Posts Tagged ‘Taxes’

Things to Consider When You’re Named as Successor Trustee

NOVEMBER 2, 2015 VOLUME 22 NUMBER 40

When a family member dies, you will need to address a number of items. One that might come up: handling the revocable living trust they created.

If you are named as successor trustee you will have a number of obligations you need to discharge. You might need help from a lawyer and/or an accountant; you should not hesitate to consult one or both to figure out how much help you do need. Many of the successor trustees who consult us can do just fine without continuing legal help, but the process is not always easy or obvious.

We can provide you with an introduction to the considerations involved in handling a trust after the death of the trust’s settlor. Before we start, though, these caveats/warnings are appropriate: we’re only writing about Arizona law, and your situation might be very different than the other facts we assume here. Any questions in your mind about what needs to be done? Ask a lawyer.

With that in mind, here are some of the issues to consider shortly after the death of someone who named you as successor trustee:

What law applies? It’s not always obvious. If your mother signed her trust in Arizona and lived and died in Arizona, and you live in Arizona as well, her trust will almost certainly be governed by Arizona law. But what if she lived in another state and you live in Arizona? Or if the reverse is true? Or the trust says that another state’s law will apply?

The general rule: the law of the state where the trustee lives usually applies. That’s you, not your now-deceased mother. If you are the trustee, start by talking with a lawyer in your own community, and ask her whether she is the right person to advise you (of, if not, if she can refer you to someone in the right state).

Notice to beneficiaries. The law of many states — including Arizona — requires specific written notice to the beneficiaries of a trust after you take over as trustee of an irrevocable trust. Did you manage the trust for a time before your father’s death? Ask your lawyer about the applicable state law. This is an area where state laws differ.

Arizona says that notice is due within sixty days of a trust becoming irrevocable (as, for instance, upon the death of the settlor):

Within sixty days after the date the trustee acquires knowledge of the creation of an irrevocable trust or the date the trustee acquires knowledge that a formerly revocable trust has become irrevocable, whether by the death of the settlor or otherwise, shall notify the qualified beneficiaries of the trust’s existence, of the identity of the settlor or settlors, of the trustee’s name, address and telephone number, of the right to request a copy of the relevant portions of the trust instrument and of the right to a trustee’s report as provided in subsection C.

That’s Arizona Revised Statutes section 14-10813(B)(3). Note that it refers to a list of items the notice must include. You can read that description at the same link, but it basically requires information about the settlor, the trustee, the trust and its assets.

Identifying the beneficiaries. Who is a “beneficiary.” Suppose your father’s trust says that if you, all your children, and all your cousins die in a common accident, everything goes to a charitable organization. Does that mean that all notices have to be sent to that charity, too? Not necessarily.

Arizona defines people and organizations who need notice (they are called “qualified beneficiaries”) to include everyone who is entitled to (or even can receive) income or principal right now, plus anyone who could receive trust money if one thing happened (like the death of a beneficiary). That’s a bit of a simplification, but it should help figure out who is entitled to notice. The details are in Arizona Revised Statutes section 14-10103(14). It’s a little hard to read and interpret — talk to your lawyer about it if you have any difficulty figuring out who is a “qualified beneficiary.”

Review the trust. Not just the parts identifying the beneficiaries, or the list of successor trustees. Read the entire trust. It might tell you to do more than the law requires. In some cases, it might tell you that you can do less than the minimum spelled out in the law — though sometimes those provisions are ineffective. Talk to your lawyer if you have any questions about minimum or maximum requirements.

Certificate of trust. When your mother signed her trust, she probably created a short (two- or three-page) document that listed the trust’s name, her status as trustee and the name of her successor trustee (among other things). You will probably want to prepare a similar document as successor trustee, and it might need to be filed with the County Recorder’s office in any county where the trust owns real estate. Arizona Revised Statutes section 14-11013 tells you what you might include in that certification, but it doesn’t provide a form. Having a hard time finding a good form? That’s because every case is so different — depending on how many and who the beneficiaries are, what kinds of assets the trust holds, the relationship of the successor trustee, and other things. Ask your lawyer for help.

Taxes. You knew that taxes would be an issue, right? Someone (and it’s probably you) will need to sign and file a final federal income tax return for the part-year they lived. The trust will be a separate taxpaying entity, and will need to secure a taxpayer ID number (an EIN) and file at least one federal income tax return. There will need to be state income tax returns for the state where your family member lived, and for the trust in one or more states. This is a good item to discuss with your accountant.

There’s more. This list is far from complete. It’s an attempt to give you some idea of what you’re facing, and to help you figure out whether you need to consult a lawyer. Not sure? That’s the best evidence that you need to get good legal counsel.

Income Taxation of Trusts — Not Just Special Needs Trusts

APRIL 6, 2015 VOLUME 22 NUMBER 13

We have previously explained the income taxation of self-settled special needs trusts and third-party special needs trusts. We focused on special needs trusts because, well, that’s what we do — and also because there seems to be so much confusion about special needs trusts. But that is not the only confusion out there. We find a lot of confusion about taxation of trusts, generally. Let’s see if we can clarify some of the issues.

The income tax issues are actually the same for trusts that are not “special needs” trusts. But the generalizations are a little harder to keep straight, since there is a much broader variety of trusts out in the world. So let’s see if we can lay out some questions and answers to help you understand the issues.

The first question: is the trust a “grantor” trust?

Why is this question the first (and probably the most important)? Because if the trust is a grantor trust it (a) does not need to have a separate taxpayer identification number (what is called an EIN, or Employer Identification Number, in tax language) and (b) should not file a separate tax return. If the trust is a grantor trust, you can (and usually should, if only for convenience purposes) use the grantor’s Social Security Number and report income on the grantor’s personal income tax return.

So how do you know if your trust is a grantor trust? Let’s ask a few qualifying questions:

  • Did you create the trust, or did the money in the trust once belong to you?
  • Is the trust revocable (by you)?
  • Are you the trustee?
  • Are you a beneficiary of the trust?

If you answer the first question “yes” and any one or more of the following questions “yes,” your trust is almost certainly a grantor trust. There are some exceptions, but they are relatively rare. Talk to your attorney and your tax preparer — and we recommend you talk with both. Why? There is a lot of misunderstanding out there, and neither lawyers nor accountants always get the answer right on this question.

What are the most common misunderstandings? You will sometimes hear accountants, bankers, stockbrokers and lawyers assure you that an irrevocable trust that names someone other than the grantor as trustee must have a separate EIN (and, presumably, file a separate tax return). That’s simply not true. It’s also not relevant to whether or not the trust is a grantor trust.

There are also some “magic” provisions in irrevocable trusts that are usually used precisely to make them grantor trusts. If, for instance, your irrevocable trust includes a provision that says the person who set it up retains the right to trade (“substitute”) property in the trust for their own property, it’s pretty likely that was included precisely to make sure the trust is a grantor trust.

What if the trust is not a grantor trust?

Then the trust will need an EIN, and it will file a separate income tax return. That does not necessarily mean it will pay any income tax, but it will need a return filed.

Depending on the language of the trust and the nature of its distributions, some or all (or, rarely, none) of its distributions will be taxed to the recipient — or to the person who benefited from the distribution. So, for instance, if a non-grantor trust sends cash to its beneficiary, the beneficiary will probably pay some income tax on the distribution. Same answer if, instead, the trust pays the beneficiary’s rent, college tuition and car payments directly — all of those distributions are for the benefit of the beneficiary.

Note that not all of the trust’s distributions will be treated as income to the beneficiary. Only the portion of the distributions that would have been taxed to the trust (that is, the trust’s income) will be subject to being passed through to the beneficiary. So, for instance, if a trust has $1,000 of interest income, and pays $15,000 in rent and tuition bills for the beneficiary, no more than that $1,000 figure will be taxable income to the beneficiary. At least some of the administrative costs will probably be deductible before calculating the tax effect.

How does the non-grantor trust report its income for tax purposes?

The federal tax form used by trusts is called the 1041 (it’s similar to, but different from, the individual’s 1040 income tax form). It actually looks a little simpler than the personal income tax return, but that’s misleading — some of the accounting and tax concepts are more complicated and less understood. We recommend that trustees get a professional to prepare the trust’s tax return.

What about state income tax returns?

The trustee will likely need to file state income tax returns that mirror the federal return. But for which state(s)? That’s a hard question to answer, and impossible to generalize about. Some states want trust income tax returns for any trust that has a trustee or co-trustee living in their state. Others look primarily to where any one beneficiary lives. Other states do not have income tax at all, and so do not require a trust to file an income tax return. Your professional tax preparer will want to consider at least: (a) the language of the trust, (b) the residence of all beneficiaries, and (c) the residence of all trustees.

Can any tax preparer handle a trust’s income tax return?

Yes. Probably. Maybe. Wait — let us ask you a question: have you asked the tax preparer how often he or she prepares trust income tax returns? If not, we suggest you might want to ask. The returns are not bewilderingly complicated, but they are unfamiliar to people — even professionals — who are not used to working with them. Your best bet: get a professional (probably a CPA, perhaps a lawyer or law firm) who does this kind of tax return on a regular basis.

Good luck getting through this tax season. We hope this helps. Be careful, though — there are exceptions and qualifications to the general rules we’ve outlined. Check with your experienced tax preparer or attorney before actually preparing returns. Better yet: let the professionals do it.

Taxation of Pooled Special Needs Trusts

SEPTEMBER 23, 2013 VOLUME 20 NUMBER 36

We write a lot about taxation of trusts, and especially of special needs trusts. But there is one type of trust that we haven’t written much about, and we can’t find other explanations for. “Pooled” special needs trusts are a special kind of trust, and there is much confusion about how they should be treated for federal income tax purposes.

First, we don’t think there are a lot of other tax issues about pooled special needs trusts (other than income taxation, that is). They are seldom — perhaps never — large enough to raise gift tax issues or estate tax concerns. We can imagine an occasional parent wondering about the gift tax treatment of contributions to a pooled trust account, but only the wealthiest parents are going to need to worry about that, and they are probably getting an abundance of good tax advice from their lawyers and accountants.

So let’s just talk about income taxation of pooled special needs trusts. But first perhaps we need to define terms.

What is a pooled special needs trust?

Pooled trusts are just what the name suggests: a single trust consisting of money held for the benefit of a number of individuals. Usually those separate trust accounts are managed together but accounted for separately. In other words, your contribution to a pooled special needs trust will be used just for you (or for the other person you designate), not for other beneficiaries. But your money and theirs will be pooled into a single investment structure, so that your administrative costs will probably be lower and your earnings higher than they would be if you were on your own.

By convention pooled special needs accounts tend to be smaller. There is no reason that needs to be true, but it often is. People with substantial money to be set aside in a trust tend to want separate treatment, separate management and different structures. But that is not always true, so some pooled accounts are large.

Most pooled special needs trusts include only money that once belonged to the beneficiary — like personal injury lawsuit settlements, or inheritances from someone who never set up an appropriate trust, or even back payments from Social Security. Increasingly, though, parents (and others) wanting to set aside money for a child with a disability are looking at pooled trusts as a convenient and cost-effective alternative.

When money comes from personal injury settlements or unrestricted inheritances, the resultant pooled trust share is referred to as a “self-settled” or “first-party” pooled trust.  When the trust is set up by a parent or another person, the pooled trust share is called a “third-party” pooled trust. That’s important for income tax purposes.

Taxation of self-settled pooled trust accounts

If a person with a disability transfers funds to a trust for their own benefit (or someone else does it on their behalf), the trust share is called a “grantor” trust. That means that the self-settled share does not pay separate income taxes, or even file a return. The larger trust may have to file a return, but none of the income attributable to the self-settled share (and none of that share’s portion of deductible expenses) gets reported on a trust (or fiduciary) income tax return. For income tax purposes, the self-settled pooled special needs trust share simply doesn’t exist.

That doesn’t mean that there is no income tax. The beneficiary may still have to file an individual tax return, including any income and deductible expenses. Of course, the beneficiary may not have sufficient income — even with the trust’s income added in — to need to file a return, and the fact of the trust won’t change that.

Of course, the beneficiary only knows what he or she has to do if the trustee passes information along to them. So the federal government requires that the trustee give the beneficiary all the information they need to fill out their own tax return. But the trustee doesn’t file anything for the trust, except the brief statement that the trust is a grantor trust and is not filing a separate return.

Taxation of third-party pooled trust accounts

If someone else puts the money into a pooled trust account, that may (or may not) set up a requirement for separate tax filings. Often, the person contributing the money will be treated as the “grantor” and have to report the income and take the appropriate deductions — even if they are not benefiting from the trust. That decision is based on a complicated set of rules known as the “grantor trust” rules. Volumes have been written about the peculiar twists those rules may take, but let’s make the simple over-generalization that, during the lifetime of the donor, it is likely that the donor will be liable for the income tax on a third-party pooled special needs trust share.

If the third-party trust share is not a grantor trust, then the trustee will need to file a federal Form 1041 — the fiduciary income tax return — if the larger trust has more than $600 of income. That return will list all income and deductible expenses, and then may result in taxable income being assigned to the beneficiary — to the extent that the beneficiary receives assistance from the trust. Did the trust pay dental bills, or moving expenses? There may be an income tax consequence to the beneficiary (but only to the extent of taxable income received by the trust — not usually the full value of services or goods purchased by the trust).

Does a pooled special needs trust need an Employer Identification Number — an EIN?

Yes. always. It’s always fun to be able to give a simple and absolute answer. There is a lot of detail behind that simple answer, but the answer is always simple: yes.

We hope that helps. The follow-up questions can be bewilderingly complicated, but go ahead — we’ll see if we can give at least generalized answers. If you have specific legal questions based on your trust’s particular circumstances, you should ask your lawyer (or a lawyer) rather than posting your query online. But we’ll (gently) let you know if we think that’s the case based on your question.

Tax Issues for Trusts — Simplified

JULY 29, 2013 VOLUME 20 NUMBER 28

Judging from the questions and comments we get here, taxation of trusts is one of the most confusing issues we regularly write about. We’re going to try to collect the most important rules here for your convenience. Note that we will not try (in this summary) to touch on every exception, every caveat — we want to try to spell out some of the major categories of trusts and of taxation, and see if we can help you figure out what tax issues you have to face. We will try to give very concise answers, a little explanation and a warning about some of the more common or important exceptions in each category.

Do I need to get an EIN for my revocable living trust?

Short answer: no.

More detail: if you created a trust, put your money in it, and retained the right to revoke it — the IRS doesn’t think of it as a trust at all. It is not a separate taxpaying entity. Not only do you not need to get an Employer Identification Number, you can’t get one. A revocable living trust is always a grantor trust, and it does not file its own tax return.

Important exception: if you are trustee of a revocable living trust created by someone else, you can get an EIN but you are not required to do so. Even if you do get an EIN, the trust does not file a separate trust tax return.

I am setting up a special needs trust for my child, who has a disability. I plan on leaving his share of my estate to the trust. Does it need an EIN?

Short answer: probably not — yet.

More detail: while you are still alive you probably will be the “grantor” of the trust for tax purposes — and that may even be true if the trust is irrevocable. Probably you will pay the taxes on any income the trust receives (note: your contributions to the trust are not “income” for tax purposes). But probably this is not important — you really are probably asking about what happens when you die and your estate flows to this trust. THEN it will need an EIN and it will file its own tax returns. Probably it will be what the IRS calls a “complex” trust.

Important exception: if the trust is both irrevocable and immediately funded, it probably does need an EIN even before you die and leave a larger share of your estate to it.

My daughter’s special needs trust was funded with money from a personal injury settlement. Does it need an EIN?

Short answer: almost certainly not.

More detail: even though it is irrevocable, and even though your daughter is not her own trustee, this trust is almost unquestionably going to be a grantor trust for tax purposes. That means it does not need to have a separate EIN; it uses your daughter’s Social Security number as its taxpayer identification number.

Important exception: although it does not have to get an EIN, this kind of trust may get an EIN. But even if it does, the trust does not file a separate income tax return — all the trust’s income gets reported on your daughter’s individual return.

My father established a revocable living trust to avoid probate, and he died earlier this year. Do I need to get an EIN for his trust? Can I just keep using his Social Security number?

Short answer: Yes, you do. No, you can’t.

More detail: With your father’s death his trust became a different entity. It is no longer a “grantor” trust, so should be filing its own income tax returns for the rest of the calendar year of his death and for the future (if the trust continues).

Important exception: While the trust should have its own EIN, it will only have to file a return if it earns $600 in income in any one year after his death. So if the trust gets resolved fairly quickly, and/or does not hold any income-producing property, it may not need a tax return. In that case, and that case only, it may also not need to have a separate EIN.

As a separate exception to the general rule, note that there are some limited circumstances in which your father’s trust may not have to use a calendar year. That can have significant favorable income tax consequences, so be sure to discuss the tax issues with your accountant and/or attorney.

My wife and I created a joint revocable living trust. She died two years ago, and I was simply too busy dealing with everything to do anything about the trust. Are there tax issues I need to resolve, or am I going to get into trouble for not doing anything quickly?

Short answer: You probably are not in any serious trouble, but you should talk with an accountant and/or attorney soon. Don’t continue to put it off, please.

More detail: It may be that nothing needs to be done regarding your trust. It may be that your trust was supposed to be divided into two shares upon the first death. It may be that such a division no longer makes tax sense — but it might still be necessary to deal with it. It’s too hard to generalize about all those possibilities, and your lawyer needs to look at the trust document AND know how assets are titled. Make an appointment and start gathering information. If you don’t do anything before your own death, your children (or whomever you have named as ultimate beneficiaries) will have a much more complicated time dealing with it than you do now. Incidentally, in our experience it is fairly rare that a surviving spouse does not want to make any changes whatsoever — even if all you want to do is to accelerate the pace at which your children receive your estate, it is a good idea to meet with your attorney.

Important exception: If you are certain that your trust does not require division into separate shares on the first spouse’s death, AND you still want the same people to administer your estate, AND you still want everything divided the same way as the original document provides, then it may not be necessary to make any changes. Most lawyers will tell you that it still makes sense to update powers of attorney and your will to remove your late wife’s name (just so your back-up agent doesn’t have to produce a death certificate before banks and doctors will talk with her), but it may not be critical to do so. Still, talking with lawyers is kinda fun, and almost everyone should do it more often.

There you have it. Our most-asked-about trust taxation questions, with simplified answers. Please be careful about this information, though — there is a lot of nuance we have glossed over. Talk to your accountant and your lawyer to confirm what we have told you here before relying on it. Our goal is to give you a bit of a roadmap, not to answer complex legal questions with oversimplified generic answers. But we hope we have helped.

Principles Governing Third-Party Special Needs Trusts

OCTOBER 3, 2011 VOLUME 18 NUMBER 35
Last week we tried to demystify some of the principles of self-settled special needs trusts, and to distinguish them from third-party trusts. This week we continue that education effort, focusing on the rules governing third-party trusts.

Generally speaking, there are two kinds of special needs trusts. Those set up to handle money owned by the beneficiary (like a personal injury settlement, for instance) are usually called “self-settled” special needs trusts. Those set up by someone other than the beneficiary, to handle money not belonging to the beneficiary, are usually called “third-party” special needs trusts. It is the latter kind of trust we want to explain here.

What kind of property can go in to a third-party special needs trust?

Any property someone wants to leave or give to a person with a disability can (and usually should) be placed in a third-party special needs trust. Homes, cash, stock and bonds are all common third-party trust assets.

Are all inheritances properly viewed as third-party trusts, since they come from someone other than the beneficiary?

This is one of the common confusions for those not closely familiar with special needs planning. An inheritance can be left outright to someone, or in a trust for their benefit. In the case of a trust, it can be designated for the “support and maintenance” (or similar language) of the beneficiary, or for their “special” and/or “supplemental” needs (or similar language).

If an inheritance is left outright to a person with a disability, it might be transferable to a trust — but probably only to a self-settled special needs trust, since the beneficiary had an absolute right to possess the property outright. If an inheritance is left in what we might call a “support” trust, it may be a third-party trust but not necessarily a third-party special needs trust. Only if a trust contains money from someone other than the beneficiary and includes language limiting its use to special or supplemental needs will it be considered a third-party special needs trust.

Can an inheritance which is not left to a third-party special needs trust be “fixed”?

Sometimes. State law varies greatly. Fact patterns are very different. This is an important question which should be asked of a qualified attorney. Expect the response to be “let me ask you a few more questions.” The likelihood is high enough, though, that the possibility should definitely be addressed.

Are all third-party trusts funded with inheritances?

Absolutely not. Many people create third-party trusts for their children, loved ones, friends or family members while the person creating the trust is still living. Perhaps a wealthy family is eager to reduce assets in the first generation’s name, but unable to transfer funds outright to a child with a disability. Perhaps friends want to band together to provide assistance to someone who is or has become disabled. Perhaps one generation wants to create a vehicle for other family members — including other generations — to make contributions to the welfare of a person with a disability.

Are all third-party special needs trusts irrevocable?

No. Self-settled special needs trusts must be irrevocable, but the same is not true for third-party trusts. Usually a trust established during the life of the trust’s grantor (rather than in their will) is revocable during the grantor’s life. It is important that the beneficiary not be able to revoke the trust, but there is no reason someone who is not the beneficiary can not be given the authority to terminate it.

Who is the “grantor” of a third-party special needs trust?

“Grantor” is a term that has meaning in the tax code — and that meaning is not always synonymous with the general understanding of the language. A grantor is the person who created a trust and is still liable to pay the income taxes on the trust’s earnings. In the case of a revocable third-party special needs trust, the grantor will usually be the person who (a) contributed the money and (b) has the power to revoke the trust — though even that general statement will not always be true. In the case of an irrevocable third-party special needs trust, the person contributing the money may still be the grantor. This is a question best addressed in individual cases by a qualified attorney and/or Certified Public Accountant.

The income tax definition of a “grantor” is important. The grantor will be taxed on the trust’s income, even though he or she may not receive any benefit from those earnings. Though this sounds ominous, it may well be a desirable result — the tax rates on a trust are usually higher than those on an individual, and a wealthy donor might actually prefer to bear the income tax burden rather than have the trust depleted by having to pay taxes. The income tax filings for a third-party trust created by a living grantor can be very complicated, and almost always require the tax preparation skills of a CPA or other experienced professional.

Can a third-party special needs trust be a “Qualified Disability Trust?”

Yes, it can — but only if it is not a grantor trust, taxed to the person who put the money into the trust in the first place. If a trust is a Qualified Disability Trust, there can be important income tax benefits. Basically, such a trust is permitted to claim an “extra” personal exemption, reducing income tax liability in some (but not all) cases. For more detailed information about Qualified Disability Trusts (or to help educate your tax preparer), consider the Special Needs Alliance article authored by Fleming & Curti partner Robert Fleming and friend Ron Landsman.

What happens to the “grantor” status of a third-party special needs trust when the grantor dies?

The trust is no longer a grantor trust. It is now almost certainly what the Internal Revenue Service calls a “complex” trust, and will need to file a separate income tax return (and pay its own income taxes). One important note, though: distributions for the benefit of the beneficiary — the person with a disability — will be treated as income to him or her, reducing the trust’s income tax liability but possibly creating income tax liability for the beneficiary.

Does a third-party special needs trust need its own tax identification number?

If it is still a “grantor” trust (to the person putting the money into the trust) then it might not need a separate tax number or any income tax filings. Upon the death of the grantor, and earlier in many cases, the trust does need to have an Employer Identification Number (an EIN) and to file separate income tax returns. Even though it may not need an EIN while the grantor is still alive, it is usually permissible for it to obtain one, and to file informational returns (though the tax liability all flows to the grantor, and trust administration costs are probably not deductible). This is one of the areas of greatest confusion, and is yet another good reason for the trustee of any special needs trust to seek out an experienced and qualified tax preparer, usually a CPA who has prepared many returns for special needs trusts.

What kinds of things may a third-party special needs trust pay for?

Though there may be limitations in state law and Medicaid rules about what a self-settled special needs trust can pay for, there are almost no limitations on third-party trust distributions. The trustee must remember this, though: some distributions may have the effect of reducing — or even eliminating — some or all of the beneficiaries public benefits.

That may not always be a bad result. Many times a thoughtful trustee will make distributions that affect public benefits in at least these kinds of scenarios:

  • The effect is to lower, but not eliminate, benefits — and the positive outcome is worth the reduction in benefits (as, for instance, when the trust pays housing expenses and causes a small reduction in Supplemental Security Income payments but improves the beneficiary’s quality of life)
  • The effect is temporary (as, for instance, when the trustee makes cash distributions that allow the beneficiary to pay off old debt that the trust can not tackle directly, or replenish depleted cash reserves, or purchase food or shelter directly — or all of those things)
  • The benefit of distributions outweighs the loss of public benefits (as, for instance, when the special needs trust is very large, the beneficiary’s disability is slight and his or her quality of life is better enhanced by allowing the trust to pay all bills and eliminate public benefits — and the limitations on eligibility — altogether)

Where can I get more information?

One excellent resource is the Special Needs Alliance’s “Handbook for Trustees.” It covers both third-party and self-settled special needs trusts, and provides a wealth of practical information for trustees. It is also available in Spanish.

So what, again, are the differences between third-party and self-settled special needs trusts?

The take-away message: third-party special needs trusts are much more flexible and can be much more beneficial to a person with a disability than the more-restrictive self-settled trust. That means that the trustee of a third-party special needs trust often has a more challenging job, having to weigh intangibles and balance the wishes of the original donor of the funds, the hopes and aspirations of the beneficiary (and family members, friends and supporters) and general trust principles. That is why professional help and advice are so important.

Distinguishing Two Kinds of Special Needs Trusts

AUGUST 23, 2010 VOLUME 17 NUMBER 27
It really is unfortunate that we didn’t see this problem coming. Those of us who pioneered special needs trust planning back in the 1980s should have realized that we were setting up everyone (including ourselves) for confusion. We should have just given the two main kinds of special needs trusts different names. But we didn’t, and now we have to keep explaining.

There are two different kinds of special needs trusts, and the treatment and effect of any given trust will be very different depending on which kind of trust is involved in each case. Even that statement is misleading: there are actually about six or seven (depending on your definitions) kinds of special needs trusts — but they generally fall into one of two categories. Most (but not all) practitioners use the same language to describe the distinction: a given special needs trust is either a “self-settled” or a “third-party” trust.

Why is the distinction important? Because the rules surrounding the two kinds of trusts are very different. For example, a “self-settled” special needs trust:

  • Must include a provision repaying the state Medicaid agency for the cost of Title XIX (Medicaid) benefits received by the beneficiary upon the death of the beneficiary.
  • May have significant limitations on the kinds of payments the trustee can make; these limitations will vary significantly from state to state.
  • Will likely require some kind of annual accounting to the state Medicaid agency of trust expenditures.
  • May, if the rules are not followed precisely, result in the beneficiary being deemed to have access to trust assets and/or income, and thereby cost the beneficiary his or her Supplemental Security Income and Medicaid eligibility.
  • Will be taxed as if its contents still belonged to the beneficiary — in other words, as what the tax law calls a “grantor” trust.

By contrast, a “third-party” special needs trust usually:

  • May pay for food and shelter for the beneficiary — though such expenditures may result in a reduction in the beneficiary’s Supplemental Security Income payments for one or more months.
  • Can be distributed to other family members, or even charities, upon the death of the primary beneficiary.
  • May be terminated if the beneficiary improves and no longer requires Supplemental Security Income payments or Medicaid eligibility — with the remaining balance being distributed to the beneficiary.
  • Will not have to account (or at least not have to account so closely) to the state Medicaid agency in order to keep the beneficiary eligible.
  • Will be taxed on its own, and at a higher rate than a self-settled trust — though sometimes it will be taxed to the original grantor, and sometimes it will be entitled to slightly favorable treatment as a “Qualified Disability” trust (what is sometimes called a QDisT).

So what is the difference? It is actually easy to distinguish the two kinds of trusts, though even the names can make it seem more complicated. A self-settled trust is established with money or property that once belonged to the beneficiary. That might include a personal injury settlement, an inheritance, or just accumulated wealth. If the beneficiary had the legal right to the unrestrained use of the money — directly or though a conservator (or guardian of the estate) — then the trust is probably a self-settled trust.

It may be clearer to describe a third-party trust. If the money belonged to someone else, and that person established the trust for the benefit of the person with a disability, then the trust will be a third-party trust. Of course, it also has to qualify as a special needs trust; not all third-party trusts include language that is sufficient to gain such treatment (and there is a little variation by state in this regard, too).

So an inheritance might be a third-party special needs trust — if the person leaving the inheritance set it up in an appropriate manner. If not, and the inheritance was left outright to the beneficiary, then the trust set up by a court, conservator (or guardian of the estate) or family member will probably be a self-settled trust.

That leads to an important point: if the trust is established by a court, by a conservator or guardian, or even by the defendant in a personal injury action, it is still a self-settled trust for Social Security and Medicaid purposes. Each of those entities is acting on behalf of the beneficiary, and so their actions are interpreted as if the beneficiary himself (or herself) established the trust.

Since the rules governing these two kinds of trusts are so different, why didn’t we just use different names for them to start with? Good question. Some did: in some states and laws offices, self-settled special needs trusts are called “supplemental benefits” trusts. Unfortunately, the idea didn’t catch on, and sometimes the same term is used to describe third-party trusts instead. Oops.

We collectively apologize for the confusion. In the meantime, note that the literature about special needs trusts sometimes assumes that you know which kind is being described and discussed, and sometimes even mixes up the two types without clearly distinguishing. Pay close attention to anything you read about special needs trusts to make sure you’re getting the right information.

Want to know more? You might want to sign up for our upcoming “Special Needs Trust School” program. We are offering our next session (to live attendees only) on September 15, 2010. You can call Yvette at our offices (520-622-0400) to reserve a seat.

Deductions for Taxpayers and Families With Special Needs

APRIL 5, 2010  VOLUME 17, NUMBER 11

Tax time is upon us yet again — just like last year and the year before. Funny how it rolls around every twelve months. OK — “funny” might not be the best word.

There is a certain irony in describing the tax deductions available to families raising or caring for a child with special needs. What families usually need is help (both financial and otherwise), and tax deductions may not provide much help for the family with income limited by the need to provide care for their child. Still, some deductions may be useful and many often go unclaimed; perhaps we can alert you to one or more you should consider while preparing or filing your own tax returns.

Claiming a dependent. Are you providing more than half the financial support for a person with a disability? You may be able to claim them as a dependent on your tax return. Of course, that means no one else can claim them as a dependent — including themselves.

Medical deductions. Remember that medical deductions are only useful on your federal income tax return to the extent that they exceed 7.5% of your adjusted gross income. Let’s use real numbers: if your income is about the national median this year, you will report something like $45,000 to $50,000 of income. In that case the first $3,500 (or so) of medical expenses you incur will not affect your tax return at all.

With that in mind, there are still expenses you should track. You might find that the 7.5% limit is easier to reach than you thought. You might also live in a state that does not apply the limitation (Arizona, for instance), so that medical expenses should be tracked.

What medical deductions most often get overlooked? Expenses for special schools might be deductible as a medical expense — if a medical professional has signed a recommendation. Tutoring, specialized books and software, evaluations and transportation might also be includible. Sometimes even special summer programs, residential schools — even disability-focused conferences — may be deductible as a medical expense.

Child and Dependent Care Credit. This one is not a deduction, but a credit — and that makes it valuable even for those who might not have enough medical expenses to deduct them. The credit is available to parents who have to pay caretakers in order to work (and earn income). The amount of the credit: up to 35% of the care costs incurred. See IRS Publication 503 for more information.

There are also other deductions and credits you might be overlooking. We were recently interviewed for a television report that indicated up to 30% of families with special needs children may failed to claim tax benefits due to them.

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