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The following materials were presented at a seminar held in Denver, Colorado, on August 4, 2000, sponsored by HalfMoon Seminars. The materials contained in this page are from the portion of the program presented by Randy Robida. If you would like additional information about the issues discussed herein, related legal issues, or other seminars presented by Randy Robida or HalfMoon Seminars, please contact our office, or HMS.

Please Note: These materials should not be used as a substitute for professional advice where questions of interpretation should be addressed by a professional advisor. Please read the DISCLAIMER before continuing on this page.



Medicaid Planning Tax Traps


1 - Income Tax Treatment of Personal Injury Settlements
2 - New Section 104(a)(2) Rules
3 - Allocation of Damages among Causes of Action and Claims
4 - Who Is the Grantor of a Medicaid Planning Trust


5 - Creation of OBRA '93 Trusts - Gift Tax Treatment
6 - Avoiding the Gift Tax in Connection with the Creation of OBRA Trust
7 - Creation of OBRA '93 Trusts - Income Tax Treatment
8 - Operation of OBRA '93 Trust - Income Tax Treatment
9 - Termination of Trust - Income Tax Consequences
10 - Termination of Trust - Estate Tax Consequences
11 - Estate Tax Planning for OBRA '93 Trusts


12 - Miller Trust - Creation
13 - Miller Trust - Operation
14 - Miller Trust - Termination
15 - Miller Trust - Payment of Income Tax and Tax Preparation Fees


16 - Conservatorships


17 - Asset Transfers
18 - Disposal of Residence

Code Sec. 2038





    1. Medicaid planning often involves substantial sums of money, especially when its done in connection with the settlement of a personal injury suit. It also often involves creation of trusts and transfers of assets. All of these transactions can have significant tax consequences. Unfortunately, tax issues are often overlooked or ignored in the context of a Medicaid planning, even when the amount of money involved is substantial.

    2. Often, in cases involving a personal injury settlement, the Medicaid planning attorney is not brought into the picture until the end of the process when many of the potential tax traps have already been set. The author's experience suggests that the Elder Law/Medicaid planning attorney is usually not brought into a personal injury case until after the parties have agreed to a settlement and sometimes not until after a check has been received by the personal injury attorney. Frequently there has been no consideration of tax issues up to that point.

    1. In addition, Medicaid planning transactions often involve complex income, estate and gift tax issues. Many of these issues spring from areas of the tax law which are not particularly well developed or which include unusually complex tax rules.

    2. Experience also teaches that personal injury attorneys, defense counsel, insurance companies, and structured settlement experts involved in a personal injury case are not always focused on the tax issues affecting the transaction. All of these factors tend to put the Medicaid planning/probate attorney on the list of potential defendants should a major tax issue slip through the cracks.

    3. As a result, it is important that any attorney involved in the creation of Medicaid planning devices understand the potential tax consequences associated with those devices and take action to avoid Medicaid tax catastrophes in connection with the transaction to be implemented.



For federal income tax purposes gross income generally includes all income from whatever source derived. I.R.C. 61(a).

The Supreme Court has said that by the broad language of 61(a) Congress intended to tax all income except those items specifically exempted. Comm. v. Glenshaw Glass Co., 348 U.S. 426 (1955).

Though the determination of what constitutes "income" can be problematic at the margins, it is clear that damages received as the result of a lawsuit are covered by the language of 61. Consequently, unless a damage award is specifically excluded under the Code, it is included in gross income and subject to the income tax. I.R.C. 104(a) provides a limited exclusion in the case of damages received as the result of personal injuries.

2. NEW SECTION 104(a)(2) RULES
The Small Business Job Protection Bill of 1996 made major changes to 104(a)(2) of the Internal Revenue Code effective for amounts received after August 20, 1996 in taxable years ending after such date.

The act revised 104(a)(2) to exclude from income,

The amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.

The act further amended 104 to state that for purposes of the exclusion emotional distress shall not be treated as a physical injury or physical sickness except for certain instances where the amount of damages for emotional distress is not in excess of the amount paid for medical expenses attributable to the emotional distress.

Under new 104(a)(2) punitive damages are not excluded from income even if received as a result of physical injuries, and other damages may be excluded only if they are received on account of personal physical injuries or physical sickness.

However, if an action has its origin in a physical injury or physical sickness, then all damages other than punitive damages that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. For example, damages other than punitive damages received by an individual on account of a claim for loss of consortium due to the physical injury or physical sickness of such individual's spouse are excluded from gross income. H.R. Rep. No. 104-, 104th Cong., 2nd Sess (1996).

It is important to remember that the old rules apply to any amount received on or before August 20, 1996. The old rules should be consulted in connection with any amounts received before the effective date of the new rules.


In a typical personal injury suit there are multiple causes of action and claims. Under 104(a)(2), the allocation of damages among the causes of action and claims may become very important. For example, where an action involves both physical and non-physical injuries, the allocation may determine whether particular amounts are excluded from income or subject to tax.

It is often difficult to determine exactly how the damages from a large settlement should be allocated among the different causes of action and claims. In many cases, the damages received as a result of a personal injury type case are not clearly allocated among the various causes of actions or claims for damages by the parties. In cases involving some claims which are excludable and other claims which are not excludable, the allocation of the award becomes very important. For tax purposes the allocation process depends on whether the damages result from a settlement agreement or an award by a judge or jury.

The Service is not necessarily bound by any allocation made by the parties at the end of the litigation/settlement process. If an allocation is made in a settlement agreement for the sole purpose of accommodating a plaintiff's desire for a particular tax result, that allocation will not be honored. A.M. Metzger, 88 T.C. 834; E.E. Robinson, 102 T.C. 116. Instead, in determining the allocation of a settlement award between different claims (and presumably claimants) the Service will look to the best evidence under the facts and circumstances. Rev. Rul. 85-98, 1985-2 C.B. 51. The Service has shown a tendency to accept an allocation based on the relative values of the amounts set forth in the complaint. Id.

On the other hand, if a settlement agreement is the result of a bonafide arms-length negotiation the Service has indicated that it would accept an allocation made in that settlement agreement. In McKay, 102 T.C. No. 16 (1994), the Tax Court ruled that it would follow an allocation of claims contained in a written settlement agreement if the parties reached the settlement as the result of "bona fide, arms-length, adversarial negotiations." The parties in this case allocated claims in a manner that was highly favorable to the plaintiff in that it resulted in the exclusion of a large portion of the damages from income tax under old 104(a)(2). Predictably, the service challenged the allocation made by the parties. However, the Tax Court held that the allocation would be followed because it was reached as the result of bona fide arms-length adversarial negotiations. It should be noted that if the allocations in the settlement agreement are not consistent with the pleadings and other documents or events leading up to the settlement, it will be difficult for the taxpayer to argue that the allocation is the result of adversarial negotiations. See Robinson, 102 T.C. 116 (1994). Consequently, it is important to consider the tax issues at the beginning of the process. It may be impossible to correct any problems at the end.

Where an amount is awarded by a judge or jury, if the judge or jury does not indicate the allocation of the award among the various claims, the Service will look to all of the facts and circumstances, including the allegations contained the complaint, the evidence presented at trial, the arguments made at trial and any other available evidence. J.E. Threlkeld, 848 F.2d 81 (1988).

Periodic Payments

Assume a taxpayer receives a $100,000 settlement as the result of a personal injury claim involving a physical injury. The $100,000 received would be exempt from income tax under I.R.C. 104(a)(2) as discussed above. However, income earned on the $100,000 after settlement would be subject to the income tax. If instead of taking a lump sum payment of $100,000 the taxpayer negotiates for payments of $15,000 per year for 10 years, none of the amount received would be subject to tax, although the annual payments include an interest factor of approximately 8.15%. (That is annual payments of $15,000 per year for ten years have a present value of $100,000 when discounted at a rate of 8.15%.)

104 (a)(2) of the Code specifically excludes from gross income "the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness" (emphasis added).

Thus, with periodic payments (structured settlements) the taxpayer can exclude from income the imputed interest earned on a settlement as well as the initial settlement amount.

The periodic payment exclusion is not available if the claimant completes settlement for a specified amount and later negotiates periodic payments. For example, if a claimant agrees to accept a certain amount in settlement of his or her claim and the defendant tenders a signed check to the claimant or the claimant's attorney, it is too late at that point to return the check and request that payment be made in the form of a structured settlement. Under such facts the doctrine of constructive receipt would apply and the defendant would be deemed to have constructively received the lump sum settlement amount and would be liable for tax as if he or she had actually received the cash.

Though the tax benefits of periodic payments may be substantial, it is important to keep in mind that the cost is a lack of flexibility and liquidity, which may be needed in the future. For example, monthly payments under a periodic payment plan or an annuity may not be sufficient to provide for large expenses or capital outlays, which may be required from time to time, and a 7% after tax yield which looks good today may not look so good if we encounter double digit inflation and interest rates again.


    1. In analyzing the tax consequences of trusts, it is important to understand who the IRS sees as the owner of the settlement funds used to create the trust. This issue is often confusing to attorneys who are familiar with Medicaid planning because the tax rules in this area differ from the Medicaid rules. However, it is important to focus on this issue because many of the tax consequences flowing from Medicaid trusts result from the determination of who will be treated as the grantor for tax purposes.

    2. In general, for tax purposes, the initial owner of a settlement is the claimant, regardless of whether the settlement funds are actually paid to the claimant or to some other entity such as a trust.

    1. In the eyes of the IRS a settlement reached as the result of a PI claim is based on the claimant's rights, and consequently belongs only to the claimant. Rev. Rul. 83-25, 1983-1 CB 116; Buhl v. Kavanaugh, 118 F.2d 315 (6th Cir. 1941); Blackman v. U.S., 48 F. Supp 362 (Ct. Cl. 1943); Priv. Ltr. Rul. 8942083.

    2. For tax purposes the grantor of a trust is the person who furnishes the trust funds, not necessarily the person named as grantor in the trust agreement. Buhl v. Kavanagh, 118 F.2d 315 (6th Cir. 1941), 26 AFTR 687, 41-1 USTC par. 9319; Blackman v. U.S., 30 AFTR 846 (Ct. Cl. 1943); Priv. Ltr. Rul. 9004007.

    3. If the claimant is the "owner" of the settlement for tax purposes, the claimant is also the grantor of any trust established with the settlement proceeds (at least for tax purposes) - regardless of who is named as the grantor in the trust agreement.

    4. Thus, when the court is the nominal grantor of a trust, there is little basis for arguing that the court should be treated as the grantor for tax purposes because it is clear that the court did not furnish the funds.

    5. Where the nominal grantor is the defendant, there may be some rational basis for arguing that the defendant should be treated as the grantor for tax purposes since the defendant actually provided the funds. However, there do not appear to be any cases or rulings which take this position.

    6. It is important to understand that the above analysis is based on the Internal Revenue Code and applies for tax purposes only. Treatment of the transaction for Medicaid purposes is a completely separate and unrelated matter and is determined under the relevant Medicaid laws. The fact that a settlement is treated as belonging to the claimant for tax purposes should have no significance for Medicaid purposes.



Because a settlement is deemed to belong to the claimant for tax purposes, the funding of a trust with the proceeds of a personal injury settlement is treated as a transfer from the claimant to the trust. The transfer may or may not constitute a completed gift for gift tax purposes depending on the terms of the trust. This is true even though the funds may pass directly from the defendant or defendant's insurance company into the trust. Consequently, the claimant may be subject to gift tax when the proceeds of the settlement are put into a trust.

If a trust is established with someone else's property (e.g., a parent's assets), the person providing the property is treated as the grantor for tax purposes, and a completed gift results if the grantor has surrendered dominion & control over the property transferred as discussed below.

Generally, a transfer is deemed to constitute a completed gift where the donor has so parted with dominion and control as to leave in him no power to change its disposition whether for his own benefit or for the benefit of another. Reg. 25.2511-2(b). It is not necessary that there be an identifiable donee for a transfer to constitute a completed gift for gift tax purposes. Reg. Section 25.2511-2(a). Where a transferor transfers property to a third person in trust, the transfer constitutes a completed gift if the transferor retains no power to control the disposition of the property, even if the trustee has discretionary authority to make distributions back to the transferor. Reg. 25.2511-2(b).

For example, in the case of a trust funded by settlement proceeds where the claimant is the beneficiary of the trust, if the trust document calls for discretionary distributions to the beneficiary for life followed by the required reimbursement of Medicaid expenses with any remainder to pass to the beneficiary's issue at death, the transfer of property to the trust would likely constitute a completed gift subject to the gift tax. Such a transfer will constitute a completed gift unless, under state law, the beneficiary has an enforceable right to distributions in spite of the discretionary language of the trust. This is true even though the parties contemplate that a large portion of the trust property may be distributed to or for the benefit of the transferor/beneficiary during life.

In light of the above analysis it is important to draft the trust so that transfer of property to it does not result in a completed gift. There are a number of ways to accomplish this. Perhaps the simplest is to give the transferor a testamentary general power of appointment over the assets that remain in the trust after payment of any Medicaid reimbursement. Retention of such a general power of appointment will prevent the transfer of property to the trust from constituting a completed gift. This is true even though the transferor may lack the capacity to exercise his or her general power of appointment. Note that there may be times when it will be better to draft the trust so that the transfer does constitute a completed gift in order to avoid estate taxes later on.

Note that where a taxpayer makes a transfer, contending that he or she has retained a power which renders the gift incomplete, the taxpayer is still required to file a gift tax return which includes a copy of the instrument of transfer and discloses all relevant facts associated with the transfer. Reg. 25.2511-2(j).


There are other ways of avoiding the gift tax in connection with the creation of a trust. These other methods are important because assets transferred to a trust which is drafted so as not to result in a completed gift at the time of transfer will generally be included in the estate of the beneficiary at death and consequently will be subject to the estate tax. Therefore, techniques which avoid transfer of assets to the trust, not only avoid the initial gift tax, but possibly the subsequent estate tax associated with the trust.

Gift Tax Planning Prior to Final Settlement

Perhaps the best Gift Tax planning strategy is to include other potential beneficiaries of any damage award as claimants in the initial pleadings. This may be difficult. With a limited number of exceptions, only an actual injured party has standing to file a personal injury claim. For example, in Colorado a parent has an independent right of action for the loss of a child's services during minority and may recover certain expenses incurred as a result of an injury to a minor child, but a parent cannot make a claim for loss of consortium or apparently for any other damages stemming from injury to a child.

For example, in a case involving injuries to a minor it would be wise to include the minor's parents and possibly siblings as claimants (to the extent they have claims recognizable under state law) so that a portion of any settlement may be allocated to them, thus keeping it out of the minor's estate. E.g., if a parent will have to stay home to provide for an injured child, that parent may have a valid claim for projected lost income. (Note that to the extent a portion of the damage claim is allocated to anyone other than the "primary" claimant, a separate determination will be required as to whether that portion of the award is the result of a personal injury and therefore exempt from the income tax.)

If an allocation to a parent or sibling is to be respected by the IRS it must be supported in the pleadings and other documents associated with the case.

To the extent a settlement can be allocated to additional parties, they can reduce gift and estate taxes by making use of the $675,000 lifetime gift and estate tax exemption equivalent available to every individual.

Example: In the case of a settlement of $1,800,000, if the settlement can be allocated equally between the injured child and each of her parents, all gift and estate tax can be eliminated on subsequent transfers of the settlement proceeds to other family members (assuming that neither the child nor either of her parents has previously used any of their $675,000 exemption equivalent).

In determining whether to and how to allocate a portion of a damage claim among other potential claimants, the advisor should consider the tax implications of the separate claims. For example, if a portion of a claim is to be allocated to the parent of an injured child, will such portion be excluded from income under 104 and, if not, will the estate and/or gift tax benefits exceed the income tax cost associated with the allocation?

Gift Tax Planning After the Settlement. Once settlement is complete, there are still several planning strategies available. At this point, the strategies are the same as the gift and estate tax planning strategies available to any individual with a substantial net worth. These will be discussed in more detail as part of the estate tax planning section of the outline.


The transfer of property to a trust generally has no income tax consequences to either the individual transferor or the trust.


Under Internal Revenue Code 677 the grantor will be treated as the owner of any portion of a trust whose income may be distributed to the grantor without the consent of an adverse party. Payments of a grantor's medical expenses are treated as distributions to the grantor. Consequently, Medicaid trusts should be classified as grantor trusts under 677.

The income and expenses of a grantor trust are reported on the individual income tax return of the grantor. As a result, the income, expenses and other tax attributes of most Medicaid trusts are reported on the individual income tax return of the grantor/beneficiary.

Even so, the trust is required to file a trust income tax return (Form 1041) if the trust has $600 or more of gross income for any taxable year. The return filed by the trust need only contain the name, address and other basic trust information and a statement showing the income and expense items which are reported on the individual return of the grantor. The statement must also show the grantor's Social Security number.

The rules which excuse the filing of a return by certain grantor trusts where the grantor and the trustee are the same individual generally will not apply to a Medicaid trust. (See page 7 of the instructions to Form 1041.)


On the death of the grantor/beneficiary Medicaid trusts generally provide for the required Medicaid reimbursement with any remaining trust property to be distributed according to the terms of the grantor/beneficiary's will.

The trust terminates for tax purposes when all debts have been paid and final distributions have been made. However, trust income tax returns will be required for the trust's final year if the trust receives over $600 in gross income. Consequently, the trustee should provide for preparation of final tax returns prior to making final distributions from the trust.

The trustee should be aware that the Internal Revenue Service generally has three years from the date a return is filed to audit that return. Consequently, it is possible that a trust income tax return could be audited after final distributions have been made from the trust. In the event the audit determines that there is a tax liability, the trustee could be put in the position of having to pay the liability and then seek reimbursement from trust beneficiaries. In the context of a grantor trust, this issue is generally not a major concern. However, there are procedures for requesting a quick assessment by the IRS should the trustee desire to do so.

The reimbursement of Medicaid expenses may qualify as a medical deduction on the final income tax return of the grantor/beneficiary.


When an individual dies his or her estate will be subject to the estate tax if the value as of the date of death of the individual's estate exceeds $675,000 after deduction of specified expenses and liabilities. Consequently, if the value of the assets in a trust exceed $675,000 on the date of the beneficiary's death and if the trust assets are included in the beneficiary's estate, there may be a resulting estate tax liability.

Generally, the trade-off for drafting a trust so that the initial transfer to the trust will not constitute a completed gift is that on the death of the beneficiary the property in the trust will be included in the beneficiary's gross estate for estate tax purposes.

For purposes of the estate tax the value assigned to the assets of the trust will be fair market value at the date of the transfer/beneficiary's death.

For example: Suppose taxpayer P wins a $5,000,000 personal injury settlement which is immediately placed into a trust which contains a testamentary general power of appointment to avoid gift taxes. If P dies one year later when the value of the trust is still at $5,000,000 his estate will be subject to an estate tax of something on the order of $2,000,000.


As discussed above, property remaining in a Medicaid trust after payment of expenses, (including the mandatory Medicaid reimbursement) will generally be included in the estate of the deceased beneficiary/grantor for estate tax purposes. Because of the potentially large burden imposed by the estate tax, it is important to plan for estate taxes in advance. If possible, estate tax planning should be considered prior to final settlement of the personal injury claim. Additional estate tax planning strategies can be used after the claim has settled.

Estate Tax Planning Prior to Final Settlement

The primary estate tax planning strategy prior to final settlement of a personal injury claim is to make sure that any family members or other appropriate parties with potentially valid claims are included as claimants in the pleadings.

This allows the parties to allocate any settlement among the different claimants, which in turn allows each claimant to take advantage of the $675,000 lifetime gift and estate tax exclusion and the $10,000 per donee annual gift tax exclusion.

Note: Use of the $10,000 annual gift tax exclusion does not use any of the $675,000 lifetime exclusion.

To the extent it makes sense to do so in light of non-tax considerations, Estate Taxes may be reduced by allocating as much of the settlement as possible to younger generations. For example, if an injured party has both parents and children with potentially valid claims, it will save Estate Taxes if a large portion of the settlement can be allocated to the children. This is because whatever is allocated to the children will not have to pass through the parents' estates.
Estate Tax Planning After Final Settlement

Once settlement has occurred and the proceeds have been transferred into a trust, estate tax planning is essentially the same as for any individual with substantial wealth. However, in the context of a trust the estate tax planning options may be severely limited by the restrictions on distributions from the trust.



Gift Tax Treatment. Because the grantor retains the use and enjoyment of the trust property, funding of a Miller Trust is not a completed gift and is not subject to the gift tax.

Income Tax Treatment. Because the assets of a Miller Trust are to be used to pay for the beneficiary's medical expenses, a Miller Trust will be treated as a grantor trust under 677 of the Internal Revenue Code. That section provides that a grantor shall be treated as the owner of any portion of a trust whose income can be distributed to or for the benefit of the grantor without the approval or consent of an adverse party.

As discussed elsewhere in this outline, the trust will still be required to file an abbreviated fiduciary income tax return (Form 1041). The return will contain the name, tax identification number and other basic information about the trust, as well as a statement of income and expenses which statement will indicate that those items are reported on the personal income tax return of the grantor. This statement must include the grantor's Social Security number.

Only grantor trusts under which the grantor and the trustee are the same person, are excluded from the tax return filing requirement.


Income Tax Issues. As discussed above, a Miller Trust will virtually always be a grantor trust for income tax purposes. This means that the income and expenses of the trust will be reported on the individual income tax return of the trust beneficiary. The primary income tax issue in Miller Trust situations is the deduction of the medical expenses paid by the trust. Since these expenses are reported on the individual's income tax return, they are subject to the same rules for deduction as medical expenses incurred directly by the individual.

Generally, the expenses associated with placement in a nursing are deductible as a medical expenses (subject to the 7.5% AGI4) so long as placement in the nursing home was required for medical purposes.

Deduction of Legal Fees as Medical Expenses. In C. A. Gerstacker, 414 F.2d 448 (6th Cir. 1969), the Court ruled that legal expenses incurred in establishing conducting and terminating a guardianship where the purpose of the guardianship was to provide for compulsory medical confinement of the patient were deductible as medical expenses. In revenue ruling 71-281, 1971-2 C.B. 165, the Service indicated that it would follow the Gerstacker decision in that it held that legal fees necessary to authorize medical treatment were deductible medical expenses. In T.M. Smith, TC Memo 1982-441, the Tax Court held that legal fees were deductible as a medical expenses in a similar situation where the legal fees were incurred in connection with obtaining the patient's commitment and hospitalization for treatment of a mental illness. In light of these cases, it appears that the taxpayer would have a reasonable basis for deducting the legal fees associated with the creation of a Miller Trust as a medical expenses where the Miller Trust is put in place for the purpose of providing for services that qualify as medical treatment to the beneficiary. This same rationale may also apply with respect to legal fees incurred in creating other Medicaid trusts.

Gift and Estate Tax Issues. Generally, there will be no gift or estate tax issues associated with the operation of a Miller Trust.


Income Tax Issues. There should be no special income tax issues associated with the termination of a Miller Trust. The trust will be required to file a final income tax return if it has received $600 or more of gross income in its final tax year. The beneficiary of the trust will also be required to file a final income tax return if he or she meets the gross income and other filing requirements in the year of death (taking into account the income passed through from the trust).

Estate Tax Issues. As a practical matter there should rarely if ever be estate tax issues associated with the termination of a Miller Trust. Individuals for whom Miller Trusts are appropriate seldom have sufficient assets to create an estate tax liability.

In addition, because of the restrictive provisions regarding distributions from a Miller Trust, there will generally be no gifts from the trust during its existence. (Payments of the beneficiary's medical expenses are treated as distributions to the beneficiary.)


It should be noted that there appears to be some confusion within the state Department of Social Services regarding income tax issues associated with Miller Trusts. The state has apparently told some attorneys that the IRS has that medical expenses paid by a Miller Trust are not deductible because a trust cannot have medical expenses. As discussed above, a Miller Trust should be treated as a grantor trust for income tax purposes. Consequently, the medical expense deduction will be taken on the individual return of the beneficiary and not the trust return and the analysis discussed in the preceding sentence should not apply.

In addition, there has been some confusion among the legal community regarding whether Miller Trust funds can be used to pay an income tax liability or to pay tax return preparation fees. The author's understanding is that the state's current position is that Miller Trust income can be used to pay a tax liability but not to pay for tax return preparation fees. When asked how a Miller Trust was supposed to get its tax returns prepared, a representative of the state department of Social Services indicated that tax return preparation fees should come out of the beneficiary's monthly allowance.



Not treated as a separate taxable entity. A conservatorship probably falls within the technical definition of a trust under the Code. See Reg. 301.7701-4. However, the IRS has historically not treated conservatorships as separate taxable entities nor required them to file returns. In addition, the beneficial interest in the property transferred to a conservatorship still belongs to the protected person. Consequently, there are usually no estate or gift tax issues associated with the formation of a conservatorship.

Because the IRS treats the property held by the conservatorship as belonging to the protected person, any gift or estate tax analysis will be exactly the same as if the protected person held the assets directly.



There are no exceptions to the application of the income and gift tax rules for transfers of property made for Medicaid planning purposes. In general, if property is transferred for less than its fair market value there is a gift, regardless of whether the transferor intended to make a gift. On the other hand, if property is transferred for fair market value, there is a sale with the usual income tax consequences.

When a parent (or anyone else for that matter) transfers property for medicaid planning purposes the transfer is most often for no consideration and a gift results. If the value of property transferred to a particular donee in any tax year is less than $10,000 the gift may qualify for the annual exclusion and, if so, a gift tax return is not required. To qualify for the exclusion the gift must be of a present interest, as opposed to a future interest, in the property transferred.

If the transfer is of a future interest, or is of a value greater than $10,000 the donor is required to file a gift tax return for the year of transfer. Like the income tax return, the gift tax return is due on April 15th of the year following the year in which the gift is made. A gift tax return can be extended on the same form used for extending an income tax return.

There is a credit against gift and estate taxes equivalent to an exemption of $675,000 in 2000. The amount is scheduled to increase to $1,000.000 by the year 2006. Use of the annual $10,000 exclusion does not count against the lifetime $675,000 exemption.

Example: A makes a gift of $9,999 to be in 2000. A is not required to file a gift tax return for 2000 and does not use up any of his $675,000 lifetime exclusion. If A made of gift of $25,000 instead he would be required to file a gift tax return. He would use the $10,000 annual exclusion, resulting in a taxable gift of $15,000. There would be no tax due, but his remaining available lifetime exclusion would be reduced from $675,000 to $660,000.

Gifts are specifically excluded from income, so the recipient does not pay income tax on gifts. In general, the recipient takes the donor's tax basis in the property received.

Example: A gives B a 1962 Corvette with a fair market value of $12,000. A paid $6,000 for the car a few years ago and has not taken any depreciation or made any improvements to it. B does not have to report the receipt of the car as income and gets a carry over basis of $6,000. If B sells the car for $12,000 he will have a taxable gain of $6,000.


One planning technique is to transfer the client's residence to his or her children. As with any transfer of property this has income and gift tax consequences.

Income Tax

The transfer of the residence is a gift, usually to the client's children. As discussed above the recipient of a gift does not recognize income for tax purposes and takes the transferor's tax basis in the property received.

If the client (the transferor) will remain in the house it is probably best to pay fair rental to the new owners of the property. Though the IRS has not shown an inclination to impute income to the rent free use of the property for income tax purposes the rent free use creates estate tax concerns and will likely cause the date of death value of the property to be subjected to the estate tax on the donor's death.

Gift Taxes

The transfer of a residence for less than fair market value is a gift subject to the gift tax.

The value of the gift is the value of the residence at the time of the gift reduced by the value of any mortgage or deed of trust to which the property is subject.

If the net value of the property exceeds $10,000 (per donee) a gift tax return will be due.

Example: C transfers a residence worth $200,000 to his 5 children as tenants in common. There is no mortgage on the house. C has made a gift of $40,000 to each of his 5 children and will have to file a gift tax return on April 15th of the following year. The return will show taxable gifts of $150,000 ($200,000 total less 5 $10,000 exclusions). Assuming C had not previously used any of his lifetime $675,000 exemption his available lifetime exemption will be reduced by $150,000 to $525,000

PLR 9437034

Code Sec. 2038

* Sec. 2038 Issues: Revocable transfers (included v. not included in gross estate).


This is in response to your letter dated February 18, 1994, and other submissions in which you request a ruling concerning the inclusion in the decedent's gross estate of an irrevocable inter vivos trust funded with proceeds from a settlement of a lawsuit.

The decedent, a United States citizen, died testate in October 1993. Several months prior to his death, the decedent was injured in an automobile accident resulting in severe, permanently disabling injuries. Litigation was instituted on his behalf relating to the accident. The case was settled in May 1993 pursuant to a settlement agreement entered into between the decedent and the defendants. The defendants agreed to pay a lump sum amount and a specified amount monthly for the longer of the decedent's life or 10 years. These funds were to be paid to an irrevocable trust established for the support of the decedent.

A special needs trust was created to receive these funds. The decedent's mother was designated as "trustor" and a bank was named as trustee. The terms of the trust provide that the trustee is directed to pay to or apply for the decedent's benefit such amounts from the principal or income, up to the whole thereof, as the trustee in its sole discretion deems necessary for the satisfaction of the decedent's special needs. Any income not distributed is to be added to principal. The term "special needs" is defined as those requisites for maintaining the decedent's good health, safety, and welfare when, in the discretion of the trustee, such requisites are not being provided by any public agency or department of the federal government.

The trust was to terminate on the death of the decedent at which time the corpus was to be distributed pursuant to the exercise of a testamentary special power of appointment held by the decedent. The decedent could appoint the corpus to any person or persons, other than his estate, his creditors, or the creditors of his estate.

The trust was initially nominally funded by the decedent's mother. The lump sum settlement amount was received by the trustee in June 1993, and the monthly payments were to commence in January 1994. Under the terms of a will executed in August 1993, the decedent exercised the special power of appointment by appointing the trust corpus to designated individuals.

You request that we rule whether the corpus of the trust (the lump sum payment plus installments payable for 10 years) described above is includible in the decedent's gross estate for federal estate tax purposes.

Section 2038(a)(1) of the Internal Revenue Code provides that the value of the gross estate includes the value of all property of which the decedent has at any time made a transfer (except where there has been a bona fide sale for adequate and full consideration in money or money's worth), by trust or otherwise where the enjoyment thereof was subject at the date of death to any change through the exercise of a power by the decedent, to alter, amend, revoke, or terminate the interest in the property or where the decedent relinquished this power within the three-year period ending on the date of the decedent's death.

Section 25.2511-2(b) of the Gift Tax Regulations provides that the transfer of property constitutes a completed gift to the extent that the donor has so parted with dominion and control of the property as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another. However, if the donor reserves any power over the disposition of the property, the gift may be wholly incomplete, or may be partially complete and partially incomplete, depending upon all the facts in the particular case. Accordingly, in every case of a transfer of property subject to a reserved power, the terms of the power must be examined and its scope determined. For example, if a donor transfers property to another in trust to pay the income to the donor or accumulate it in the discretion of the trustee, and the donor retains a testamentary power to appoint the remainder among his descendants, no portion of the transfer is a completed gift.

In Estate of Robinson v. Commissioner, 675 F.2d 774 (5th Cir. 1982), the donor made a community property election to take under the will of her husband and transfer her interest in her community property to a testamentary trust created under her husband's will for her benefit during her lifetime. Under the terms of the trust, the donor possessed a power to appoint the trust property attributable to her contribution. The property could be appointed to her children, to the surviving spouse of any deceased child, or to charity. Subsequently, the donor released the power and the Service maintained that the release of the power constituted a completed gift of the remainder interest portion of her contribution.

Citing section 25.2511-2, the court held that the donor's initial transfer of the community property interest to the trust was an incomplete gift because of the special power granted the donor. The donor argued that the release of the power should not constitute a transfer of the trust remainder that would be subject to gift tax since, if she had not released the power, the trust would not be includible in her gross estate. The court specifically rejected this argument and held, inter alia, that the special power constituted a retained power to change the enjoyment of the trust corpus through a power to alter, amend, or revoke under section 2038. See also, Estate of Vardell v. Commissioner, 307 F.2d 688, 690 (5th Cir. 1962).

In the present case, under the settlement, the defendant agreed to pay a lump sum and make monthly payments over the longer of the decedent's life or a period of 10 years. The lawsuit was brought by the decedent as plaintiff, and emanated from an automobile accident in which he had been seriously injured. The lawsuit was, thus, based on a cause of action personal to the decedent. The proceeds compensated the decedent for his personal injuries.

Under these circumstances, the proceeds from the settlement of the lawsuit were the decedent's property and, thus, the decedent is the transferor with respect to the funds placed in the trust, notwithstanding the designation of the decedent's mother as "trustor." Under the terms of the trust, the decedent retained the right to alter the disposition of the trust corpus at his death through exercise of the special testamentary power of appointment. In view of this retained power, the initial transfer of the funds to the trust constituted an incomplete gift under section 25.2511-2(b), and the trust corpus is includible in the decedent's gross estate under section 2038. Estate of Robinson, supra at 778. See also, section 2036(a).

Accordingly, we conclude that the corpus of the trust described above is includible in the decedent's gross estate for federal estate tax purposes under section 2038.

Except as we have specifically ruled herein, we express no opinion under the cited provisions or under any other provision of the Code.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.


Assistant Chief Counsel
(Passthroughs and Special Industries)

By ____

George Masnik

Assistant to the Branch Chief

Branch 4


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