sections 671 through 679 of the Internal Revenue Code (the Code). 

The following is a list of some powers that would cause a trust to be considered a grantor trust for federal income tax purposes: 

• The power to reacquire the trust corpus by substituting other property of an equivalent value under Section 675(4)(C) of the Code. 

• The power to add additional beneficiaries, other than the grantor, which may include a charitable beneficiary, along with the power held by a non-adverse party to make distributions among those beneficiaries. 

Historically, a grantor did not want the transfer to be a completed gift to avoid gift tax on transfer of the assets to the trust. However, with the federal estate tax exemption set at $11.4 million in 2019 for a single individual, this is of less concern today. 

Some grantor trust provisions are not advisable for Medicaid asset protection trusts, such as: 

• Giving the grantor the power to revoke the trust under Section 676 of the Code; 

• Giving the grantor the power to control the beneficial enjoyment of trust assets under Section 674(a) of the Code.

Since some states are more restrictive as to retained powers, an attorney should review his or her state’s Med­i­caid policy as to the use of such powers. 

Preservation of Section 121 Exclusion of Gain From Sale of Principal Residence

Section 121 of the Code creates an exclusion from capital gains tax of up to $250,000 if the taxpayer’s principal residence is sold and the taxpayer owned and lived in the residence at least two of the past five years before the sale. If the individual is residing in a nursing facility, the individual must have resided in the property for at least one year. A husband and wife may exclude up to $500,000 of gain upon the sale. 

A trust can preserve this benefit if it is a grantor trust as to both income and principal. Such favorable income tax treatment is not available with an outright gift of the home to a child. The sale proceeds to a child will be subject to capital gains tax on the proceeds of the sale that exceed the parent’s cost basis in the property. The power to substitute property of equivalent value under Section 675(4)(C) of the Code is considered a power over both income and principal which will preserve the Section 121 exclusion. 

Preservation of a Stepped-Up Basis at the Death of the Grantor 

When an appreciated asset is included in a decedent’s taxable estate for federal estate tax purposes, it receives a stepped-up (or stepped-down) basis to the date of death value of the property under Section 1014 of the Code. For assets transferred during the donor’s lifetime, the donee receives a “carryover basis,” that is, the donee receives the assets with the donor’s adjusted cost basis, rather than the fair market value of the assets on the date of transfer. 

For highly appreciated assets, as well as assets that are expected to increase in value after transfer to the trust, such as the donor’s residence or securities, obtaining a stepped-up basis at the death of the grantor can be a huge benefit for minimizing or eliminating capital gains tax when the donee sells the assets after the death of the grantor. The benefit of a stepped-up basis can easily be forfeited by outright gifting. 

When the grantor retains the right to the income from the property for life, or the right to reside upon the property during his or her lifetime, the property will be included in the grantor’s estate under Section 2036(a) of the Code. Giving the grantor a limited testamentary power of appointment to change beneficiaries under Section 2038(a)(1) of the Code will also cause the assets to be included in the grantor’s estate at death, in those instances where the grantor has not retained an income interest in the property or the right to reside upon the property. 

Marketing Considerations

Marketing the five-year trust can be divided into four categories. They are target market, venues, key points to address, and closing the sale.

1. Target Market

When considering the target market for the five-year trust, elder clients are the obvious audience. While attorneys may differ on age, most attorneys surveyed believe that persons in their late seventies are the target market. The reason is that the person is young enough to have the capacity to understand and appreciate the disastrous consequences of not planning for long-term care, while old enough to see that the future is right around the corner. 

Another potential market is the spouse or child of a chronically ill person. In these situations, the value of the assets and the length of time before institutionalization will dictate the feasibility of the five-year trust. Those family members can easily understand the implications of what is going to happen if they do not divest some or all of their assets. If there are enough assets, only a fraction of the assets will be lost if nursing home placement can be delayed for a few years. Also, children of aging parents who are not chronically ill will be receptive to this type of planning.

Some attorneys use a “Client Maintenance Program” in their practices that ensures continued contact with their clients on an annual basis. As these clients age, the traditional estate planning documents will not afford them protection from future nursing home costs. At some point, the subject of the five-year trust will become an appropriate topic for conversation, and the trust between attorney and client built up over the years will add credibility.

Another market for the five-year trust is other professionals. Attorneys, accountants, financial planners, and trust officers regularly meet with their clients to do planning for the future. Since the purpose of this trust is for the protection of assets and sometimes income in the event of assisted living or nursing home placement, this type of trust should be of interest to all of the above professionals.

Finally, VA preplanning sometimes requires the transfer of substantially all of a person’s assets to qualify for Improved Pension with Aid and Attendance in the future. The five-year trust is typically used for the qualification of VA benefits after three years, as well as Medicaid benefits after five years. 

2. Venues

Venues for the target audience can be accomplished in many ways. For example, an attorney’s waiting room or conference room is an ideal place to have articles, brochures, and seminar announcements for the five-year trust. Attorneys who do seminars, either for the public or other professionals, can build a marketing program around the five-year trust. In this electronic age, websites, blog posts, videos, and social media attract persons who would potentially have an interest in asset protection for the elderly or disabled. 

In addition, estate planning meetings with younger clients are a great opportunity to talk about the client’s parents, grandparents, or other family members who could benefit from the five-year trust. Also, older clients who are meeting with an attorney to discuss revocable trusts or wills might decide to establish a five-year trust, once they are introduced to the idea.

3. Key Points to Address

Whether the attorney is writing an article, brochure, or presenting a live seminar, there are key points to emphasize regarding the five-year trust. 

The devastating cost of long-term care is the primary point to stress. Current studies showing the rising cost of long-term care should be part of any written materials or PowerPoint presentations. Projections as to the future cost of long term-care are a further illustration of the seriousness of the problem.

Future changes in the law are key points to discuss. When clients realize that current asset protection techniques may very well disappear in the future, they will realize that establishing a five-year trust now could preserve their life’s savings. A good example to discuss is the DRA. When the audience understands how the DRA eliminated planning opportunities, they will realize that nothing should be taken for granted. Hypotheticals illustrating before and after scenarios regarding the DRA will make it easier for the audience to relate to the situation.

One major problem is convincing a potential client to give up control of his or her assets for the safety of an asset protection trust like the five-year trust. While some clients will never give up control, most clients are willing to do so at the appropriate time in their lives. Emphasizing the goals for the client’s family versus losing everything to a nursing home is a powerful argument in favor of the five-year trust. Moreover, it is not an all or nothing decision. The client may feel comfortable giving away substantial assets, as long as he or she retains sufficient assets for any foreseeable shortfall over the next five years. The house and often a second home or rental property is a wonderful asset to place in a five-year trust since income is still received by the client while protecting the asset.

Exploitation of the elderly is growing exponentially. Placing an elderly person’s assets in a five-year trust can help prevent this insidious behavior. The idea of protecting the family’s primary residence in some states where it can be attached, or protecting vacation homes, resonates with elderly persons who have great sentimental connection to where they raised their children. 

Lastly, branding the five-year trust is another effective way to underscore the purpose of the trust. For example, one elder law attorney refers to his five-year trust as the “Legacy Trust.” This type of marketing personalizes the five-year trust and helps evoke a feeling of protecting the elder’s assets for future generations.

4. Closing the Sale

Whether the attorney has presented a live program on the five-year trust or discussed it in person with a potential client, family member, or other professionals, the right follow-up can make all the difference. Sending a letter to the potential client, family member, or other professional is a great way to reinforce points made at the meeting while ending with a call to action. If the attorney sends out a newsletter or uses social media, the potential client, family member, or other professional should be added to the distribution list as part of his or her drip marketing campaign. At some point, a follow-up telephone call will be helpful to remind the potential client of the benefits of this type of future planning. 

Finally, if the attorney presents seminars from time to time, the potential client, family member, or other professional should be sent a courtesy invitation in order to maintain his or her interest.

In conclusion, with the replacement of the three-year look-back period for direct transfers to a beneficiary with a five-year look-back period, the five-year trust has become more popular with clients seeking asset protection in the event of the future need for long-term care. As discussed in this article, the five-year trust has many advantages over a direct transfer to a beneficiary. Elder law attorneys should become knowledgeable regarding the five-year trust as to all non-tax and tax aspects of the trust, as well as the best ways to market this type of planning. As crisis Medicaid planning is curtailed, precrisis planning using the five-year trust will make more sense. 

About the Authors

This article was originally published in the April/May/June 2019 issue of NAELA News. Copyright 2019. 

Donna Jackson, LLM, Oklahoma City, Oklahoma, is a member of the NAELA Board of Directors, a member of the Oklahoma NAELA Chapter Board of Directors, and chair of the NAELA Trusts and Special Needs Trust Section.

Leonard E. Mondschein, LLM, CELA, CAP, is a member of the NAELA Board of Directors, a member of the NAELA News Editorial Board and Past Chair of the NAELA Practice Development/Practice Management Section.

This article is a follow-up to a joint webinar presentation made by the Tax Section, Practice Development/Practice Management Section, and Trust Section of NAELA. The webinar was presented by Donna Jackson, Leonard E. Mondschein, Hyman Darling, CELA, CAP, Fellow, and Robert C. Anderson, CELA, CAP.

The authors would like to recognize Philip H. Mondschein, LLM (Tax), and Hyman Darling for their editorial contributions to this article.

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