Article: Protecting Marital Assets From Recovery: Using the “SPA” To Solve A Tax Problem For The Non-Citizen Spouse

By, Gene L. Osofsky, Esq., CFLS, Hayward, CA.    

Published By California Advocates For Nursing Home Reform, “Legal Network News” , Volume 20, No. 3, Fall, 2009, (Reprinted Here With Permission)  

When planning to avoid Medi-Cal recovery against marital assets where one spouse is in a Skilled Nursing Facility and receiving a Medi-Cal subsidy, a common technique is to consider a lifetime transfer of the SNF Spouse’s ownership interest to the At-Home Spouse. The usual assumption is that there is no gift tax on the transfer, as married couples commonly enjoy an unlimited marital deduction for transfers between them. 1 But what if the At-Home spouse is not a United States Citizen? Is the tax rule any different? Answer: Yes!

 Lifetime Transfer To Non-Citizen Spouse: Gift Tax Implications   

Where the donee spouse is not a United States citizen, the couple does not enjoy an unlimited marital deduction and a lifetime transfer between them will generate a Gift Tax for amounts in excess of the limited exclusion permitted Non-Citizen transferees. For calendar year 2009, that exclusion is limited to $133,000 per year, in essence an annual exclusion gift.  2 The excess value transferred in any calendar year will be subject to a significant gift tax.  3 Advocates who recommend outright interspousal transfers without considering the citizenship status of the donee spouse potentially expose the couple to a significant Gift Tax in the year of transfer.   

Death Transfer to Non-Citizen Spouse: No Estate Tax Up to Applicable Exclusion   

However, upon the death of a spouse, the marital assets passing to the survivor enjoy a much larger protective tax umbrella. Upon death, the decedent’s estate may pass estate tax free to the Non-Citizen surviving spouse up to the full amount of the Applicable Exclusion, currently set at $3.5 Million for persons dying in 2009.  4 This sure beats the limited $133,000 annual gift tax exclusion for lifetime transfers.  5 Hence, for non-citizen spouses, lifetime transfers carry a potentially much heavier tax burden than death transfers.  

Dilemma: Gift Tax vs. Recovery Avoidance 

For non-citizens, this differential treatment of the gift tax, on the one hand, and the estate tax, on the other, presents a real dilemma: if a spouse makes a lifetime transfer to a non-citizen spouse in order to avoid Medi-Cal estate recovery, the gift tax is implicated and a potentially hefty gift tax may be incurred. This tax might even be more than the eventual Medi-Cal recovery claim. However, if the couple waits until the death of the Ill Spouse to make the transfer, then the much larger Applicable Exclusion protects the transfer from estate tax but also exposes marital assets to a Medi-Cal recovery claim upon the death of the survivor. Hence, the apparent dilemma for couples in this situation: is it better to incur gift tax by a lifetime transfer of the home between them, or is it better to avoid the tax and instead incur a recovery claim by hanging on to the home until the death of the SNF spouse?

While it is theoretically possible to transfer, over a period of years, annual exclusion gifts to the non-citizen spouse which, together, aggregate to significant value over time, most Elders (and certainly those in SNF’s) do not have the luxury of extended time horizons over which to make the series of annual exclusion lifetime gifts necessary to accomplish the intended result.   6 

A Suggested Solution 
 
Is there another solution to this dilemma? Yes, I believe there is. It is actually quite straight forward. The solution is to design an interspoual lifetime transfer which is a sufficient divestment for Medi-Cal recovery purposes, but which is incomplete for federal gift tax purposes. Well, how do we do that? Answer: By transferring marital assets in a manner which reserves to the transferor a Testamentary Special Power of Appointment (“SPA”)  7 If created properly, the transfer would be incomplete for federal gift tax purposes 8 , but would be complete for Medi-Cal recovery purposes.

This strategy avoids the Gift Tax problem entirely, eliminates exposure to Medi-Cal recovery claims (at least under current practice), and allows the marital assets to pass to the survivor under the much larger tax-free umbrella of the estate tax applicable exclusion. To make this work, one would include in the deed or other transfer instrument appropriate language reserving a SPA, such as the following:

I [Ill Spouse] hereby transfer my entire interest in Blackacre, whether separate, community or quasi-community, to [At-Home Spouse, or To the Trustee of the XYZ Irrevocable Trust], but reserve to myself the testamentary power, exercisable by my Will or other testamentary instrument (whether or not formally admitted to probate) to re-appoint the property, or any portion thereof, to anyone else, OTHER THAN myself, my creditors, my estate, or the creditors of my estate. 9 
 
 Under the Internal Revenue Code, a gift is incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interest of the beneficiaries as between themselves. 10  The Testamentary SPA does that. By using appropriate language to reserve the SPA, the retained power would accomplish that purpose and the transfer would be treated as incomplete for federal gift tax purposes. 11 A gift which is incomplete under the tax code would not be subject to gift tax.  12

The transfer could be via an outright Deed from one spouse to another if death of the grantor is likely to occur before 12/31/2009 13 , but preferably to the trustee of an Intentionally Defective Irrevocable Trust (“IDIT”) if death is likely to occur thereafter. This author strongly recommends the use of the IDIT in this situation, in view of proposed changes in the tax law for estates of persons dying after 12/31/2009, which will then require a transfer “in trust” to obtain even a modified step-up in basis, at least for persons dying in the year 2010. See further discussion, below. Using the IDIT, the transfer would be via a deed or assignment to the trustee thereof. 14     The trustee should be a U.S. Citizen (perhaps an adult child?). While incomplete for Gift Tax purposes, the transfer to the trustee of the IDIT would nevertheless be complete for purposes of Medi-Cal Recovery, at least under current Recovery Unit practice. 15

If there be concern that the value of the transferor’s interest in the transferred assets might grow to be worth more than the then Applicable Exclusion at the death of the Grantor  16 , an IDIT incorporating a Disclaimer sub-trust with appropriate Qualified Domestic Trust (“QDOT”) 17 provisions might be included into which the appreciated assets might be funneled upon the death of the Grantor.  

Cautionary Comment: Acquisition By ‘Survival’ ? 

As with many things in life, there are some concerns and cautions. The use of the SPA, which reserves to the grantor the right to change his mind, may –at least theoretically– expose the transaction to recovery under the following analysis: the Recovery Unit could argue that the trust beneficiaries acquired their interest in the assets by “distribution or survival” within the meaning of the federal and state Estate Recovery Statutes. 18 , thus exposing them to recovery.

In making this claim, the state might argue that the named beneficiaries acquired their interest by “survival”, inasmuch as the grantor retained the right to change their identities and/or interest until his death, and that the remainder gifts were subject to defeasance until the death of the grantor. That said, this author is unaware of the Recovery Unit making that argument, except in the limited situation involving the grant of a home wherein the grantor retained a life estate and the right to revoke the remainder transfer to her daughters. Bonta v. Burke, 98 Cal. App. 4th 788, 120 Cal. Rptr 2d 72 (DCA, 3rd, 2002). This author believes that the Bonta case was an anomaly because the grant of the remainder in that case was revocable, and is therefore distinguishable from the transaction suggested here. Others share that view. 19

However, advocates and their clients should nevertheless be mindful of this issue in planning their transaction. In a sense, the choice to use the transfer with retained Testamentary SPA might be viewed as a choice between avoiding a Gift tax which is certain and risking a recovery claim which is only theoretical. It is suggested that advocates who recommend the SPA in this context confirm their recommendation to clients in writing.   

Caution: The End Of Full Step-Up In Basis And New Requirements To Transfer “In Trust”  

Another caution: If the current rules 1 providing for basis adjustment on death are allowed to expire on 12/31/2009, to be then replaced by a modified carryover basis system as per IRC § 1022, the proposed change will add yet another factor to be weighed by advocates when planning to avoid both gift tax and estate recovery for an inter-spousal transfer to a non-citizen spouse. That factor has to do with the proposed changes concerning adjustment in basis upon death of the transferor, as follows:

(1) in the case of a decedent who is not a citizen of the United States, the basis adjustment will be limited to only $60,000 21 ; and

(2) the retention by the decedent of a SPA in the transfer deed, alone, will no longer be enough to make the asset(s) eligible for basis adjustment. Instead, it will be necessary to make the transfer into a qualified trust. 22

If the proposed provisions of IRC §1022 are allowed to become law, then it would appear that item (1) would only affect the couple where both spouses are non-citizes. In that event, the very modest adjustment in basis would seemingly result regardless of how the transaction were structured and would therefore not likely be a significant factor in deciding whether to use the technique suggested in this article.

On the other hand, if the transferor spouse is a U.S. Citizen, and the proposed transfer is to his non-citizen spouse, then it may still be possible to secure a more generous adjustment in basis if rule (2) is observed. This rule would require, as a condition to receiving an adjustment in basis, that the transfer be to a “qualified revocable trust”  23 or to a trust which reserves to the grantor the right to “make any change in the enjoyment thereof through the exercise of a power to alter, amend, or terminate the trust” 24 .

Open Question:  with respect to the trust described in (b), above, will a Limited Power to modify beneficial enjoyment (similar to a SPA) be enough to so qualify the trust, or must the grantor reserve a full General Power which includes the power to revest title of the trust corpus in himself? Although the use of the words “any change” in the proposed statute suggests that the use of language similar to a SPA will qualify the asset(s) in the trust for modified “step-up” in basis treatment, yet the definitive answer is presently unknown. If a qualifying reserved power may be a limited power to modify beneficial enjoyment, then it would seem that a transfer to an IDIT which reserves a limited power to the grantor (similar to a SPA) would meet the requirements of proposed IRC § 1022(e)(2)(B), thereby permitting an adjustment to basis upon death and likewise rendering the gift incomplete under Treas. Reg. 25.2511-2(b). If so construed, then this reading would breathe continued life into the strategy suggested in this article.
However, if reservation of the broader general power to revest corpus in the grantor would then be required, then use of the suggested strategy would be at the expense of the much desired step-up in basis. In that event, advocates would need to weigh the future impact to the transferee of this loss of basis adjustment against the upside benefit of a different form of transaction aimed at either avoiding the gift tax or avoiding estate recovery, and the original dilemma posed in this article would then resurface.
 To further complicate matters, IRC § 1022 may only be in effect for the one year of 2010, in view of the sunset provisions of the original enabling legislation. 25 Complicating the picture still further is the commonly held expectation that Congress will likely soon make further revisions to the entire estate tax scheme so as to modify or eliminate some of the proposed changes. 26 In a word, the treatment given to decedent’s estates for persons dying after 12/31/2009 is presently highly uncertain. Therefore, advocates should watch developments in Congress closely and revisit the strategy discussed in ths article when the future law and regulations become known.

In the meantime, unless one spouse is very ill and death is likely to occur before 12/31/2009 27, advocates may wish to consider either,

(1) a transfer of the asset(s) now into an IDIT with provisions which carefully track proposed IRC § 1022 and which retain in the grantor the limited power to change beneficial interests as to others (i.e., language of a SPA), but not the power of reversion, and which authorizes a Trust Protector to modify the trust to fully comply with changes in the law and regulations when fully known, or

(2) to temporarily delay inter-spousal transfers to a non-citizen spouse, but instead create sufficient stand-by authority in Durable Powers Of Attorney so as to permit each spouse or his/her attorney-in-fact to appropriately structure qualifying lifetime transfers in the future, after the law and regulations become known.

The author wishes to thank attorneys Kevin Urbatch and F. Bentley Mooney, Jr., for reviweing a draft of this article and for their helpful comments.

Endnotes Omitted.