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.