Third Party Special Needs Trust

A “Special Needs Trust” (SNT) is designed to help a disabled child who currently qualifies (or will probably qualify) for governmental disability benefits, such as Social Security Disability or MediCal, to keep those benefits while providing for any special needs. Many governmental benefits are tied to the financial resources of the receiving individual. Therefore, usual outright or in trust distributions to a child of the settlor or settlors who is receiving governmental benefits will probably disqualify that child from receiving the benefits until the assets from the distribution are almost exhausted. So, a Special Needs Trust allows the settlor or settlors to provide for a disabled child without disqualifying the child from the benefits.

Because the guidelines for qualification for the various federal and state benefits change (and because guidelines vary from state to state), you should receive advise from an attorney about these changes and how it may not be possible to ensure continued qualification of the child, regardless of what provisions are made in the SNT. The settlor or settlors may also, depending on the probable size of the trust, want to weigh whether trying to keep the child qualified will result in hardship when in fact the trust assets that could be made available to the child would ensure sufficient money for the child’s comfortable maintenance without reliance on disability benefits.

Basically, a SNT is an individual trust for the disabled child with a spendthrift provision and limitations on the amount of income payable to the child and on the child’s ability to invade the principal. Obviously, if a SNT is desirable for a child, it is imperative that the child not be named as trustee or successor trustee of the living trust. Therefore, a provision prohibiting the “special needs” child from becoming a trustee must be included in the trust document.

A third party SNT (commonly referred to as a supplemental needs trust) is funded with assets belonging to a person other than the beneficiary.  Common funding comes from the estates of parents or grandparents and life insurance policies naming the third party SNT beneficiary. Practically anyone other than the beneficiary can create a third party SNT. This trust has no provisions to pay back Medicaid upon the trust’s termination; rather, the person creating the trust decides how the trust remainder is distributed. A third party SNT can be testamentary (i.e., established under a Last Will & Testament) or inter-vivos (i.e., established during the lifetime of the person creating the trust). An inter-vivos third party SNT can be revocable or irrevocable.

An important decision to be made is the selection of the independent trustee. With an independent trustee, government programs usually do not count the trust assets as a resource since the beneficiary (special needs child) does not have control over the trust assets.

However, if the trustee is the child’s parent and the child is a minor, it may be difficult to argue that the child does not have any control over the assets of the trust.

This sounds as if it makes a powerful case to avoid a parental trustee situation, right? Well, not exactly.  Unless you plan to apply for Medicaid for your child prior to his or her 18th birthday, what is the impact on governmental benefits?  None!  Prior to age 18, your child is considered a minor and therefore, your assets are considered when applying for SSI.  (Note: For Medicaid purposes parents are financially responsible until age 21, unless the child is not living in the home for a specified period of time for medical purposes.  However, age 18 is the age of majority for SSI purposes, and you can get Medicaid through SSI.)  If you are so impoverished as to be able to qualify for SSI, it is likely that you are not concerned about setting up a Supplemental Needs Trust for your child.  And, if you wait until your child turns 18 years of age, the issue disappears.  For SSI purposes, the issue of whether the parents are the trustees becomes a moot point.

There may be other practical reasons such as income and estate tax that need to be considered when deciding whether the parent(s) should be the trustee(s), but the need to protect government benefits is not one of them.  Because of the discretion given a trustee in a Special Needs Trust, adverse income tax and estate and gift tax consequences may occur whenever a beneficiary may also become the trustee of the trust.

First, the drafter should be sure that no person who can serve as trustee of the Special Needs Trust is specified as a termination beneficiary for the Special Needs Trust. Since the trustee has the discretionary power to terminate the trust, a trustee who is a termination beneficiary could be determined to hold a general power of appointment for estate and gift purposes, resulting in adverse estate and gift tax consequences to the trustee [see I.R.C. 2041(a)(2),(b)(1)(A), 2514(b),(c)(1),(e); Treas. Reg. § 20.2041-1(b)(1),(c)(1),(c)(2)].

Furthermore, it is advisable to ensure that none of the sprinkling beneficiaries (whether they be the special needs beneficiary’s issue or the alternate beneficiaries) becomes sole trustee. Since the trustee is given the discretionary power (regardless of the standard) to pay income to the sprinkling beneficiaries, if one of those income beneficiaries becomes sole trustee, that income beneficiary will be treated as the owner of the income interest in the trust for income tax purposes and will be taxed on all of the trust income, including income not distributed to him or her [see I.R.C. §§ 671, 678(a); Rev. & Tax. Code §§ 17731, 17745]. For this reason, it is important to ensure that none of these alternate or termination beneficiaries are a possible trustee of the Special Needs Trust. Otherwise, the trustee may be determined to have a current interest in the trust whenever the trustee is an income beneficiary and, therefore, be responsible for income taxes on the trust. Also, if the trustee is a discretionary termination beneficiary, then adverse estate and gift tax consequences to the trust may result since the trustee could be determined to hold a power of appointment over the Special Needs Trust.

A provision in the trust instrument governing the appointment of successor trustees ensures continuity in the administration of the trust without resort to judicial proceedings in the event the initial appointees are unable to serve. Potential successor appointees should be consulted concerning their willingness to serve as trustees, as a person may not be forced to be trustee without his or her consent.

If the trustee will be given certain discretionary powers, it may be advisable to appoint as successor trustee a person who is not a trust beneficiary, since the discretionary powers might subject a trustee-beneficiary to adverse income, estate, or gift tax consequences [see I.R.C. §§ 678(a)(1), 2041(a)(2),(b), 2514(b),(c),(e)].  The resources for the questions in which the drafter specifies the provisions of individual trusts contain more specific information regarding the powers that will result in adverse tax consequences for a trustee-beneficiary.  However, the adverse income tax consequences can be avoided, and some of the adverse estate and gift tax consequences might be mitigated, by appointing a co-trustee to serve along with a trustee-beneficiary.

If the trust is testamentary, it is possible for it to qualify as a qualified disability trust for income tax purposes. In 2001, Congress created IRC section 642(b)(2)(C), establishing a tax benefit for certain disabled individuals who are beneficiaries of SNTs. The qualified disability trust must satisfy certain statutory requirements under IRC section 1396p(c)(2)(B)(iv):

  • The trust must be irrevocable.
  • The trust must be for the sole benefit of the beneficiary who is disabled.
  • The trust itself cannot be a grantor trust (i.e., it must be a taxpaying entity).
  • The beneficiary must be under the age of 65 at the time the trust is established and must have a disability that is included in the definition of disabled under the Social Security Act (IRC section 1382c[a][3]).

A qualified disability trust is eligible for a deduction equal to the personal exemption in lieu of the $100 complex trust exemption. (The personal exemption is $3,900 for the 2013 tax year.) If the testamentary third party SNT cannot meet the requirements of a qualified disability trust, then it will be taxed as a complex trust and receive a significantly lower exemption.

If the third party inter-vivos SNT is revocable, all income is taxed to the grantor. Certain irrevocable inter-vivos SNTs are grantor trusts for income tax purposes, but a careful assessment of the trust must be made to determine whether the trust qualifies as such. For example, if the grantor retains certain administrative powers, such as the power to reacquire trust assets by substituting other property of equivalent value or the power to borrow without adequate security, then the trust constitutes a grantor trust for income tax purposes.

The grantor’s retention of a limited power of appointment also renders it a grantor trust for income tax purposes. Again, grantor trusts only need to file an information fiduciary income tax return indicating that all items are reported on the grantor’s personal income tax return. Unlike in first party SNTs, the grantor is not the beneficiary in third party SNTs; rather, it is the person who created the trust (e.g., parent or grandparent).

It is also possible for an irrevocable inter-vivos third party SNT to be taxed as a qualified disability trust, provided that all of the requirements are satisfied. If the trust does not meet the requirements of a qualified disability trust or a grantor trust, then it will be taxed as a complex trust.

Taxation of SNTs is exceedingly complex. The language in SNTs can vary greatly from one to another, resulting in vastly different tax treatments. If you are uncertain about how the SNT should be taxed, it is essential to have it reviewed by a legal professional experienced in special needs planning and taxation.

As always, I appreciate your referrals and your business and look forward to working with you as part of your professional team and showing you ways to protect and maximize your wealth and assets and discuss a special needs trust with you further. If you need help in selecting your team of professions, I would be glad to assist you and draw from the team members whom I know, trust and are proven professionals.