How to Draft and Use DRA Compliant Promissory Notes

One area where the elder law bar considered there to be an expanded planning opportunity was in promissory note planning. Then along came the DRA, with provisions that seemed to revive the use of notes in the planning process by setting clear guidelines, which, if followed, deemed the use of a note not to be a transfer of assets subject to a penalty period. Thus, promissory note planning in Non-Partial Return of Funds States had as its primary objective the preservation of the gifted share while utilizing the DRA compliant share (or the share transferred pursuant to the terms of the promissory note.)

Since Florida is a Partial Return of Funds State, meaning that a simple return of funds will not effect the “otherwise eligible” status of the individual, the need to use promissory note planning in a crisis situation did not (and still does not) exist. Once Florida began to allow the use of promissory notes (as per the January 2010 change in the ESS Manual), meaning that a DRA compliant note was neither a transfer of assets for penalty period purposes nor an available resource due to the secondary market issue, the use of notes could be pursued.

By making a loan to a family member in exchange for a promissory note, the community spouse’s resources are brought below the CSRA at the point of application for Medicaid benefits for the ill spouse. This unmarketable income stream would constitute income to the community spouse, but not a resource, thereby avoiding the need to file a spousal refusal. However, use an annuity if in fear of repayment.

The DRA explicitly excludes funds used to purchase a promissory note if the note: has a repayment term that is actuarially sound as determined in accordance with actuarial publications of the Office of the Chief Actuary of the Social Security Administration; provides for payments to be made in equal amounts during the term of the loan, does not permit deferral or balloon payments, and prohibits the cancellation of the balance upon the death of the lender.

Be certain that the face of the note addresses each of the foregoing DRA requirements. Proper drafting would suggest that the elder law attorney should draft the note by explicitly stating on the face of the note that it is non-negotiable, non-assignable and otherwise not transferable by the payee. For an added level of comfort, make the note even loess attractive to a third party buyer. Do not provide for acceleration in the event of default; do not provide for an incremental increase in interest rate due to a missed payment or default; do not add a provision authorizing the collection of attorney’s fees in the event of default; and do not waive the requirements for presentment, notice of dishonor and protest – make it difficult for a potential third party to enforce the note.

The promissory note requires the calculation of a monthly loan amortization schedule based upon a reasonable rate of interest until the desired time to zero out the note is reached. In Partial Return of Funds States, like Florida, this could be any amount of time desired as long as it was actuarially sound. It is important to remember, however, that the final payment of the note must be scheduled to occur within the life expectancy tables required by the DRA. Further, the state need not be named as a remainder beneficiary with the use of notes as is the case with annuity transactions. The interest received by the payee (client) will be considered taxable income.

In a Partial Return of Funds States, such as Florida, this strategy could be used in a spousal planning scenario, whereby assets of the community spouse are made the subject of a note to the extent such assets exceed the CSRA. The community spouse makes a loan equal to available assets. A repayment term of two months is conceivable, thereby giving the CS her excess funds back in a relatively short period of time while still avoiding the filing of a spousal refusal.