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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.

Subjects: Certified Public Accountants, income tax, self-settled trust, Special Needs Trusts, Taxes, third-party trust
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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.

Subjects: conservator, grantor trust, Guardian, guardian of the estate, income tax, Medicaid, QDisT, Qualified Disability trust, self-settled trust, Seminar, Special Needs, Special Needs Trusts, Supplemental Benefits Trusts, Supplemental Security Income, Taxes, third-party trust, Trust administration, trustee
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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.

Subjects: deductions, disability, Special Needs, Special Needs Trusts, Taxes
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