Using a Charitable Remainder Annuity Trust to Pay for Long Term Care Insurance

Faced with the possibility of spending all of their savings on the costs of their long-term care, many elderly or aging persons recognize that covering the possible problem with long term care insurance is far and away their best choice, due to the changing nature of Medicare and Medicaid laws.  With this problem hanging over their heads, elder law attorneys and other estate planning professionals are forced to consider long term care insurance first and foremost in long-range planning, and elderly or aging persons look to their advisors for creative ways to pay for the policy.

Currently, many elderly or aging persons do not buy long term care insurance because they feel that they cannot afford it.   Some of them feel that way because they consider their principal to be untouchable, and are concerned whenever any plan causes them to invade it.  A deeper inquiry into their finances often shows that much of their principal would not be needed for anything except paying for the costs of their long-term care.  (They could therefore be considered to be gambling with their principal by going without long term care insurance.)

Some elderly or aging persons would consider purchasing long term care insurance but want to evaluate its cost in today’s dollars.  Such clients would prefer to be shown a single premium long term care insurance policy.  For the many insurance companies that do not offer such a product, the use of an immediate annuity with a lifetime payout (or term certain payout equal to or exceeding the client’s life expectancy) to pay for the premium is one way to approximate such a policy.

Some elderly or aging persons would consider purchasing long term care insurance but feel that their principal is untouchable because it includes appreciated assets that would result in substantial capital gains taxes if sold.  They may view the appreciated asset as merely a stream of income that they receive.  Unlocking the equity in these appreciated assets can often provide the funds necessary to pay the premiums for long term care insurance.  Selling these assets, however, usually results in substantial capital gains taxes, thus reducing the amount remaining to pay for the insurance.  It is this author’s opinion that elder law attorneys and other estate planning professionals should be exploring with these clients the possible uses of a charitable remainder annuity trust (CRAT).

A CRAT is an irrevocable trust established pursuant to Internal Revenue Code section 664 that provides a payout to one or more individuals for their lives or a period of up to 20 years.  The payout must be at least 5%, and is based on the initial fair market value of the trust.  The payout that is selected by the client is payable each year without regard to the actual income of the trust.

The primary reason to consider the use of a CRAT in long-term care planning is that when a CRAT sells appreciated assets that had been donated to it, no capital gains taxes are immediately payable.  The CRAT can then invest the full amount of the proceeds in order to provide the payout, which in turn can be used to pay the long term care insurance premium.

The payout from the CRAT generally represents taxable income to the client. If the payout exceeds the current and accrued income of the trust, capital gain will be received by the client.  The type of taxable income should not be of much concern to the client,  since these taxes do not cause the principal of the CRAT to be diminished.  In fact, any long-term capital gain received from the CRAT could end up being taxed on the client’s income tax returns at a lower percentage than the trust’s income.

At the end of the payout period, any amount left in the CRAT must be paid to a charity selected by the client that is described in Internal Revenue Code section 170(c).  When establishing the CRAT, the client need not make an irrevocable decision about which charity will eventually benefit, as the client can reserve a special power of appointment and thereby preserve the right to change the charity receiving the remainder of the trust at the end of the payout period.

Although the remainder of the CRAT would be inherited by a charity instead of the client’s intended heirs, the existence of the long term care insurance would presumably ensure that the client’s other assets would be left behind as an inheritance to them.

A charitable remainder unitrust (CRUT), the other basic type of charitable remainder trust, is not as good a choice for this type of planning. First, the amount received from a CRUT is determined on an annual basis, and is dependent on the income generated by the CRUT’s investments.  If the investment performance in a CRUT were poor for a substantial period of time, the client would be required to invade the client’s remaining principal to pay the long term care insurance premiums.  Thus, the use of a CRUT is often rejected here because it does not provide the certain payout that a client would be looking for in order to pay the annual long term care insurance premium, which should remain level.

The client establishing the CRAT would be entitled to a charitable deduction on the client’s income tax return based on the present value of the charitable remainder.  It is assumed here, however, that the client would be focused primarily on eliminating capital gains taxes on the sale of appreciated assets and receiving the highest feasible payout in order to pay the long term care insurance premium rather than leaving a large amount to charity and receiving a large income tax deduction.

The difficult choice that a client must make on a CRAT is whether to establish a term certain payout or a lifetime payout.  It is this author’s experience that many elderly or aging persons do not wish to enter into a financial gamble that is based on their meeting or exceeding their life expectancy under an actuarial table.  They are concerned about having lost money if they die earlier than their projected life expectancy, and would prefer a payout for a term certain.  Upon the client’s death prior to the end of the term certain, the remaining payout would go to a beneficiary designated by the client.

Another argument in favor of a term certain payout in a CRAT is that the calculations to meet IRS scrutiny are simpler.  With a lifetime payout and a high payout percentage, the IRS could disqualify the CRAT if statistically there could possibly be no remainder to  be left to charity.  The IRS therefore requires that with a lifetime payout there be no greater than a 5% chance that the CRAT could be exhausted by the payout.  The result of the required calculation often is that for a lifetime payout the payout percentage must be smaller than the payout percentage on a term certain. To pay for the client’s long term care insurance premium with a lifetime payout, then, the CRAT would require a greater initial fair market value via more assets to make up for the lowered percentage payout.  Faced with these figures, the likelihood of needing a payout period of greater than 20 years should be considered.

Statatistically, a 20-year payout may be sufficient for most clients.  Under HCFA  Transmittal No. 64 (November 1994),  a female who is 64 years of age or older or a male who is 58 years of age or older has a life expectancy of less than 20 years.  Thus, for most clients purchasing long term care insurance a CRAT for a term certain of 20 years would be longer than needed.  (If the client wished to cover long term care insurance premiums only for the client’s average life expectancy, persons over these ages would require a shorter term certain for their CRAT, and it would therefore require a lower initial fair market value.)

Since the client’s taxable income will be increased by the CRAT, the client may wish to increase the initial funding and receive a payout in excess of the long term  care insurance premium in order to help pay the increased income taxes. The ability of many clients to deduct the premium as an itemized medical expense on Schedule A of their federal income tax return, however, could in many cases offset the taxable income caused by the CRAT.