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Financial Planning > Tax Planning

When Medicaid and tax rules collide

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It’s tax season again. With that in mind, I noticed several incongruities between long-term care Medicaid rules and tax rules that every advisor should know and understand. So before you get too busy filling out your 1040, I thought I’d recap some good ways to make sure you and your clients are ready. 

Three years of tax returns vs. five-year look back 

Two recent cases brought up the same issue. In one case, I was talking to a financial accountant who does taxes and investments for her clients. Her client needed five years of statements for the Medicaid caseworker. “I only tell my clients to keep three years of statements,” she said, “because that’s what the IRS requires.” 

I just shook my head. 

In the second case, someone said to me, “The IRS only requires three years of back financials and Medicaid has a five-year look back. Since the IRS is a federal program and Medicaid is run by the state, doesn’t the federal rule prevail?” 

After that, I had to chuckle. 

To each, I have the same basic reply: “If you want Medicaid to pay, you’ve got to play by their rules.” In 2006, the Deficit Reduction Act established the five-year look back for transfers of assets. This is used to determine if the applicant has transferred or gifted any assets for less than fair market value. 

How do they look back? 

They ask for bank statements or financial statements for each account owned by the applicant during the five-year period. If you didn’t keep the statements, you’ll likely have to go to the financial institution and have them order copies. Most financial institutions do this for free, but some charge a fee. In one case, a bank charged $5 a statement and the client had two accounts. For 120 statements, it would cost the client $600, and the bank was unsympathetic with the client’s need for the statements. 

The better solution: Stop telling your clients to only keep three years of statements! Instead, be a smarter advisor and understand why they need to keep five years of statements.

Gift tax exclusion vs. Medicaid divestment penalties 

One of the classic myths of Medicaid planning is that you can give away $14,000 a year per person without a penalty. That’s just not true! The $14,000 limit comes from the annual gift tax exclusion. Over $14,000, you either pay a gift tax or use up part of your exclusion (discussed more fully below). But just because the same Congress passed the tax code and the Medicaid code, don’t think that the two actually agree with each other. 

Medicaid will look back five years and add up all gifts or transfers. Unless they were made to an exempt transferee (e.g., a disabled child), Medicaid takes the total amount and divides it by the average cost of care per month in the applicant’s state or region to determine how many months they will be ineligible for Medicaid. 

Gift and estate taxes are usually the least of most people’s true worries, but by thinking that the $14,000 exclusion applies, many people give this gift annually thinking there will be no negative consequence. 

When lecturing to a bar association’s tax section recently, I gave the example of a lady who gave her daughter $14,000 a year and ended up in a nursing home where the cost of care quickly drained her remaining resources. She files for Medicaid and they ask her if she transferred or gave away any money and she says yes, $14,000 a year. That totaled $70,000. 

Then Medicaid does the math: $70,000 ÷ $7,000/month = 10 months. So in this case, the woman would be ineligible for Medicaid for nearly a full year. Medicaid will require her to get the money back from her daughter and use it for care expenses. If the daughter won’t or can’t cough it up, most states require that the applicant “seek all legal remedies” to get the money back before they’ll grant a hardship waiver. 

What a mess! But this mess can be avoided. It starts with the advisor understanding and communicating the difference between the Medicaid rules and the tax code. A good advisor should caution clients against gifting without a long-term care strategy.

Gift tax vs. gift-and-wait strategies 

For advanced planning, we do a lot of gifting. Most choose to gift and wait out the 5-year look back. For VA benefit planning, we gift and apply for benefits where appropriate because of the lack of a penalty period for gifting. Even in crisis cases, for single patients it is usually advantageous to gift a portion of the assets and buy an annuity or use a promissory note with the remaining assets to help pay through the penalty period. 

See also: Medicaid and veterans’ benefits 

Gifts can be $10,000 or can be $600,000. So what about the gift tax? 

In reality, the gift tax is never a bar to good gifting strategies for Medicaid because of how the gift tax works. The gift tax was the tax code’s attempt to curb gifting to avoid the estate tax. So the two taxes were tied together. If you gifted more than the limit per person, the gift is subject to a tax, but the tax can be offset by using the estate tax exemption. 

So how much can you really gift? In the last few years, Congress increased the estate tax exemption to $5.34 million! That’s a lot of gifting. And practically speaking, if you have $5 million to gift, you probably aren’t too worried about needing long-term care Medicaid. 

The other issue is that recipients think their receipt of a gift is taxable to them. Most people don’t understand that gifts — even if they were taxable — are not taxable to the receiver but to the giver. 

If the new proposed VA rule takes effect adding a three-year look back to gifting for eligibility in the VA Aid & Attendance pension benefit, more people are going to have to execute gifting strategies to take advantage of necessary benefits.

Gifting vs. income 

There are times when you want to pay tax on transfers between a parent and a child so that it won’t look like a gift. This mostly arises when using a personal caregiver agreement to pay a child or close family member for care. Medicaid assumes that if a family member is providing care, then they’re doing it out of love and affection. If a person pays the family member for care, Medicaid — by default — will presume that the payment is a gift and add those gifts up to determine a period of ineligibility for Medicaid. 

To avoid those payments being treated as a gift, Medicaid has a complex set of rules that vary from state to state. For the most part, they require that a valid caregiver agreement be set up between the family members and that the payment is reasonable based on what it would cost for the same services in the local area. 

But what happens when Grandma pays the granddaughter $700 a week to care for her? Most forget to write up a contract. And even if they do, Grandma writes a check for $700 each week to the granddaughter. The granddaughter conveniently forgets to report the pay on her tax return each year because she hasn’t kept any money back to pay taxes. It’s usually not a big problem, because the funds look like a gift and gifts aren’t taxable to the recipient. 

Where the problem comes in is when Grandma goes on Medicaid. If there’s any question about whether or not they have a valid care agreement, whether the caregiver reports the income as taxable or not makes a big difference. When establishing that the payment is not a gift, one of the easiest ways to prove it wasn’t is to see if the recipient reported it as income. When the caregiver granddaughter puts the income on her tax return and treats it as income — even if Grandma was overpaying her to bleed down estate resources — Medicaid is likely to exclude the payments from the transfer penalty calculation because they were treated as payments and income by both parties to the caregiver agreement. 

See also: President’s plans for estate, gift and GST taxes 

Where this is exceptionally helpful is when the person needing care is a veteran. The VA currently accepts caregiver agreements and paid family caregivers as valid care expenses towards eligibility for the VA Aid & Attendance enhanced pension. By paying a family member, the caregiver expenses could trigger a benefit as much as $2,149 in 2015 for a married couple. That money comes in tax-free, but the caregiver has to pay tax on the care payments. Even so, the net plus to the family is in the tens of thousands each year. 

Where many VA benefit planners get it wrong is they advise payment for care but fail to follow through with advice on how to make those payments compliant with the future need for long-term care Medicaid and the IRS. 

Ultimately, the better advisors are aware of these issues and know the subject matter, the better off their clients will be — with far less of a need to dread tax season.


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