Top Ten Estate Planning, Wealth Transfer, And Asset Protection Techniques iIn Arizona

By Thomas J. Murphy
Murphy Law Firm, Inc.
Presented on February 12, 2008


Federal estate tax – going, going, gone?

The past several years have seen a drastic drop in estates exposed to the estate tax, so that practitioners may be overemphasizing its importance and frequency. According to the Statistics of Income Division of the IRS, the figures are as follows:

Year                 # of FET returns         # of FET returns         FET returns as
From AZ                     % of persons dying

2006                49,050                         713                              unavail
2005                45,070                         615                              unavail
2004                65,039                         1,262                           unavail
2003                73,128                         1,014                           unavail
2002                99,603                         1,417                           1.17
2001                108,071                       1,706                           2.11
2000               108,322                       1,660                           2.18
1999                103,979                       1,965                           2.30
1998                97,856                         1,628                           2.19
1997                90,006                         1,309                           2.12
1996                79,321                          1,252                           1.80
1995                69,755                          1,180                           1.63

This sharp decline is not an anomaly. IRS projections are that the drop in 706 filings will continue:

2007            30,400
2008           28,900
2009           26,700
2010           17,600
2011            7,000
2012           55,100

States’ estate tax – here to stay.

According to Tax Analysts and ACTEC, 24 states now have some form of state estate and/or gift tax. They are: Connecticut, Illinois, Indiana, Kansas, Kentucky, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia, Washington and Wisconsin plus the District of Columbia. For most of these states, the estate tax exemption is $1M. However, Ohio’s exemption is only $338,000 and New Jersey, Rhode Island and Wisconsin have a $675,000 exemption.

This means that simply because an estate is not subject to federal estate tax does not mean there will not be state estate consequences. This will occur most often where clients own out-of-state real estate, such as a family cabin.

Estate tax allocation

There is no estate tax allocation statute in Arizona. After the Fogelman case, 197 Ariz 252 (CA1, 2000), it is probably malpractice not to include an allocation provision in the will or trust. Simply allocating this to the residue of the probate estate can be a disaster if title to assets is passing outside of probate.

Suggested clause:

I direct that all estate, inheritance, succession, transfer or other death taxes, to include penalties and interest, paid to any domestic or foreign taxing authority with respect to all property taxable by reason of my death shall be charged against my entire estate. For these purposes, my estate shall be my federal gross estate as defined by applicable federal estate and gift tax law (currently Section 2031 of the Internal Revenue Code) and shall include any and all interests in property, real or personal, tangible or intangible, wherever situated, that I have at the time of my death, to include any and all property passing outside the probate process such as proceeds from life insurance policies, retirement plans and other employee benefit plans as well as jointly titled property and property with payable-on-death designations. Payment of such taxes shall be equally allocated among all estate assets. The prorated allocation shall be made in the proportion that the fair market value of the property received by each person interested in the estate bears to the total fair market value of all property received by all persons interested in the estate. If any of my property does not come into the possession of the personal representative, the personal representative is entitled, and has the duty, to recover from any persons possessing such property the proportionate amount of tax that is attributable to the assets possessed by that person. If the personal representative cannot collect from such person the amount of tax apportioned to such assets, then the amount not recoverable shall be prorated among the remaining estate assets. Any charge for taxes against my estate shall first be made against the estate’s principal and not the estate’s income.

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Loans and gifts to children

Do not ever overlook the existence of loans or gifts to the children, especially if they are in unequal amounts or if not all children are aware of the loans/gifts. In my experience, this is probably the single biggest cause of family discord after the client has died. Establish if it is a gift or loan. If a gift, is it an advance of an inheritance? If a loan, is it to be forgiven? If so, is the forgiven amount to be included in the beneficiary’s share of the estate? Obtain whatever documentation exists verifying the gift or loan since these may disappear post-mortem. Has a large expense been undertaken for one child but not another, such as paying for a college education?

Involvement of children.

Inquire of the client if a meeting with the children should be held. Some clients resist this, some welcome it. I prefer that the children be involved to some extent, especially if there is any Medicaid/ALTCS planning to be done. There are often concepts and strategies that are difficult for the client to fully understand. Having a child present creates comfort and reassurance for the client. The attorney can also make sure that the children receive the information first hand rather than through the parent who may not understand some of the subtle issues.

Warn the client that the attorney-client privilege is waived if a client discusses the communication with a third party, such as a child, or if a third party is present during the communication with the attorney. Alexander v. Superior Court, 141 Ariz 157 (1984); Tripp v. Chubb, 69 Ariz 31 (1949); State v. Beaty, 158 Ariz 232 (1988); State v. Sands, 145 Ariz 269 (CA2, 1985).

Involvement of children – too much can be a problem

Beware of the child who is actively involved in having the client draft a new will. The recent case of Mullin v. Brown, 210 Ariz 545, 115 P 3d 139 (CA2, 2005) should be setting off alarm bells. It is the first case to discuss the ramifications of Estate of Shumway, 198 Ariz 323 (2000) regarding the shifting of the burden of proof in a will contest. At issue was the following jury instruction, which the Court upheld:

If Chris Mullin Jr. and/or Dr. David Mullin had a confidential relationship with Ralph Mullin; was/were active in procuring the execution of the 1995 will; and was/were a principal beneficiary under its terms, then the 1995 will is presumptively invalid and the defendants must prove by clear and convincingevidence that Chris Mullin Jr. and/or Dr. David Mullin did not unduly influence Ralph Mullin.

Shortly before death, Chris Jr. had his grandfather change his will, leaving the entire estate to him and disinheriting Chris’ brother, who under a prior will was a 50% beneficiary. Chris Jr. also emptied a joint account and had the decedent issue a new deed for certain, unspecified gas and oil interest. The will in question had been prepared by an attorney.

The Court began by noting that “A presumption of undue influence arises when one occupies a confidential relationship with the testator and is active in preparing or procuring the execution of a will in which he or she is a principal beneficiary. See In re O’Connor’s Estate, 74 Ariz. 248 (1952). The precise issue on appeal was under what circumstances does this presumption cease? The Court emphasized the statement made in Shumway that “`[W]here a confidential relationship is shown the presumption of invalidity can be overcome only by clear and convincing evidence that the transaction was fair and voluntary.”‘ Id. ¶ 16 (alteration in Shumway), quoting Stewart v. Woodruff, 19 Ariz. App. 190, 194 (1973). The court noted that “[t]his is a difficult standard of proof ”.

Healthcare issues – current or impending

Do not tiptoe around this issue. The elderly are constantly talking about their health. It is usually their foremost concern. They have no problem having a frank discussion about it.

Confirm any current conditions. Ask them what medications they are on and what they are for. This may tip you off to potential issues of incapacity or susceptibility to undue influence. Ask about any hospitalizations or significant medical treatments in the previous several years. Are there any future major treatments in the foreseeable future?

Confirm what all this is costing them and compare this to their finances. Where is this heading? Are these costs greater or expected to be greater than their income? How is the shortfall met (ie, from what assets and how often)? If there is a shortfall and unless the estate is well into six figures, the elder law practitioner must consider the issue of participation in the Arizona Long Term Care System (ALTCS) program.

Note that, as discussed below, the new Medicare Part D will in most instances cover nearly all prescribed medications beginning January 1, 2006 for those who have enrolled.

Healthcare issues – surviving spouse on ALTCS

Planning for the payment of current or future healthcare costs is a continually increasing portion of my practice. This issue creates more anxiety among seniors than any other issue, replacing the two prior standbys — death and taxes.

There is one very important and effective planning tool involving trusts and AHCCCS that is very frequently overlooked by practitioners. This involves creating a supplemental benefits trust that will protect the assets of the first spouse to die from exposure to the nursing home costs of the surviving spouse as well as preventing the disqualification of the spouse who is on ALTCS when the other spouse dies. The other aspect is to avoid the estate recovery process when the spouse receiving ALTCS benefits dies. Both aspects are governed, in part, by federal statutes and regulations, primarily 42 USC 1396p, 20 CFR 1103 et seq and Social Security POMS SI01120, as well as state statutes, such as ARS 36-2934.01 and the AHCCCS Policy and Procedures Manual.

Other portions of this outline will deal in detail with AHCCCS/ALTCS eligibility issues. The issue revolves around the amount of funds that the non-ALTCS spouse can retain. For 2007, this amount is between $20,328 and $101,640. Let’s assume that the non-ALTCS spouse has $50,000. The problem is what happens to this $50,000 if the non-ALTCS spouse dies before the ALTCS spouse? If the will of the non-ALTCS spouse leaves the entire estate (ie, all $50,000) to the ALTCS spouse, then the ALTCS spouse will be over-resourced and lose ALTCS eligibility.

Rather than simply disinherit the spouse, a “supplemental benefits trust” can be created for the benefit of the surviving spouse who is receiving ALTCS benefits. This is basically a fully discretionary trust. The theory is that, since the surviving spouse has no right to a distribution, the trust corpus is deemed unavailable for ALTCS eligibility purposes. AHCCCS Eligibility Manual 708.02 & 803.04; 42 USC 1396p(d)(2)(A)

To draft a testamentary trust that will not render the surviving spouse ineligible for benefits, I use the following language:

A-3.     Supplemental Care Trust.

a)         My ….., ________, is currently receiving Public benefits. As long as ——(first name) is receiving means-tested public benefits (such as those offered as Supplemental Security Income or Arizona Health Care Cost Containment System), (First Name)——’s share of my estate shall be distributed to the trustee of the Supplemental Care Trust as set below.

(b)       Trustee. I hereby appoint my ——–, —————–, to serve as Trustee of the Trust created for my spouse, ——————–(full name).

(c)        Purpose of ——–(full name) Supplemental Care Trust. It is my intention by this trust to create a purely discretionary supplemental care fund for the benefit of (full name)———. It is not my intention to displace public or private financial assistance that may otherwise be available to him.

(d)       Distribution of Income and Principal. The Trustee may pay to or for the benefit of (full Name)—— such amounts from the principal or income of the Trust, up to the whole thereof, as the Trustee in Trustee’s sole discretion may from time to time deem necessary or advisable for the satisfaction of his supplemental needs. As used in this instrument, “supplemental needs” refers to the requisites for maintaining (full name)——’s good health, safety, and welfare when, in the discretion of the Trustee, such requisites are not being provided by or are unavailable from any public agency or private resource. The following enumerates the kinds of supplemental disbursements which are appropriate for the Trustee, to make from this Trust or to or for the benefit of my beneficiary. Such examples are not exclusive: medical, dental and diagnostic work and treatment of which there area no private or public funds otherwise available; medical procedures that are desirable at my ‘Trustee’s discretion, even though they may not be necessary or life saving; supplemental nursing care and rehabilitative services; differentials in cost between housing and shelter for shared and private rooms in institutional settings; care appropriate for my beneficiary that assistance programs may not or do not otherwise provide; expenditures for travel, companionship, cultural experiences, and expenses in bringing my beneficiary’s siblings and other appropriate persons for visitation with my beneficiary.

(e)        Trust Intent. I declare that it is my intent, as expressed herein, that because the beneficiary is disabled and unable to maintain and support himself independently, the Trustee shall, in the exercise of Trustee’s best judgment and fiduciary duty, seek support and maintenance for (full name)—- from all available private and public resources, including but not limited to Supplemental Security Income (SSI), Federal Social Security Disability Insurance (SSDI), Arizona Long Term Care System (ALTCS), and Arizona Health Care Cost Containment System (AHCCS). In making distributions to (full name)—- for his supplemental needs, as herein defined, the Trustee shall take into consideration the applicable resource and income limitations of the public assistance programs for which (full name) — is eligible or potentially eligible. In determining distributions, the Trustee shall consider the needs of (full name)—- and shall consider other funds known by the Trustee to be available for the specified purposes.

(f)        Trust Asset Separation. The income or assets of (full name) —-, as well as any other beneficiary interest (full name)— may have in any other trust should not be commingled with the assets of the Trust.

(g)        Discretion of Trustee. Under no circumstances may (full name) —- compel a distribution from the Trust for any purpose. The Trustee’s discretion in making non-support disbursements as provided for this instrument is final as to all interested parties, even if the Trustee elects to make no disbursements at all. Further, the Trustee may make arbitrary determinations. The Trustee’s sole and independent judgment, rather than any other party’s determination, is intended to be the criterion by which disbursements area made. No court or any other person should substitute its or their judgment for the decision or decisions made by the Trustee.

(h)       Trustee Powers: The Trustee of the Trusts created herein shall have all powers conferred by Arizona law, to include those powers delineated in A.R.S. §14-7233.

(i)        Amendment of trust. Notwithstanding the irrevocability of this trust, it is my intention and a material purpose of this Trust that it comply with all applicable laws regarding (1st name)’s eligibility for public benefits. In particular, it is my understanding that the terms of this trust, as a third party trust, comply with the eligibility criteria set forth in 42 USC 1396p(d)(4)(a), 20 CFR 416.1210 et seq., Social Security POMS SI 01130.005 & SI 01150.120-127 and Arizona Revised Statutes section 36-2901 et seq. In accordance with ARS 14-10410 et seq., the trustee is authorized to amend, modify or reform this trust to comply with any new applicable law, regulation or other authority that may affect (1st name)’s eligibility.

For more guidance on drafting these types of trusts, see the leading treatise on this, Third-Party and Self-Settled Trusts: Planning for the Elderly and Disabled Client, 3rd edition by Clifton B. Kruse, published by the American Bar Association and available through the ABA, and other booksellers.

Note that this is not a special needs trust for the disabled as authorized under 42 USC 1396p(d)(4)(A).

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Other advisors.

Determine who are the accountants, insurance agents and financial advisors that the client may be using. These advisors may be telling your client something very different than what the attorney is. Make sure everyone is on the same page and understands the concepts involved. Unfortunately, other advisors may be quick to criticize something they do not understand and, since they have had a much longer relationship with the client, these advisors often have more credibility with the client. The attorney can never be too careful here. The attorney also needs to confirm certain information, such as beneficiary designations.

Pre-paid planning for funeral and burial.

Does the client desire to be cremated or buried? Where will the burial be? Will organs be donated? Will an autopsy or other post-mortem examination be done? Who should be notified? What kind of marker and epitaph? It is often best to have these arrangements made in writing while the client is alive. ARS 36-831.01. If client does pre-pay, keep record of receipts since I have had mortuaries inexplicably lose any record of pre-payment. Pre-planning also greatly alleviates the grief of immediate family members who are spared the emotionally wrenching decision of choosing a casket and the like. Family members are also in a very vulnerable state that could lead to unnecessary expenditures. See my attached form entitled “After Death Instructions”.

Creditor protection for life insurance and annuities

There have also been some very important recent developments in Arizona regarding the creditor protection now afforded life insurance policies and annuities. ARS 20-1131 and 33-1126 codified and extended the creditor protection set forth in May v. Ellis, 208 Ariz 229 (2004). These statutes provide for unlimited creditor protection of life insurance policies and annuity contracts that are at least two years old and name a family member as beneficiary.

Irrevocable trusts

It has been my experience that the use of irrevocable trusts has decreased dramatically over the past ten years. This is probably due to adverse income tax issues stemming from the 1993 tax bill and the increased popularity of alternative entities such as family limited partnerships.

The primary advantage of an irrevocable trust is that the property owned by the trust will be out of the grantor’s estate for estate tax purposes. If it is unlikely that a grantor will have a taxable estate, then a revocable or testamentary trust will usually work just as well. The other two advantages are that it can provide creditor and other spendthrift or incentive-laced protections for non-grantor beneficiaries and, as with any properly drafted trust, it avoids probate.

There are two primary disadvantages of irrevocable trusts. One that clients often need to be reminded of time and again, is the loss of control by the grantor. IRC 2511. A related problem can be inflexibility. Both of these problems may be ameliorated by the use of a trust protector, a concept that is becoming increasingly popular. See “Trust Protectors” by Alexander A. Bove Jr. in the November 2005 edition of Trusts & Estates.   The other disadvantage is the very high income tax rates applicable to trusts. For 2006, trusts hit the highest 35% bracket at $10,050 of taxable income. By contrast, an individual taxpayer does not hit the 35% bracket until she reaches $336,550 of taxable income. This means that you either fund the trust with non-income producing property (non-rental real estate or shares of stock) or qualify the trust for grantor trust status, as discussed below.

The primary form of an irrevocable trust that most practitioners will use is an irrevocable life insurance trust (ILIT). Other forms of irrevocable trusts commonly used are grantor retained income trusts (GRITs), grantor retained annuity trusts (GRATs), grantor retained unitrusts (GRUTs), charitable remainder trusts (CRTs), charitable lead trusts (CLTs) or qualified personal residence trusts (QPRTs).

Irrevocable trusts – life insurance (“ILIT”)

There is no magic to drafting an ILIT. The main issue is to avoid being snared by IRC sec. 2036 for estate tax purposes. Sec 2036 allows the IRS to include the trust in the estate of the grantor if the grantor retains possession or enjoyment of the property held by the trust or has the right to designate the person who have possession or enjoyment of the property. As a result of sec 2036, the grantor cannot be the trustee or beneficiary of the beneficiary nor can the grantor have the authority to later name or remove a successor trustee or beneficiary (so be careful with powers of appointment). Because of community property issues, I am reluctant to name the spouse in either of these capacities although many practitioners will disagree with me. This means that, in my practice, an ILIT is for the benefit of the children with another family member or professional fiduciary serving as trustee.

There are three other technical aspects that the practitioner needs to be aware of. One concerns Crummey powers, Crummey v. Commissioner, 397 F2d 82 (9th Cir, 1969), which deals with giving the beneficiaries a present, not future, interest in the trust. A future interest will not qualify as a present interest for gift tax purposes. In order for the contributions made by the grantor to the trust to qualify as a completed gift, the beneficiaries must be given the right to have immediate access to those contributions for at least a reasonable period of time, generally 30 days. See also Estate of Cristofani, 97 TC 74 (1991), Estate of Kohlsaat, TC Memo 1997-212, Rev Rul 81-7 & IRC sec 2503(b)

The IRS hates Crummey powers, so this warrants special attention. The customary Crummey notice will suffice but note that, contrary to the understanding of many practitioners, such notices are not required as long as the beneficiaries are aware of the withdrawal right. Estate of Holland, TC Memo 1997-302.

Also, consider placing a “5&5” limitation on the withdrawal right. If the withdrawal right can exceed that and the right is not exercised (which is usually the case), the lapse is treated as a gift by the beneficiary and all sorts of adverse tax consequences can result under IRC 2514(e) and 2041(b). One solution is that have an accumulating or “hanging” power for those withdrawal rights not exercised. Rev Rul 85-88 & PLR 8901004.

Another technical area involves income taxes for the trust. This has really hurt the usefulness of irrevocable trust since the trusts have extremely high or “compressed” tax rates. This is particularly so if the trust is a dynasty-type trust meant to accumulate rather than distribute income. This tax issue often makes a family limited partnership look very attractive.

The conventional solution is to have the trust qualify as a grantor trust for income tax purposes, in accordance with IRC sec. 671 through 678. The two most common provisions are to allow the grantor to substitute assets of equivalent value or to allow the grantor to borrow assets without requiring adequate security for the loan.   Estate of Jordahl, 65 TC 92 (1975), PLRs 9247024 & 9843024. See also Rev Rul 2004-64. Because of the grantor trust status, contributions by the grantor to the trust will not trigger income tax on the appreciation of the asset. PLR 9535026

Have updated beneficiary designations for retirement plans.

Make sure that valid, current beneficiary designations exist. Do not simply assume all is in order since, with the consolidation of many banks and brokerage houses, records are misplaced or lost with increasing frequency. Second, make sure they are current. Be especially vigilant if the client has been divorced since the designations often still reflect the former spouse. The provisions of ARS 14-2804 (where the divorced spouse is disinherited) does NOT apply to 401(k)’s and other ERISA plans. Egelhoff v. Egelhoff, 121 SCt 1322 (2001). Third, consider obtaining copies of the signature cards for any POD accounts since banks are often sloppy in maintaining these designations. For a horror story on this that cost a client of mine $1 million, see the now-depublished case of Estate of Moore, 435 Ariz Adv Rep 9, 97 P3d 103 (CA1, 2004). Fourth, if a trust is named as beneficiary, make sure the trust will qualify as a “designated beneficiary” under the minimum distribution rules. For a string of recent favorable rulings in the area, see PLRs 200615032, 200616040, 200620025 & 200708084 and Q&A 16 of IRC Notice 2007-07

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Creditor protections – retirement plans

It has been clear for some time that there is creditor protection afforded to retirement plans by ERISA, as was held in several important decisions rendered in the 1990’s by the United States Supreme Court, most notably Patterson v. Shumate, 504 US 753 (1992). The 2005 bankruptcy legislation greatly expands this creditor protection.

What is protected?

This requires a patchwork analysis. First, there is a new section 541(b)(7) that provides unlimited creditor protection for all deferred compensation plans under section 457 of the Internal Revenue Code (“IRC”) and for all tax-deferred annuities under IRC section 403(b). I most often see section 457 plans with government employees and section 403(b) plans with teachers.

Second, there is a new section 522(b)(3)(C) of the Bankruptcy Code that protects “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under sections 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code”. This is the key provision that will protect most people.   IRC sec. 401 covers all pensions and defined contributions plans. IRC sec. 403 applies to plans administered on behalf of employees of school districts, churches and other tax-exempt entities. IRC sec. 408 covers all IRAs, to include SEPs and SIMPLEs. IRC sec. 408A covers Roth IRAs. IRC sec. 414 applies to plans administered by predecessor employers and certain partnerships and sole proprietorships. Plans under IRC section 457 (deferred compensation) are afforded protection already mentioned. IRC sec. 501 covers plans for employees of tax-exempt entities.

Prior to this new law, there seemed to be a distinction between ERISA assets (ie 401(k)s) and non-ERISA assets (IRAs, SEPs and Keoghs). ERISA assets were clearly protected but it was not clear if this protection extended to non-ERISA assets. This distinction is now gone – as long as the asset is exempt from taxation, it will come within the protection of the new section 522.

Also note that these protections apply to all states. Most states allow or require its residents in bankruptcy to use that particular states’ list of exemptions, so that the federal exemptions are of no consequence. Not so here – debtors in all states must use the exemptions, which they will want to do anyway since the new exemptions are much more generous than that offered under most states’ law.

How much is protected?

It would have been nice if the new legislation had stopped there – creditor protection for any tax-exempt retirement asset. But Congress added a new section 522(n) to the Bankruptcy Code that deals with IRAs. The section begins with limiting protection for IRAs to $1 million but then creates three exceptions to that amount. First, the section does not apply to SEPs or SIMPLEs, which will have unlimited protection like other retirement assets.

Second, the statute states that the $1 million exemption amount is made “without regard to amounts attributable to rollover contributions” from other protected retirement accounts. The conventional wisdom from nearly all the commentators I have read is that this means that rollover IRAs will have unlimited protection so that $1 million plus all rollover IRAs will be protected. But at least one prominent commentator has interpreted this to mean that the aggregate amount of all IRAs is the $1 million. He reasons that the “without regard” language means that it does not matter if the sources of the funds are rollover funds – there is a $1 million cap, period.

The third exception is that the $1 million cap “may be increased if the interests of justice so require”. No criteria, definitions or guidance is given as to what exactly this means.

This bill was enacted less than two weeks after the United States Supreme Court had issued its decision in Rousey v. Jacoway, 125 SCt 1561 (2005) that held that, in bankruptcy, IRAs, which are non-ERISA assets, were afforded the same creditor protection as ERISA plans. The new legislation has made much of Rousey dead letter law but there are situations where the Rousey holding can still be used. Rousey held that an IRA was protected to the extent the funds were “reasonably necessary for the support of the debtor or his dependents”. In most situations, it is difficult to envision situations where the need for support would exceed the $1M statutory exemption. But persons with disabilities or parents with disabled children could conceivably exceed this amount so Rousey remains an important case for them.

The legislation also overrules the controversial Supreme Court holding in Yates v. Hendon, 541 US 1 (2004) that held that there is no creditor protection for retirement assets where the only participants were the business owner and family members. This meant that sole proprietors and other one-person or husband-and-wife businesses lost this protection. The new section 522 ignores this distinction and places these businesses on equal footing with all other qualified plans

Who is protected?

Clearly, plan participants come within the protections outlined above. But what about surviving spouses and other people who inherit an IRA or other qualified plan assets?   It appears that these situations will be afforded protection. The new section 522(b)(4)(D) specifically extends protection to any rollover, so any surviving spouse should be protected. But what about other beneficiaries? As long as the funds remain in a tax-exempt account, the creditor protection should be maintained. But what of funds that are simply withdrawn from the account? An apparent drafting lapse may work to the beneficiaries’ advantage. The new section 522(b)(4)(C) states that “a direct transfer of retirement funds from 1 fund or account that is exempt from taxation…. shall not cease to qualify for exemption…by reason of such distribution”. It seems quite clear to me that the drafters forgot to include the phrase “to another account exempt from taxation” regarding the transfer. Whether this will be subject to a technical corrections bill remains to be seen.

Note that, unlike other provisions, there are no time restrictions on when contributions to retirement accounts can be made. In other words, a person can make maximum contributions to a 401k or a SEP, file for bankruptcy the next day and the funds should be protected.

 529 plans and Coverdell education accounts

Another favorable development is the amendments to sections 541(b) & (c) that protect IRC section 529 college savings plans and Coverdell education accounts. Any of these accounts that name a child, grandchild, stepchild or stepgrandchild as a beneficiary will be protected. Any contributions made prior to two years of a bankruptcy filing are protected as long as they did not exceed the amounts that are tax-qualified under the IRC. This will be in the $250,000 range for most 529 plans and, for Coverdell accounts, will be the accumulation of the $2,000 maximum annual contributions per beneficiary. For contributions made within one to two years of filing, only an aggregate amount of $5,000 per beneficiary will be protected. Contributions made within one year of filing will not be protected in any amount.

Prenuptial agreements

Arizona has adopted the Uniform Premarital Agreements Act that provides for the enforceability of a prenuptial agreement as long as the factors set forth in ARS 25-202 are met. The primary stumbling block is ARS 25-202(c)(2)(a) that requires “fair and reasonable disclosure” of both parties’ financial matters. Unless otherwise unconscionable, the agreement will be upheld and enforced. Schlaefer v. Financial Management Service, Inc., 196 Ariz 336 (CA1, 2000).

In reviewing pre- and postnuptial agreements, I also review the disclosures and whether both parties were represented by counsel. Then make sure that the terms are consistent with the will, trust and other dispositive designations. Also look for any sunset provisions where the agreement ends if the parties remain married for a certain number of years.

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Gifting issues – tuition and medical care

I am always surprised at how many clients are unaware of the tax code provisions that allow for unlimited tax-free gifting for the payment of tuition and/or medical expenses under IRC sec. 2503(e). The rules are fairly simple. Treas Reg 25-2503-6. Payments must be made directly to the school or provider. In other words, reimbursing someone for their expenses will not qualify. The payments must be for tuition only, not room & board or other related educational expenses. Since the payments must be made to the educational institution, contributions to 529 plans do not come within protection but would still qualify for the annual exclusion.

A recent Private Letter Ruling 200602002 gave a big boost to prepaying tuition. In this PLR, the donor had three children and six grandchildren. The donor wanted to enter into a separate written agreement with a school to prepay tuition for each of his six grandchildren. Under the terms of the agreement, the donor would prepay the total annual tuition for each grandchild through the 12th grade. The agreement provided that tuition could increase in subsequent years and if it did the donor or the parents would be responsible for any tuition increase. The agreement provided that the tuition payments were non-refundable and that the pre-payment did not afford the grandchildren any special rights or privileges over any other students at the school and the prepayment did not guarantee enrollment.

As for medical expenses, the expense must meet the test of deductibility under IRC 213, as discussed below. Note that this appears to cover health insurance premiums.

 Gifting issues — highly appreciated property

The most common mistake, particularly among persons not represented by counsel, is to transfer highly appreciated property rather than having the property past via inheritance or other death-related transfer. If this is done, the donee will have a carry-over basis rather than a stepped-up basis. IRC 1014 & 1015. For many, and probably most, of our clients, the step-up in basis is the single biggest tax break available to them, so be careful not to inadvertently lose it. Yet many clients, including those previously represented by competent counsel, are not aware of this distinction. When discussing annual exclusion gifting or other gifting, warn clients to consult with you if they are planning on some form of gifting other than cash.

Gifting issues — transfers within three years of death

This is seldom an issue with most gifting but it can crop up in three settings. First, any transfer of life insurance policies are subject to the three year rule. IRC 2035(a). Second, any payment of gift taxes made within three years of death are brought back into decedent’s estate, so avoiding the “tax upon the tax” with estate taxes will not happen. IRC 2035(b). Third, the amount of tax deferral for certain businesses available under IRC 6166 will not apply to any property transferred within the three year period. IRC 6166(k)(5) & 2035(c)(2).

Gifting issues — property with encumbrance in excess of basis

A taxpayer will recognize gain to the extent that property is transferred where the encumbrance exceeds the basis. Johnson v. Comm., 495 F2d 1079(6th Cir, 1974); Estate of Levine, 634 F2d 12 (2nd Cir, 1980). The facts of the Johnson case are typical – taxpayer had a basis of $11,000 in stock. At the time of the gift, the stock had an FMV of $500,000 but there was a loan against the stock in the amount of $200,000. Taxpayer was deemed to have a gain of $189,000 by reason of the transfer.

Gifting issues — property where basis exceeds FMV

Basis cannot exceed the FMV of the property on the date of the gift. The donee is limited to using the FMV as the basis. IRC 1015(d).

Gifting issues — property that generates tax-exempt income or a large deduction

For a high-income taxpayer, be wary of gifting assets that are generating tax-exempt income, such as municipal bonds, or that generate a large deduction, such as depreciation.

Gifting issues — where AHCCCS/ALTCS could be an issue

The 2006 passage of the Deficit Reduction Act (“DRA”) has increased the lookback period from three years to, eventually, five years. Currently, any gift made after July 2003 will come within the lookback period and will be subject to a period of ineligibility. Also note that the DRA also requires that the ineligibility period will not commence until an application is submitted in which the applicant would be otherwise eligible but for the transfer. Under prior law, the period began to run when the gift was made. This change has the effect of greatly lengthening the period of ineligibility.

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Lack of funding of trust – clean-up issues

All is not lost if, after death, you are presented with a trust that has little or none of the funding (ie, transfer of title into the trust). In Arizona, there is little authority as to what exactly one must do to transfer an asset into a trust.   California has a line of cases beginning with Estate of Heggstad, 20 Cal Rptr 2d 433 (CA1, 1993) that concerned a revocable trust that was “self-settled”, meaning it was created by Mr Heggstad to hold title to his property while he was alive. He was both trustee and beneficiary while he was alive. Mr Heggstad owned real estate but he never executed a new deed transferring the land into the name of the trust. The issue before the court was whether the land could be considered trust property.

The court ruled that the land was trust property. It held that there was:

“abundant support for our conclusion that a written declaration of trust by the owner of real property, in which he names himself trustee, is sufficient to create a trust in that property, and that the law does not require a separate deed transferring the property to the trust”.
20 Cal Rptr at 436.

The only other case on point, reaching the same result, is the Kansas Supreme Court’s decision in Taliaferro v. Taliaferro, 921 P2d 803 (Kansas, 1996). That case had similar facts — a written declaration of trust but title to the grantor’s assets (mainly shares of stock and a life insurance policy) was never changed. Citing Heggstad, the court ruled that:

“where the settlor of a trust executes a declaration of trust, no transfer of legal title to the trust property is required to fund the trust”.
921 P2d at 806.

Both cases rely heavily on the Restatement of Trusts, particularly section 17. After these cases were decided, a new draft of the section, now numbered as section 10, has been released. There is no significant change and the precise issue is now covered in subparagraph (c) of section 10 and comment (e), stating that “a trust may be created without a transfer of title to the property”. .

These cases were cited to the Court of Appeals in the case of Estate of Moore, 97 P3d 103, 435 Ariz Adv Rep 9 (CA1, 2004), that adopted the Hegsted rationale but determined that the assets could not be considered trust property for other reasons. Note that this case was ordered depublished by the Arizona Supreme Court so its precedential value is slight.

While this approach may serve in a pinch, the better course is to execute funding instruments – deeds, assignments, beneficiary designations, etc – to avoid the issue as to whether a transfer actually took place or was intended.

My office routinely has the client complete an omnibus assignment, a copy of which is attached to these materials. The assignment essentially states that all property is transferred to the trust. The idea is that this assignment will serve as the equivalent of a pour-over will without the probate proceeding.

But the better practice is to clearly and unequivocally transfer assets into the trust.

The book that is generally considered to be the leading authority on the funding of trusts is “The Funding of Living Trusts” by Carla Neeley Freitag, published by the Real Property, Probate and Trust Law section of the American Bar Association.

Planning for the nursing home

43% of all Americans who reach age 65 will eventually enter a nursing home

  •  21% will stay at least 5 years
  • 34% will stay 1 – 5 years
  • 19% will stay 3 — 12 months
  • 26% will stay less than 3 months
  • Average length of stay – 2.3 years
  • Average cost of care in Maricopa County — $4,781.99 per month (according to Center for Medicare and Medicaid Services)
  • Average cost of care for all counties outside of Maricopa, Pima and Pinal counties — $4,445.00 per month
  • My experience:
    • Early stages of Alzheimer’s — $2,000.00 per month
    • Mid-stage Alzheimer’s — $3,000 to $5,000 per month
    • Mid-level skilled care — $5,000 to $6,000 per month
    • Ventilator — $12,000 to $15,000 per month
    • 24 hour at-home care — $15,000 per month

Many of the studies are rather dated. The study generally considered the best and most recent is by “Long Term Care Over An Uncertain Future: What Can Current Retirees Expect?” by Kemper, Komisar & Alecxith in the journal Inquiry, Vol 42, pp. 335-350. Note that this study shows a significant difference in gender – 58% of men over the age of 65 will require some form of LTC as compared to 79% for women.


  • 44% paid by patient’s own funds
  • 38% paid by Medicaid (ALTCS)
  • 11% paid by Medicare
  • 7% paid by long term care insurance


  • Option #1: Pay as you go
  • Option #2: Medicaid (ALTCS)
  • Option #3: Long term care insurance
  • Option #1: Pay as you go

Not covered by health insurance

Very limited coverage Medicare

Must have been discharged from hospital within previous 30 days

Only covers daily skilled nursing or skilled rehabilitation (as opposed to custodial care)

1st 20 days paid in full by Medicare

Next 80 days – co-pay of $128.00 per day

After 100 days – No further Medicare payments – patient pays all costs

In Arizona, Medicaid = ALTCS (Arizona Long Term Care System).

ALTCS is division of AHCCCS

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 MEDICARE                                                     ALTCS

Over 65 years of age                                            Any age

Automatic eligibility                                           Means-tested

Hospital and doctor visits                                 Nursing home

Never have to repay for care received            Estate recovery


Two tests – income test and asset test

Single person

  • Income test
    • cannot exceed $1,869.00 per month
    • Includes ALL income, regardless of tax characterization
  • Asset test – cannot exceed $2,000.00 in countable assets
    • Countable assets are everything except:
      • Primary residence
      • Equity in home cannot exceed $500,000
      • Automobile – no limit on value – Not have to have drivers license but must be used to transport the person
        • Prepaid burial plan – Includes gravesite/crypt, headstones, casket, urn, costs of opening and closing of gravesite and costs for perpetual care
        • Can be done for both spouses
        • Must be irrevocable
        • Usually involves purchase of life insurance to fund the plan with mortuary named as beneficiary
    • $1,500 burial fund — for flowers, cost of service, etc.
      • Must be in a separate, designated account
      • Only if no prepaid burial plan
    • Household goods and personal effects
      • Artwork and antiques are excluded

Married person

Income test

Combined income cannot exceed $3,738.00 ($1,869.00 X 2)

If more than $3,738.00, then use “name on check” rule plus one-half of all jointly titled checks. The total for that particular spouse cannot exceed $1,869.00.

Asset test

“Snapshot date”: look to when ill spouse entered the nursing home, even if it is well before applying for ALTCS

Take total combined countable assets and divide in half

Healthy spouse gets to keep his or her one-half

  • Minimum of $20,328.00
  • Maximum of $101,640.00

Ill spouse must “spend down” his or her one-half to $2,000.00

“Income only” or “Miller” Trust

Problem: you have $2,000.00 in income but your cost of care is $5,000.00.

Solution: create trust with all of person’s income (not assets) assigned to the trust to pay ALTCS for cost of care

Cannot be used if monthly income exceeds private pay rate:

  • $4,781.99/$4,445.00 for single person

Double this amount for married couple or use “name on check” rule.


Sheltering funds in excluded resources

  • Purchase a home if none owned
    • Must be done before entry into nursing home
  • Pay down mortgage
  • Do repair work or modify and improve home
    • New roof, paint, carpeting or A/C
    • Add garage or enclose carport
    • Build a pool
  • Purchase burial insurance
    • Policy is irrevocably assigned to mortuary
  • Purchase the parcel of land next-door
    • Must be contiguous
  • Purchase automobile
    • Unlimited value if necessary for medical treatment
    • Travel to doctor’s office should be “necessary”
    • Otherwise, FMV cannot exceed $4,500.00
    • Only one car per couple
  • Purchase burial plan
  • Create burial fund up to $1,500.00 per spouse
    • Use for payment of flowers, transportation for family, embalming, cost of church service
    • Must be in separate account designated as such
  • Purchase new household goods
    • New furniture or appliances
    • Useful to buy items for “homier” nursing home
  • Travel or take a vacation
  • Purchase a single premium immediate annuity
    • Converts an asset into an income stream

Can be very useful for married couple. Unlikely to work for single person

Once again, be careful. Many requirements to satisfy, and several more were added with passage of Deficit Reduction Act passed in February 2006. Most annuity sales representatives have no understanding of these rules. Terms of annuity must

  1. a) name state as beneficiary for up to the estate recovery amount,
  2. b) have repayment of principal within annuitant’s life expectancy (using Social Security, not IRS, tables). For instance, a 75 year old person is deemed to have a life expectancy of 11.97 years. An 80 year old is deemed to have a life expectancy of 8.94 years.
  3. c) must be irrevocable and non-assignable,
  4. d) no withdrawal rights, and
  5. e) no balloon payment at end of annuity period

Always compute effect on share of cost

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In most cases, healthy spouse will be able to retain most, if not all, of the couple’s income under the concept known as “minimum monthly maintenance needs allowance” or “MMMNA”. This means that healthy spouse is entitled to minimum monthly income of at least $1,712.00 but cannot exceed $2,541.00


Be very, very careful in this area, especially since the enactment of the Deficit Reduction Act passed in February 2006. In Arizona, it takes effect for all transfers made after July 1, 2006

Includes any transfer for less than FMV

AHCCCS has de minimus amount of $400 per month

AHCCS has “lookback period” beginning July 2003 for any gifts that have been made.

Watch out for revocable trusts. If transfer from a trust, then 60 month lookback period applies

Be careful of home that is titled in name of trust. ALTCS takes position that the home in a trust is not an excluded resource (ie, that it is a countable asset).

Solution – deed home out of trust to the owner/grantor prior to application.

Be mindful that home in the trust may actually be advantageous by increasing the amount of property that the healthy spouse can retain.


IRAs and other retirement entities are not excluded (ie, they are countable assets) unless they are annuitized. Same with cash value of life insurance policies and deferred annuities. Liquidating these accounts can create big income tax problems.

Estate recovery – ALTCS will file claim in probate court for cost of services rendered once ill spouse has passed away.

Solution – title property so that title passes outside probate. Jointly titled assets between spouses work very well here but can be a disaster if healthy spouse dies first.

Problem – ARS 14-6102 broadens ALTCS’s estate recovery options but has not actively enforced these collection rights. Beginning in mid-2005, AHCCS has begun filing liens on real estate owned by AHCCCS patients but there are four important exceptions.

Only applies to medical services rendered to persons over the age of 55.

  1. Cannot be asserted against a surviving spouse.
  1. Cannot be asserted if the patient is survived by a child under the age of 21.
  1. Cannot be asserted if the patient left a surviving child of any age who is blind or is disabled under the criteria set forth by Social Security.

In other words, AHCCCS can only pursue a lien against an unmarried person with no minor or disabled children.

$12,000 annual exclusion gifts – a tax concept. Does not apply to ALTCS situation.

Divorce & marriage — Divorce is suitable only when healthy spouse has a large amount of sole and separate (ie, pre-marital) property.. From an ALTCS standpoint, marriage is not recommended if future spouse is likely candidate for nursing home.

Do not forget share of cost. Ill spouse is only entitled to keep $93.45 per month. ALTCS will allow payment of health insurance premiums and non-covered medical expenses such as non-emergency dental and eye care, hearing aids and chiropractic care

Third party guarantees of nursing home bill are unenforceable and probably illegal (ie, children cannot be forced to pay for parents’ care). 42 CFR 483.12(d)

Cannot disclaim property that is about to be inherited or is otherwise due to applicant or spouse (except that healthy spouse can inherit or disclaim if it occurs after snapshot date)

Loss of control on health care matters once ALTCS is paying

Very limited services in certain areas – dental, occupational therapy, experimental treatments, most routine foot care

Most (at least 75%) nursing homes accept ALTCS patients. Always check on this if patient is initially going to pay with his or her own funds so that patient can remain in same facility once ALTCS assumes responsibility for payment

ALTCS provides VERY limited coverage for assisted living facilities

Only provides for care that is 1) “medically necessary” – must prevent death, treat or cure disease, ameliorate disabilities or prolong life; and 2) at risk of institutionalization

Care at ALFs is considered to be “supervisory care”

ALFs are not considered to be a “nursing facility”. Come within characterization of “Home and Community Based Services” — will cover personal care and homemaker services but NOT room and board

Where to go for help in finding placement in a nursing home:

 Adult Care Connection
4811 East Calle Ventura
Phoenix, AZ 85018

Alzheimer’s Association
1036 East McDowell
Phoenix, AZ 85006
(602) 528-0545

 Area Agency on Aging
1366 East Thomas
Phoenix, AZ 85014
(602) 264-2255

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This is still a difficult and complicated decision since these policies have a very mixed and spotty history. The passage of HIPAA in 1996 eliminated many, but by no means all, of the sleazy practices in this industry. It also resulted in cookie-cutter, one-size-fits-all policies that are not appropriate for many clients and that are sold by insurance agents who have only a vague idea of the Medicare and Medicaid rules.

Consequently, purchasing LTC insurance remains a very dicey proposition. A useful but somewhat dated source of information is the “Shopper’s Guide to Long Term Care Insurance published by the National Association of Insurance Commissioners, available in pdf form at

Among the factors to consider are:

  • Does the person need LTC insurance?
    • Purchasing life insurance may be a better option
    • Death benefit can be used for anything rather than only LTC Person may never enter a nursing home so may never end up using the policy
    • Accelerated death benefits (pre-death payments) make this much more attractive
  • Does client have Medigap or supplemental insurance?
    • Medigap policies C through J usually provide some, but not much, coverage
  • Tax-qualified policies, as set forth in IRC Sec. 7702B, allow premiums to be partly deductible and benefit payouts are not taxable.
  • Must be chronically ill
  • Unable to perform at least 2 of 6 ADLs (as defined below) for at least 90 days or
  • Severe cognitive impairment – not defined

Among the terms to address in reviewing a policy are:

  1. What services are covered?
    1. Skilled, intermediate and custodial care are usually covered. However, many pre-HIPAA (pre-1996) plans only cover skilled care
    2. Pay close attention as to whether home care, adult day care and assisted living are included.
  2. When does the policy take effect (aka “triggering events” or “gatekeepers”)
    1. Cognitive impairment (ie, Alzheimer’s), or
    2. Medical necessity (only in pre-HIPAA policies), or
    3. 2 of 6 ADLs (activities of daily living)
      1. Eating, toileting, transferring, bathing, dressing, mobility and, in a few policies, continence
  3. When will benefits start (aka “elimination period”)
    1. Sets forth the number of days you will pay the bill yourself
    2. Same idea as deductible, only measured in days, not dollars
    3. Most policies have a 100 day elimination period
    4. Some policies have an “accumulation period” so that the number of days does not have to be consecutive
  4. How much will be benefits be?
    1. Reimbursement policy – payment made directly to provider for services rendered
    2. Indemnity policy – set, pre-determined amount per day
    3. Is there a lesser rate for home care?
      1. Often, a % of the care facility payment amount
  5. How long will the benefits last (aka maximum lifetime benefit)?
    1. Typically one to five years. With proper ALTCS planning, there shouldn’t be a need for longer than 3 years.
  6. Is there a waiver of premium?
    1. Not have to pay while receiving benefits under the policy
  7. Is there inflation protection?
    1. A specified factor or index or an option to purchase additional coverage.
    2. Usually 5% compounded
  8. Preexisting conditions – what is excluded from coverage?

Warn clients about future increases in premiums – a much too frequent occurrence that can wreak havoc on those living on fixed incomes.

Income tax deduction of medical expenses

Do not overlook all costs that may qualify as medical expenses under IRC 213. Most people know that, on your federal income tax return, your medical expenses must exceed 7.5% of your adjusted gross income (ie, the amount at the bottom of the front page of the 1040). But there are two issues that many taxpayers do not know about. One is that, in Arizona, all medical expenses are deductible. There is no 7.5% hurdle.

The other issue is that the term “medical expenses” is a surprisingly broad term that includes many expenses that might not otherwise be considered medical. The Code defines this as “amounts paid for the diagnosis, cure, mitigation, treatment or prevention of disease, or the purpose of affecting any structure or function of the body, or for transportation primarily for and essential to medical care”. IRC 213(e). A huge amount has been written or issued as to what exactly this terms means and what is covered. You can get pretty creative here.

Note that there is no mention of “as prescribed by a doctor”. There are a few instances where a doctor’s prescription is necessary, most notably with medications. Otherwise, it simply must relate to a treatable condition. Expenses that are beneficial to your general health do not qualify.

Some examples of expenses that the IRS has agreed will qualify are: acupuncture, alcohol or substance abuse counseling, bandages, guide dogs, health insurance premiums (to include Medicare B), legal fees necessary to authorize medical treatment, psychiatric care, stop-smoking programs, special foods and dietary supplements if prescribed, specially equipped telephones or televisions for the hearing-impaired, vision correction, wigs and weight-loss programs if prescribed.

The entire costs of a nursing home are deductible if the “availability of medical care” is the “principle reason for his presence there”. If the person is there for “personal or family reasons”, then only the portion of expenses attributable to medical care is deductible (eg, no deduction for room and board). Treas. Reg 1.213-1(e)(1)(v)(a)&(b).

Improvements or modifications made to the home are deductible. Generally, these expenses are only deductible to the extent they do not increase the value of the home. However, the following expenses are deductible regardless of any increase in the home’s value: entrance and exit ramps, widening doorways, installing handrails and grab bars, modifying the kitchen, lifts other than elevators and ground grading.

Travel to and from the hospital or care provider is deductible. You can use a standard rate of 12 cents per mile or actual, out-of-pocket expenses. In addition, under either method, parking fees and tolls are deductible. Lodging that is “primarily for and essential to” medical care while visiting hospitals or similar facilities is deductible up to $50.00 per person, per night.