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George F. Bearup, J.D. Senior Legal Trust Advisor

17-Aug-22

Self-Settled Income-Only Trusts, Medicaid and the Power to Adjust

Take-Away: An income-only self-settled trust enables a settlor to qualify for Medicaid eligibility. The danger is that if the settlor retains other rights in and to the corpus, that then makes the trust’s assets ‘countable’ for Medicaid eligibility. In addition, giving the trustee  the ‘power to adjust’ under the Michigan Uniform Principal and Income Act will cause the trust’s assets to be ‘counted’ for Medicaid eligibility determinations.

Background: The Michigan Trust Code (MTC) contains provisions that deal with a self-settled irrevocable trust where the settlor remains a beneficiary of the trust. This section is different from the settlor’s creation of a Michigan Qualified Dispositions in Trust, which is a statutory departure from the common law’s self-settled trust, and which exists expressly for creditor protection purposes as a domestic asset protection trust. [MCL 700.1042 et. seq; and MCL 566.31 et. seq.]

Michigan Trust Code: Specifically, the Michigan Trust Code provides that a settlor who creates an self-settled  irrevocable trust, whether or not the terms of the trust contain a spendthrift provision, nonetheless allows the settlor’s creditors access to the trust’s assets. [MCL 700.506(1)(c) and (2).] That section provides, in part:

  • Whether or not the terms of a trust contain a spendthrift provision, the following rules apply: (c) With respect to an irrevocable trust, a creditor or assignee of the settlor may reach no more than the lesser of the following: (i) The claim of the creditor or assignee; or (ii) The maximum amount that can be distributed to or for the settlor’s benefit exclusive of sums to pay the settlor’s taxes during the settlor’s lifetime;
  • If a trust has more than 1 settlor, the amount a creditor or assignee of a particular settlor may reach under subsection (1)(c) shall not exceed the settlor’s interest in the portion of the trust attributable to that settlor’s contribution.”

This MTC section is simply a reaffirmation of Michigan’s common law, that the settlor’s creditors can reach the assets of a self-settled irrevocable trust as the trust assets are ‘available’ to the settlor. It is based on the Restatement (Second) of Trusts, section 156, which provides the traditional rule with regard to self-settled trusts:

  • Where a person creates for his own benefit a trust with a provision restraining the voluntary or involuntary transfer of his interest, his transferee or creditors can reach his interest;
  • Where a person creates for his own benefit a trust for support or a discretionary trust, his transferee or creditors can reach the maximum amount which the trustee could pay to him or apply for his benefit.

Grantor Trusts: Because many irrevocable trusts are intentionally created as grantor trusts these days for income tax purposes, the reference to the sums used to pay the settlor’s income taxes during the settlor’s lifetime is excluded from what the settlor’s creditor can claim, so that if trust property could be distributed in payment of the settlor’s income tax liability associated with the trust [per Revenue Ruling 2004-64] or the trustee’s reimbursement of the settlor’s income tax liability, that amount is not ‘counted’ to determine the amount that is distributable to the creditor in satisfaction of the creditor’s claims against the settlor.

Medicaid Planning Trusts: But then we come to self-settled trusts that are established to enable the settlor to qualify for Medicaid benefits. If the settlor has absolutely no access to the trust’s corpus by either the settlor or by the settlor’s spouse, then the assets held in the irrevocable trust will not be ‘counted’ when it comes to the settlor qualifying for Medicaid eligibility. Excluding a Michigan Qualified Dispositions in Trust instrument, in general an irrevocable trust in which the settlor, or the settlor’s spouse, retains any interest whatsoever in the corpus/principal is not an asset protection trust for purposes of either Medicaid or for purposes of lawsuit or general creditor protection. However, so long as the settlor retains rights to trust income only, then the underlying trust assets are  non-countable to determine Medicaid eligibility.

Right to Income-Only: Relevant federal Medicaid law [OBRA ‘93] states that the term “income” has the meaning given such term in 42 USC 1382a, which in turn states in the context of trusts, that “income” includes “any earnings of, and additions to the corpus of a trust established by an individual… and, in the case of an irrevocable trust, with respect to which circumstances exist under which a payment from the earnings or additions could be made to or for the benefit of the individual.” [42 USC 1382a(a)(2)(G).]   “Income” thus means interest, ordinary dividends, rental income, royalties and any other taxable income that does not qualify for capital gains treatment. The IRS definition of income in connection with trusts states that the term “income, when not preceded by the words taxable, distributable net, undistributed net, or gross means the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law.” [Treasury Regulation 1.643(b)-1.] Capital gains are excluded from the definition of “ income” because historically capital gains have been considered to be part of corpus/principal and all capital gains realized by the trust are for the ultimate benefit of the trust’s remainder beneficiaries.

No Right to Corpus: Although neither the settlor nor the settlor’s spouse can receive distributions from trust corpus from an income-only trust, they can (or must) receive distributions of trust income in an income-only trust. Some reported cases where an irrevocable trust that appeared to be income-only but was nonetheless treated as being an available asset to the settlor, thus jeopardizing his/her eligibility for Medicaid benefits, include the following:

The irrevocable trust allowed the trustee to distribute trust principal to pay for costs of the settlor’s custodial care that were not covered by Medicaid. The trust corpus was found to be an available asset, notwithstanding the settlor’s clear intent. Guyan v. Illinois Department of Human Services, 796 N.E. 657 (Illinois Court of Appeals, 2003.)

The irrevocable trust gave the trustee the discretion to make payments of trust principal for the benefit of the Medicaid applicant and his spouse. Giving the discretion to ‘invade’ principal by the trustee was fatal to the Medicaid application. Blanda v. Ohio Department of Job and Family Services, 2008 WL 1822433 (Ohio Court of Appeals, 2008.)

The irrevocable trust named its settlor as a ‘beneficiary’ but the instrument  did not restrict his rights to income only. Accordingly, the court construed the trust  in a way so that the settlor was the beneficiary of both income and principal. Wisynski v. Wisconsion D.O.H. & Family Services, Wisconsin Appeals Court, District 3, No. 2008AP1280, November 4, 2008.)

The proceeds from the sale of the settlor’s residence were paid into the irrevocable trust after the sale of the real estate, by the trustee.  The trust instrument gave the trustee the discretion to sell the beneficiaries’ home and distribute the sales proceeds “if the settlor and his spouse no longer resided in the home.”  The court found that the sales proceeds could possibly be given back to the settlor, which meant that the trust was actually not an income-only trust, but rather one that allowed principal distributions to the settlor- Medicaid applicant. Clifford and Ruth Oyloe v. North Dakota Department of Human Services, 747 N.W.2d 848 (North Dakota, 2008.)

The irrevocable trust provided that the settlor was entitled to the use and possession of real estate, as well as the annual net income derived from the real estate. The free use of the real estate was viewed as having indirect access to the trust’s principal.  Boruch v. Nebraska Department of Health and Human Services, 659 N.W.2d 848 (Nebraska Court of Appeals, 2003.)

Practice Point: If an income-only trust is intended to be used to enable the settlor to qualify to receive Medicaid benefits, then the trustee must be affirmatively prohibited from exercising any powers to adjust between income and principal, regardless of whether such powers are granted by common law, statute, or both. Similarly, the trustee must not possess any power to convert the income-only trust to a total return unitrust.

Michigan Uniform Principal and Income Act: This statute provides that a fiduciary may adjust between principal and income to the extent the fiduciary considers necessary if the fiduciary invests and manages trust assets as a prudent investor. [MCL 555.504(1); MCL 700.1501] Three conditions must be met before exercising a power to adjust: (i) the trustee must be investing and managing the assets as a prudent investor; (ii) the terms of the trust must describe the amount that may or must be distributed to the beneficiary by referring to the income of the trust, such as a requirement that the beneficiary receive ‘all income;’ and (iii) the trustee must determine that it cannot meet the impartiality requirement of the Act and any terms of the trust that require the trustee to favor one or more beneficiaries. Consequently, in many modern trusts, there is usually a boilerplate provision that directs the trustee to comply with the Uniform Principal and Income Act. In addition, the default statutory powers given to a trustee under the Michigan Trust Code include the power to adjust between income and principal and to allocate between the two as provided by law. [MCL 700.7817 (u).]

Example: A case in point is Doherty v. Director of the Office of Medicaid, 908 N.E.2d 390 (Massachusetts Court of Appeals, 2009.) There, the Court observed: “We take this opportunity to stress that we have no doubt that self-settled, irrevocable trusts may, if so structured, so insulate trust assets so those assets will be deemed unavailable to the settlor.” However, the  irrevocable trust in question allowed principal distributions via the trustee’s adjustments between income and principal, even though the trust instrument also contained an express direction to the trustee to “make no distributions of principal from this Trust, to or on behalf of the settlor.” The trust instrument also gave the trustee the power “to determine all questions as between income and principal and to credit or charge to income or principal or to apportion between them any receipt or gain.” As a result of the trustee’s powers to treat principal as income, the settlor was denied Medicaid benefits because his trust was ‘countable’ to determine his Medicaid eligibility in light of the trustee’s ‘power to adjust.’

Point: Therefore, if an income-only trust is contemplated to qualify the settlor for Medicaid benefits, the trust instrument will need to be ‘sanitized’ to curb the trustee’s power (express or implied) to treat trust principal as trust income.

Conclusion: If either the settlor, or the settlor’s spouse, has access to trust principal, all of the assets in the trust will be deemed ‘countable’ for Medicaid eligibility purposes. Accordingly, an income-only trust should be sufficient to render the self-settled trust’s assets as non-countable when applying for Medicaid benefits. However, if the trust is subject to the Michigan Uniform Principal and Income Act, which has buried within it the ‘power to adjust,’ the income-only trust will not work to assure Medicaid eligibility.