Special Needs – Special Trusts Part. 1: Overview & Taxation – Bernard A. Krooks


Part. 1 Overview & Taxation

By Bernard A. Krooks

Littman Krooks LLP New York, New York / www.littmankrooks.com

I. Overview

Special needs planning is a niche practice area within the estate planning field that requires a working knowledge of many different areas of the law, including tax, public benefits, trusts and estates, among many others. The experienced special needs planning practitioner will not only know the law, but will also be in a position to offer practical advice to his clients that will improve the lives of individuals with disabilities and their families. It is also very important to be familiar with local practice as this often differs from state to state or even from county to county. One aspect of special needs planning is special needs trusts (“SNT”s). This outline will explore the different types of SNTs available and when it is appropriate to consider them. The outline will also address certain drafting and administration issues.

One of the goals of special needs planning and SNTs is to allow the individual with disabilities to qualify for government benefits while also having a source of funds that can be used to pay for things that government programs will not pay for. By doing so, the quality of life of the individual with disabilities is improved. As a practical matter, special needs planning may be appropriate for someone who is already receiving government benefits or for someone who may potentially need government benefits in the future.

The primary government benefit available for many individuals with disabilities is Medicaid. If the eligibility requirements are met, Medicaid will generally pay for medical expenses, including the costs of long-term care and other chronic illnesses. For many individuals with disabilities, this is critically important since the benefits available under private insurance, including those policies offered under the Affordable Care Act, are extremely limited in this regard. Medicaid is a jointly-funded, federal/state program in which the federal government pays a percentage of the cost, and the state(s) the remaining percentage, which varies by state. Medicaid is the payer of last resort. Thus, in order to become eligible for Medicaid, an individual must meet strict income and asset requirements which are set forth by each state.

Another important government benefit available for individuals with disabilities is Supplemental Security Income (“SSI”). SSI is a federal program which pays a monthly stipend to those who qualify.  For 2016, the maximum monthly benefit is $733, plus a $20 per month income disregard. SSI recipients who receive payments, from a trust or otherwise, for food and shelter, will have their SSI benefits reduced by either one-third or by the presumed maximum value (“PMV”) of the third party’s contribution. Nevertheless, it may be appropriate to allow for these types of distributions from an SNT under the proper circumstances, especially if they will improve the quality of life of the beneficiary. SSI may also cover the cost of group homes or other residences for individuals with disabilities. Both SSI and Medicaid are “means-tested,” which means that, to qualify, the individual has to meet the requirements of each program. To qualify for SSI, an individual can have no more than $2,000 of non-exempt assets in his name.

Both Medicaid and SSI have rules restricting transfers of assets to others, including transfers to trusts, in order to qualify. In addition to federal statutes and regulations governing SNTs, the Social Security Administration (“SSA”) has issued the Programs Operations Manual System, commonly referred to as the “POMS.”[1] Although the POMS should not have the same weight as federal regulations, they are often given great deference by the courts and public benefits caseworkers. Thus, they are very relevant in an SNT practice since they represent the SSA’s views on a variety of issues pertaining to SSI and SNTs.

A. Types of SNTs

There are generally two different types of SNTs: First party SNTs and third party SNTs. The primary difference being that in first party SNTs the assets used to fund the trust belong to the individual with disabilities; whereas, in third party SNTs, the assets used to fund the trust belong to someone other than the individual with disabilities. Under the umbrella of first party SNTs are pooled trusts. Pooled trusts are funded with assets of the individual with disabilities, but unlike other first party SNTs, they are managed and operated by a not-for-profit organization.

By way of nomenclature, some practitioners refer to SNTs as “supplemental needs trusts” instead of “special needs trusts.” The name is not important. What is important is the source of funds used to fund the trust. In fact, when drafting SNTs, some practitioners do not use either term in the title of the trust instrument to avoid confusion, or simply to avoid offending the individual with disabilities. By using the term “special needs” in the title of the document some practitioners have expressed a privacy or HIPAA concern with respect to the beneficiary. Others feel that it is critically important to identify what type of trust you intend to draft with specificity, including the title, since many public benefits caseworkers or courts may infer the settlor’s intent from the title or other descriptive language in the trust document. The intent (or lack thereof) to create an SNT may be an important factor in construing a document which has come under the scrutiny of a government agency or court.

B. First Party SNTs

First party SNTs are also sometimes referred to as a “(d)(4)(A)” trust (referring to the federal statute 42 U.S.C. Sec. 1396p(d)(4)(A) which authorizes these types of trusts), or a “self-settled” SNT, or “payback” trust. The assets used to fund these types of trusts typically, but not always, come from medical malpractice or personal injury lawsuits, accumulated assets through work, improper estate planning by family members (including outright inheritance), or child support. One of the key characteristics of a first party SNT is that upon death, or early termination of the trust, Medicaid, but not SSI, must be repaid for the cost of services provided. The states have varying interpretations of how to calculate this payback.

First party SNTs first came into existence in 1993 with the enactment of “OBRA ’93”- the Omnibus Budget Reconciliation Act of 1993. Basically, the law provides an exception to the Medicaid and SSI transfer of asset provisions if assets are transferred to a properly executed first party SNT. In addition, those assets held by the trust do not count towards the asset limits allowed by SSI and Medicaid. In exchange for these two benefits (no penalty period and not counting the assets as available), upon the death of the beneficiary, or other early termination of the trust, the law requires those assets remaining in the first party SNT to be first used to repay the Medicaid program for benefits paid to the beneficiary during his lifetime. To create a valid first party SNT: (1) the trust must contain the assets of an individual under age 65, (2) the individual must be “disabled,” as defined by 42 U.S.C. Sec. 1382c(a)(3), (3) the trust must be established for the sole benefit of such individual by a parent, grandparent, court or legal guardian, and (4) the trust must contain a Medicaid payback provision.

It is noteworthy that the individual himself cannot “establish” his own first party SNT. It must be established by a parent, grandparent, court or legal guardian. Conversely, a pooled first party SNT (discussed below) may be established by the individual with disabilities without having to go to court so long as the individual has the requisite mental capacity to create a trust. This dichotomy is unfortunate since an individual with physical disabilities who does not have a living parent or grandparent, must get a court involved in order to set up a non-pooled first party SNT for himself.

There is currently legislation pending in Congress (the “Special Needs Trust Fairness Act of 2015”) to address this inequity. If this act becomes law, an individual with the requisite mental capacity will be able to establish his own first party SNT.

A pooled trust is a type of first party SNT that is authorized by 42 U.S.C. Sec. 1396p(d)(4)(C). Pooled trusts are created and managed by a nonprofit organization. While each beneficiary of a pooled trust has a separate sub-account identifying his share of the total assets in the trust, the assets in the trust are pooled for purposes of investment and management. The pooled trust account is created for the sole benefit of an individual with a disability by the individual’s parent, grandparent, legal guardian, court, or the individual himself. Moreover, an individual need not be under age 65 to join a pooled trust, although states have different rules on whether transfers of assets to a pooled trust by an individual who is age 65 or older are subject to the Medicaid transfer of asset provisions. Finally, these types of trusts have a modified payback meaning that, depending on state law, all or a portion of the assets remaining in the trust upon the death of the beneficiary may be retained in the trust to benefit other beneficiaries of the pooled trust instead of being repaid to Medicaid.

Pooled trusts are a good option for an individual who is not transferring a significant sum to an SNT and who does not wish to incur the costs of establishing and administering his own first party SNT. A pooled trust might also be a good option for someone who doesn’t have a capable trustee to appoint or for someone age 65 or older who cannot set up a first party SNT. In fact, many banks are reluctant to serve as trustee of an SNT or have very high minimum balance requirements. Pooled trusts have trustees who offer professional management and investment of funds and should be considered in appropriate cases. In addition, someone under age 65 who doesn’t have a living parent or grandparent may wish to join a pooled trust instead of having to go to court to set up his own first party SNT. To join a pooled trust, an individual must sign a “joinder agreement” and become part of the “master trust” established by a nonprofit organization.

C. Third Party SNTS

A third party SNT is a trust which is created by and funded with assets belonging to someone other than the individual with a  disability.  A typical example is parents creating a third party SNT for the benefit of their child with a disability. The parents’ estate plan would typically provide that, upon their deaths, the assets that are to be allocated for the benefit of the child with a disability are to be placed in the third party SNT created for the child’s benefit. The purpose of a third party SNT is to permit a parent, grandparent or other person to provide for the needs of a person with disabilities which are not being met by public benefits. If the funds were left outright to the individual with disabilities, he would be disqualified for Medicaid and SSI. Even “wealthy” families may benefit from special needs planning depending on a number of factors, including the anticipated cost of care, the age of the person with special needs, the type of disability he has, and the community where he resides, among others. Moreover, there can be no assurance that a family’s wealth will continue to the next generation(s), potentially increasing the need to rely on government benefits to pay for, at least part, of the care of the individual with disabilities.

An alternative to a third party SNT is to disinherit the person with disabilities. While this will accomplish the goal of not disqualifying the individual for government benefits, it will not further the goal of enhancing his quality of life. Alternatively, some families consider leaving the assets to a third party (perhaps a sibling) who makes a verbal commitment to assist the person with a disability. Unfortunately, this type of arrangement puts the person with disabilities at risk. The person who is entrusted with the funds could pass away prior to the death of the individual with disabilities, get divorced, get married, become disabled himself, get sued, etc. For the foregoing reasons, this option does not work for most families since it does not ensure that there will be available funds to enhance the quality of life of the individual with disabilities.

A third party SNT can be created by a revocable inter-vivos trust, an irrevocable inter-vivos trust, or a will. One of the benefits of creating a third party SNT during lifetime is that other relatives can leave assets to this trust if they so desire. Thus, it can serve as a vehicle to receive potential bequests from others thereby ensuring that the beneficiary’s government benefits are protected. If the SNT is irrevocable, the settlor can engage in his own estate tax planning through the use of lifetime gifts to the trust. The draftsperson of the trust should be careful not to give Crummey rights of withdrawal to the beneficiary with disabilities as this may result in trust assets being considered an available resource of said beneficiary for SSI and Medicaid purposes. Moreover, the failure to exercise the right of withdrawal may be considered an uncompensated transfer resulting in a penalty period with respect to the beneficiary’s eligibility for those benefits. If the SNT is revocable, it is imperative that there be a provision to convert it to an irrevocable trust upon the receipt of funds from persons other than the settlor. Without such a provision, it is unlikely that others would contribute assets to the SNT for fear that the trust could be revoked and the funds not used to enhance the quality of life of the beneficiary with disabilities. When drafting an SNT for a surviving spouse who is receiving, or expected to receive Medicaid benefits in the future, the SNT must be a testamentary trust created in a will.   Assets contained in an inter-vivos trust created by a spouse will be considered an available resource of the surviving spouse for public benefits purposes.[2]

Third party SNTs are not governed by federal law, although some states have statutes which address them.[3] Third parties can generally include anyone other than the person with disabilities, although there may be other issues to address if the beneficiary is a minor child or spouse or someone else who the creator of the trust has an obligation to support. Prior to drafting a third party SNT, it is important to determine which public benefits the beneficiary is receiving or may receive in the future. Whether the funds in a third party SNT are considered a resource will often depend upon the terms of the trust, including the existence of a support standard, the extent of discretion given to the trustee and whether the beneficiary can compel a distribution. The settlor’s intent to create an SNT should also be clearly stated in the trust instrument. Use of the words “supplement, rather than supplant government benefits” are typically good indicators of the settlor’s intent. In determining whether the assets of a third party SNT have any effect on the beneficiary’s eligibility for SSI, it is important to review the POMS to ensure that all requisite criteria are met so that trust assets do not disqualify the beneficiary for benefits.[4]

Unlike a first party SNT, any funds remaining in the third party SNT at the time of the death of the beneficiary are not subject to Medicaid payback. This makes sense since the creator of the trust would otherwise have no legal obligation to use those funds to pay for the expenses of the beneficiary. Thus, they should not be subject to a Medicaid payback. A third party SNT often resembles a traditional discretionary spendthrift trust drafted to protect the trust assets for the benefit of a person who is vulnerable to exploitation or who does not manage money well. In order for a discretionary trust to meet the criteria of a special needs trust, and thus be exempt from consideration when determining financial eligibility for public benefits, the trust must limit the powers of the beneficiary, the authority of the trustee, and the trust must include a spendthrift clause.[5]

In addition, a third party SNT does not have to be for the sole benefit of the individual with disabilities; whereas, a first party SNT must be.  Thus, it is permissible to have beneficiaries of a third party SNT who are not disabled. For families with more than one child, the assets can either be left to one “pot” trust which has sprinkling provisions or to separate trusts set up for each child. There are conflicting views as to which is the best approach. The benefit of a pot trust is that the trustee can use the money where it is determined to be most appropriate among all the children. However, this can lead to an unfair (in someone’s eyes) allocation of resources depending on the circumstances. By leaving the assets in separate trusts and having one of them be a third party SNT, it is clear from the beginning the amount of funds each beneficiary was intended to receive. However, this approach will not afford the trustee the flexibility, if needed, to spend additional funds (beyond what is in that person’s SNT) to enhance the quality of life of the individual with disabilities.

D. ABLE Accounts

On December 19, 2014, the Achieving a Better Life Experience Act, commonly known as the ABLE Act was signed into law as Section 529A of the Internal Revenue Code (“IRC”).[6] ABLE accounts are modeled after IRC Section 529 plans and provide a mechanism to fund an account in the name of certain individuals with disabilities, and allow the funds in that account to accumulate income tax-free. Moreover, if certain conditions are met, the assets contained in the ABLE account will not disqualify the beneficiary from government benefits.   Although ABLE accounts are not a type of SNT, it is anticipated that they will become part of the discussion when counselling clients regarding special needs planning.

In order to be eligible for an ABLE account, the onset of the individual’s disability must have occurred prior to age 26. Each calendar year, the individual with disabilities, or another person for his benefit, can deposit cash up to $14,000 into an account in the name of the individual with disabilities. Aggregate annual contributions from all sources cannot exceed $14,000 (this number is keyed to the annual federal gift tax exclusion amount). These contributions are not tax-deductible for federal income tax purposes. Total contributions into the ABLE account are capped at each state’s limitations for Section 529 accounts and the first

$100,000 in an ABLE account will not adversely affect the individual’s eligibility for SSI. Moreover, transfers of assets up to these amounts will not incur a penalty period with respect to SSI or Medicaid. So long as the funds in the ABLE account are used for permitted government-approved disability-related expenditures, the account will continue to accrue value income tax-free. Some examples of qualified disability expenses include, but  are  not  limited  to,  housing,  transportation,  employment  training, education, health and wellness. Upon the beneficiary’s death, any money remaining in the ABLE account is subject to the Medicaid payback rules, much like a first party SNT. This payback applies even to funds contributed by non-legally responsible third parties. This is a significant difference between ABLE accounts and third party SNTs.

As of the writing of this outline, at least 40 states had enacted ABLE legislation or had proposals pending. The Internal Revenue Service (“IRS”) has not yet issued final regulations regarding ABLE accounts. On June 19, 2015, the IRS issued proposed regulations interpreting many of the provisions of Section 529A. The preamble to those regulations, along with IRS Notice 2015-18, provide that individuals who set up ABLE accounts prior to the issuance of final regulations will not fail to receive the benefits of ABLE accounts simply because the accounts do not fully comport with the final regulations when they are issued.

It is too early to tell how useful ABLE accounts will be in a special needs planning practice. Since they do not require court approval to set up, it is anticipated that ABLE accounts will become another tool in the toolbox for special needs practitioners. For amounts under $14,000 a year they may prove to be quite useful for certain beneficiaries and provide them with a sense of independence.

II. Taxtation of SNTs

A. First Party SNTs

All first party SNTs must be irrevocable trusts. Irrevocable trusts are generally taxed at a much higher rate than individuals due to the compressed income tax rates for trusts. If the taxable income of the trust exceeds $12,400, the trust income will be taxed at the highest federal marginal income tax rate of 39.6 percent (plus the Medicare and net investment income surtax). Whereas, an individual is not taxed at the 39.6 percent marginal rate until income exceeds $415,050. Fortunately, first party SNTs are likely to be considered grantor trusts since the trustee would typically have the discretion to make a distribution of more than 5% of the income or principal of the trust for the benefit of the grantor/beneficiary.[7] If the first party SNT is a grantor trust then all trust income flows through to the grantor/beneficiary and is taxed at the lower individual income tax rates and not the trust tax rates. The draftsperson can also include other provisions in the trust which will cause it to be treated as a grantor trust.[8] However, caution needs to be exercised when drafting a first party SNT since some of the grantor trust provisions are not well-understood by local Medicaid agencies and may cause issues in having the trust qualify as an exempt trust for SSI and Medicaid purposes. For example, Medicaid might take the position that if the grantor has a power of appointment or the power to substitute property of equivalent value, that these powers could violate the “sole benefit” rule or otherwise give the grantor/beneficiary too much control over the trust to allow it to be an exempt resource.

Since the assets of a first party SNT continue to be subject to the claims of the settlor’s creditors (unless the trust is set up in one of the fifteen states that have asset protection statutes[9]), contributions to a first party SNT are generally not subject to gift tax since a completed gift has not occurred for tax purposes.[10] Moreover, the assets held by a first party SNT must be used for the sole benefit of the grantor/beneficiary during lifetime and are subject to the Medicaid payback on death. If permitted by the local Medicaid agency, you may consider having the grantor reserve a testamentary limited power of appointment in the trust assets. This would ensure that there would be no completed gift. However, you will likely need approval of the local Medicaid agency to go this route. In some cases, this may be difficult to obtain.

Upon death of the beneficiary, the value of the trust assets is generally included in his estate for estate tax purposes. Administration expenses, including attorney’s fees, and the payback to Medicaid are allowable deductions on the estate tax return. For decedents dying in 2016, the federal estate exemption is $5,450,000.

B. Third Party SNTs

If a third party SNT trust is revocable, then all income tax is reported on the settlor’s personal income tax return. Contributions by the settlor to the trust will not be a completed gift for gift tax purposes and the trust corpus will be includable in the settlor’s gross estate upon his death. Be careful if this type of trust is to be funded from sources other than the settlor as there may be unintended income or estate tax consequences.

Due to the compressed income tax rates for trusts (discussed above), income taxes are a significant concern for irrevocable third party SNTs. To address this concern, the trustee can invest trust assets in items which do not generate taxable income subject to the highest rates. Alternatively, the draftsperson can include provisions in the trust which cause it to be a grantor trust under IRC Sections 671 through 677.

Irrevocable third party SNTs are often considered Qualified Disability Trusts (“QDT”). A QDT is entitled to claim an exemption in the amount that a single individual taxpayer can claim, in lieu of the $300 or $100 trust exemptions available to simple and complex trusts, respectively.[11] For 2016, the exemption is $4,050. In order for a third party SNT to qualify as a QDT, the trust must not be a grantor trust and it must be established for the sole benefit of an individual under age 65 who is disabled. Thus, a first party SNT would not qualify as a QDT since it is typically a grantor trust.

If a third party SNT is not a grantor trust and does not qualify as a QDT, then it will be taxed as a complex trust. Complex trusts do not require mandatory distribution of income, which is the case for all properly drafted SNTs, and are entitled to a $100 exemption. To the extent that income is paid out for the benefit of the beneficiary, the trustee reports this on a Form K-1 and the beneficiary files his own tax return reporting that income.

Inter-vivos, irrevocable third party SNTs will generally not be included in the settlor’s estate so long as the settlor retains no dominion or control over the trust. Thus, any contributions to the third party SNT during the settlor’s life will be considered completed gifts and not includable in the settlor’s gross estate. If estate taxes are a concern for the settlor, Crummey powers may be utilized in a third party SNT to allow contributions to the trust to qualify for the annual gift tax exclusion. Caveat: you should not provide for Crummey rights of withdrawal powers to a beneficiary who is disabled and is receiving means-tested benefits or may be expected to receive such benefits in the future. It is possible that SSA or Medicaid could take the position that a disabled beneficiary’s Crummey right of withdrawal could cause the assets of the trust to be available to that beneficiary. Further, the lapse of the power could be considered a transfer for Medicaid and SSI purposes.

Part. 2: Drafting Considerations & Trust Administration Considerations

© 2016 University of Miami School of Law.  This outline was prepared for the 50th Annual  Heckerling Institute on Estate Planning sponsored by the University of Miami School of Law, and published by LexisNexis. It is reprinted with the permission of the Heckerling Institute and the University of Miami School of Law.



[1] https://secure.ssa.gov/apps10/poms.nsf/partlist!OpenView

[2] 42 U.S.C. Sec. 1396p(d)(2)(A)

[3] Among them are Minnesota, New York, Arizona, California, New Hampshire, Maryland, New Jersey, Illinois, Indiana, Kentucky, South Carolina, Tennessee, Wisconsin, and Pennsylvania.

[4] POMS SI 01120.200.

[5] Id.

[6] Tax Increase Prevention Act of 2014, P.L. 113-295.

[7] IRC Section 673(c).

[8] See IRC Sections 671 through 677.

[9] Nevada, South Dakota, Tennessee, Ohio, Delaware, Missouri, Alaska, Wyoming, Rhode Island, New Hampshire, Hawaii, Utah, Virginia, Oklahoma, or Mississippi.

[10] See Rev. Rul. 76-103.

[11] IRC § 642(b)(2)(C).

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