Spring 2011 Newsletter
Taxation of Special Needs Trusts:
Income, Gift and Estate Tax Considerations of Self-Settled and Third-Party Special Needs Trusts
By: Jennifer L. Moccia, J.D., LL.M. [Estate Planning]
The Special Needs Trust, or Supplemental Needs Trust, (SNT) is typically created to receive, hold, protect and distribute funds to or for the benefit of a disabled individual in order to afford an improved quality of life for the trust beneficiary. The key to successful planning and implementation of the SNT is to provide these trust benefits without causing the beneficiary to become ineligible for public benefits, such as Medicaid, Supplemental Security Income, TANF and in-home supportive services. Typically, the preparation and implementation of an SNT is factually and legally complex, in large part due to its irrevocability. Once the SNT is created and funded, there are critical issues to be observed and addressed in the administration thereof, including the taxation of the contributions to, and distributions from, the trust. This article examines the basic elements of the self-settled special needs trust and the third-party special needs trust, and provides an analysis of various income, gift and estate tax considerations inherent to each type of trust.
Self-Settled v. Third-Party SNTs. Typically, the SNT falls into one of two categories: the self-settled special needs trust and the third-party special needs trust.1 The self-settled SNT is established on behalf of a disabled person by the parent or guardian, or by a court, and irrevocably funded with assets owned by the disabled person.2 Although the disabled person never signs the trust, he or she is treated, for tax purposes, as the grantor of the trust, having “settled” the trust with his or her personal assets (such as proceeds from a personal injury settlement) by way of a personal representative. The remainder beneficiary of these types of trusts is statutorily required to be the Commonwealth of Virginia in order to reimburse the state government for benefits paid on behalf of the disabled, now deceased, grantor. By contrast, the third-party SNT is established and funded by someone other than the disabled individual, such as a parent or sibling, for the sole lifetime benefit of the disabled beneficiary.3 These trusts may be established inter vivos or on a testamentary basis through the estate plan of the third party. Third-party SNTs must be funded from a source other than the assets of the disabled person, such as life insurance proceeds payable to the trust upon the death of a parent or a testamentary SNT funded with inheritance from a family member. Unlike the self-settled SNT, which requires that any assets remaining in the trust upon the death of the disabled beneficiary be remitted to the state, the remaindermen of a third-party SNT are named by the grantor, and typically include either the siblings of the disabled individual or another descendant of the grantor.
Income Tax Considerations. In general, a trust is treated as an individual for income tax purposes.4 Characterization of income for individual taxpayers is the same as for trusts; however, trusts have an accelerated tax rate schedule that reaches a maximum marginal rate at a lower net income level than for an individual. Generally, whenever a trust earns income, the trustee of the trust must report the income on Forms 1041 (U.S. Income Tax Return for Estates and Trusts) and 770 (Virginia Fiduciary Income Tax Return), and the trust must pay tax on its net income, often calculated at the highest marginal rate. Certain trusts, however, contain distribution provisions which (sometimes intentionally) cause all of the net income earned by the trust to be taxable to the beneficiary, regardless of whether the income has been distributed.5 Therefore, determining the applicable definition of “income” is critical in order to interpret the income tax rules for each type of SNT.
The Internal Revenue Code (IRC) definition of “taxable income” is not the same as “income” as defined for benefits purposes.6 Certain items that are reported as income on a tax return for the disabled person are not characterized as income for SSI and Medicaid qualification purposes. For example, the payment of rent on behalf of a disabled beneficiary by the trustee of an SNT is considered income for purposes of determining continued SSI eligibility; however, the amount of rent paid on behalf of a beneficiary may not be included as income on the personal income tax return of the disabled person. Other examples of income counted towards the receipt of benefits include cash distributions, distributions of items that can be easily converted into cash, and in-kind support and maintenance. Alternatively, distributions that are not counted as income with regard to benefits include the direct payment of bills on behalf of the disabled person and the receipt of services such as automobile repair, education, medical care, travel, entertainment and recreation, which may nonetheless be taxable as income to the beneficiary.
Occasionally, caseworkers may be unaware of the distinction between income for tax purposes and income for SSI eligibility purposes. If a disabled client receives an incorrect notice of reduction or termination of benefits, the attorney should be prepared to advocate for the client by disputing any inaccurate characterizations of income and demonstrating why the receipt of certain income does not disqualify the recipient from receiving continued benefits.
Self-Settled Special Needs Trusts. The self-settled SNT is generally treated as a grantor trust for income tax purposes, resulting in the treatment of the disabled individual as the owner of the trust property.7 Although the trustee has full discretion over distributions made to the disabled beneficiary, the grantor remains the source of the trust assets and retains a beneficial interest in the trust income and principal of the trust. Therefore, all income generated by a self-settled SNT, whether or not distributed, is reported on the income tax return of the grantor and taxable to the disabled grantor, at a presumably lower income tax rate than the trust.8 The taxable income generated by the trust may also meet requirements for certain qualified medical expense deductions, which deductions are taken on the tax return of the grantor.9 Further, since the self-settled SNT is a complex trust, the trust provisions allow income to accumulate and do not require the distribution of all income to the disabled beneficiary, which can cause significant income tax liability for undistributed income.
In the case of a self-settled SNT funded by an award of damages, such as those from a personal injury claim, the gross income of the disabled individual does not include the amount of any damages received on account of personal physical injuries or physical sickness.10 However, any interest earned on the investment of these assets is subject to income tax unless the claimant has no control over the assets that fund a periodic payment stream.11
Third-Party Special Needs Trusts. The third-party SNT is nearly always created as a non-grantor trust, although very limited situations necessitate the implementation of a grantor trust. When drafted as a non-grantor trust, the SNT is treated as a separate taxpayer and is assigned its own taxpayer identification number (TIN). The trust reports income on its fiduciary income tax return and pays taxes on the undistributed net income, payable from the income or principal of the trust. If the SNT is established as a testa-mentary trust (rather than lifetime or stand-alone trust), the trust will be taxed as a non-grantor trust and must file annual federal and state fiduciary income tax returns. When distributions are made to the disabled beneficiary, the beneficiary receives a Schedule K-1, which form will report to the IRS that income was paid to the beneficiary. Typically, a non-grantor third-party SNT is classified as a complex trust, which means that the trust may distribute all of the trust income in a given year.
Alternatively, if drafted as a grantor trust, the income generated by the SNT is taxable to, and at the applicable income tax rate of, the third party who established the trust. This can be advantageous to the trust beneficiary since the SNT assets have the opportunity to accumulate without being depleted by annual distributions toward income tax liability.
Third-party SNTs can be named as the primary beneficiary of a qualified retirement plan (sometimes requiring spousal consent); however, any changes to beneficiary designations must also be closely supervised in order to avoid unwanted income tax consequences. If the SNT is struc-tured as a “see-through” trust, any distributions made by the trustee to the beneficiary will be taxed at the income tax rate of the disabled beneficiary, and may be offset by deductible expenses attributable to the beneficiary.12 There are specific requirements for designating a trust as a beneficiary of a retirement plan in order to avoid lump sum withdrawal treatment upon payment of income taxes, and the “stretch” withdrawal option will be available for election if the proper provisions are included in the trust document.13 In order to qualify as a see-through trust, the trust must be valid under state law, irrevocable or irrevocable upon death, timely delivered to the retirement plan administrator following the death of the owner of the retirement plan, name an identifiable beneficiary, and include only individual beneficiaries (and not, for example, a charitable beneficiary). Also, any remainder beneficiaries would ideally be younger than the special needs individual so that the distributions will be calculated based on the age of the special needs beneficiary.
Gift Tax Considerations. When an irrevocable non-grantor trust is funded, the person making the contribution to the trust is treated as having made a taxable gift upon funding the trust, subject to the available exemptions from gift tax. Alternatively, the funding of a grantor trust does not result in a completed gift.
Self-Settled Special Needs Trusts. Gift tax considerations surrounding the self-settled SNT are relatively straightforward. When funding a self-settled SNT with the proceeds of a settlement award, there is no gift from the grantor since the amount received is deemed consideration for the release of a claim against the defendant. If a self-settled SNT is funded with inheritance received by the disabled beneficiary, the act of funding the SNT is not a completed gift because the grantor does not have the requisite intent since the disabled grantor is the sole lifetime beneficiary of the trust. Also, if the grantor retains power over the disposition of the trust assets (such as a limited power of appointment), the gift is incomplete for tax purposes and not subject to gift tax liability.
Third-Party Special Needs Trusts. The gift tax implications of funding the third-party SNT are more complicated because the provisions of the trust must be analyzed in order to determine whether the transfer of assets to the trust will be considered a completed gift for tax purposes.If the SNT is an irrevocable non-grantor trust, then a completed gift has most likely occurred. In order for the grantor to avoid paying gift tax on the transfer, the grantor must file Form 709, U.S. Gift Tax Return and apply his or her remaining lifetime gift tax exemption amount to the gift. If the grantor has not retained enough of an exemption to shelter the value of the gift made to the SNT, the grantor will pay gift tax on the transfer to the SNT.14
Since the gift of a future interest does not qualify for the annual gift tax exclusion amount ($13,000 per person in 2011), this exclusion may not be used to offset a portion of the gift made to the SNT. The customary strategy of including Crummey withdrawal rights in an irrevocable trust will not prove effective for the SNT.15 This withdrawal power, which would require the Trustee to provide notice to the beneficiary of the limited opportunity to withdraw all or a portion of a gift made to the trust, would indeed establish a present interest in the gift; however, the amount available to be withdrawn by the beneficiary would be deemed an asset that would most likely cause ineligibility for benefits. Accordingly, this strategy is not recommended.
Estate Tax Considerations. Depending on the terms of the trust document, the value of the trust assets upon the death of the grantor may be includible in the gross estate of the grantor for estate tax purposes. However, in most cases, the value of the estate of the disabled individual will not exceed the federal estate tax exemption amount.
Self-Settled Special Needs Trusts. A self-settled SNT is includible in the gross estate of the grantor for estate tax purposes.16 Since most estates of disabled individuals do not exceed the federal estate tax exemption amount ($5 million in 2011), the inclusion of the value of an SNT in the estate of the grantor usually does not cause estate tax liability on the part of the disabled person. Upon the death of the disabled beneficiary, the Virginia Department of Health Services is entitled to receive reimbursement for certain government benefits received by the decedent if the SNT has trust assets remaining upon the death of the grantor. This reimbursement allowance ensures that the value of the decedent’s estate will almost always be reduced below the estate tax exemption amount, and therefore not subject to estate tax liability.
When analyzing the potential estate tax consequences of a self-settled SNT, a potential issue can arise when the SNT is established from a large personal injury settlement that receives structured settlement payments for a guaranteed period of time. Since the recurring payments are received and spent over an extended period of time, the total lifetime award could create an estate tax liability for the SNT upon the death of the grantor without providing sufficient liquidity in the trust to pay the resulting estate tax. In order to prevent this type of situation, a commutation provision can be included in the final settlement agreement. Typical commutation provisions allow the recipient of the settlement award to elect to receive a discounted lump sum of the proceeds, thereby providing liquidity. Upon the death of the disabled beneficiary, the commuted value of any remaining settlement award is includible in the estate of the grantor.17
Third-Party Special Needs Trusts. Whether a third-party SNT will be includible in the estate of the grantor is determined by the establishment, funding and language of the trust document. Depending on the inclusion or exclusion of certain provisions, the SNT can be strategically drafted so that any remaining trust assets are included in either the estate of the grantor or the estate of the beneficiary. However, since the assets of most SNTs are spent down throughout the lifetime of the disabled beneficiary, the inclusion of undistributed SNT property in the gross estate of either the grantor or the beneficiary may not cause the value of the estate to exceed the federal estate tax exemption amount.
Whether the remaining SNT assets will be includible in the estate of the grantor or the beneficiary can be predetermined by the inclusion, or exclusion, of certain retained interest provisions in the trust. For example, a gift from a grantor to an SNT can be considered “incomplete” if the grantor is given certain powers within the trust document. 18 Therefore, the trust should contain the appropriate grantor powers if the drafter intends for any undistributed trust assets to be included in the estate of the grantor upon his or her death. Alternatively, if the grantor makes a completed gift to the SNT and does not retain certain interests in or power over the trust property, the remaining trust assets will be successfully removed from the estate of the grantor and included in the estate of the trust beneficiary.19 Each set of facts and circumstances should be carefully examined to anticipate and address the desired long-term estate tax consequences of establishing a third-party SNT.
Effective Comprehensive Planning. When correctly implemented, the SNT is a highly effective estate planning tool that can greatly enhance the quality of life of a disabled loved one. The analysis and preparation of a comprehensive estate plan for a special needs beneficiary should always address the potential income, gift and estate tax issues in light of the short and long-term goals of the client. While some tax issues may be unavoidable, certain matters can and should be anticipated and strategically resolved through proper planning, drafting, funding and administration of a special needs trust.
Jennifer L. Moccia, an associate at Rack & Olansen, P.C., received her B.A. in Psychology and Business Management from the College of William and Mary, her J.D. from Regent University School of Law, and her LL.M. in Estate Planning from the University of Miami School of Law, where she served on the Ethics Committee of the Elder Law Project. She is a member of the Virginia State Bar, and Chair of the YLC Professional Development Conference, as well as a member of the American Bar Association Real Property, Trust and Estate Law Section.
1 Other types of SNTs include the pooled-income trust, authorized under 42 U.S.C. § 1396p(d)(4)(C), and the qualified disability trust, authorized under 42 U.S.C. § 1396p(c)(2)(B)(iv). See also, IRC § 642(b)(2)(C).
2 Authorized under 42 U.S.C. § 1396p(d)(4)(A). See also 12 VAC 30-40-300.
3 POMS § SI 01120.200, et. seq.
4 IRC § 641(a), (b).
5 IRC §§ 671, 1361(d)(1).
6 See IRC §§ 61(a), 63; 42 U.S.C. § 1382(a).
7 See IRC §§ 671-679 for the trust powers which cause a trust to be considered a grantor trust.
8 IRC § 677(a).
9 See IRS Publication 502 (2010), Medical and Dental Expenses.
10 IRC § 104(a)(2).
11 Rev. Rul. 79-220, 1972-2 C.B.; IRC § 104.
12 See PLR 200226015 (Mar. 21, 2002).
13 See Treas. Reg. § 1.401(a)(9)-5, A-7(c)(3), Example 2.
14 The IRS provides current information about lifetime gift tax exemption amounts and rates at http://www.irs.gov. See “What’s New – Estate and Gift Tax” at http://www.irs.gov/businesses/small/article/0,,id=164878,00.html.
15 Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968).
16 IRC § 2036(a).
17 IRC § 2039.
18 See IRC § 2033.
19 In order to avoid inclusion in the estate of the grantor for estate tax purposes, the trust provisions included to intentionally violate a grantor trust rule under IRC §§ 671-679 may not violate the incomplete transfer rules under IRC § 2036.