If an individual transferred his or her IRA directly into an irrevocable grantor income only trust, and waited for 60 months to pass, the individual could apply and be eligible for Medicaid benefits without any of the trust corpus being subject to a Medicaid spend-down. Of course, with the individual being entitled to receive all of the income distributions from the trust, as may be required by the minimum distributions regulations of the Internal Revenue Code ("IRC"), the individual would have to contribute any distributions towards his or her monthly nursing home costs.
It seems easy, and cost effective, but why is it not being done? The answer is simple; the Internal Revenue Services ("IRS") has outlawed it as a prohibited transaction. Prohibited transactions involving IRAs, whether direct or indirect, include the:
- sale, exchange, or leasing of any property between a plan and a disqualified person;
- lending of money or other extension of credit between a plan and a disqualified person;
- furnishing of goods, services, or facilities between a plan and a disqualified person of income or assets of a plan;
- transfer to, use by, or transfer for the benefit of a disqualified person of income or assets of a plan;
- act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account (self-dealing); and/or
- receipt of any consideration for his personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. See IRC 4975(c)(1).
All of the transactions listed above mention "disqualified persons." The challenge is to determine whether a party to the transaction is a disqualified person. The IRS defines a disqualified person as:
- any fiduciary to the IRA, including IRA trustee and the IRA grantor, because the owner has the ultimate power to direct the investments in the IRA;
- the IRA grantor's spouse;
- the IRA grantor's ancestors and lineal descendants;
- spouses of the IRA grantor's lineal descendants;
- anyone providing services to the IRA (e.g., investment managers/advisers and the IRA trustee or custodian); and/or
- any corporation, partnership, trust, or estate in which the IRA grantor or family member listed above has a 50% or greater interest. See IRC 4975(e)(1).
In summary, virtually any transaction between an IRA and a disqualified person is a prohibited transaction. In addition, any self-dealing by a disqualified person who is a fiduciary to the IRA is considered a prohibited transaction.
The penalty to the IRA grantor for a prohibited transaction in an IRA is significant. The entire IRA becomes taxable as of the first day of the year in which the prohibited transaction occurred. See IRC 408(e)(2)(A). For example, a prohibited transaction in a $100,000.00 IRS in December of 2009 causes the entire $100,000.00 to be taxable as of January 1, 2009.
Finally, through an arrangement between the IRS and the Department of Labor (the "Department"), it is the Department's responsibility to determine whether a specific transaction is a prohibited transaction and to issue prohibited transaction exemptions. When the IRS discovers what appears to be a prohibited transaction in an IRA, the IRS turns the matter over to the Department to make the determination. The Department reviews the situation and responds to the IRS, which in turn responds to the taxpayer. If the IRA grantor wants to apply for a prohibited transaction exemption, he or she must apply to the Department.
