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Tax Section

NAELA Basics: Tax Basics of Special Needs Trusts

By Vincent J. Russo, JD, LLM, CELA, CAP, Fellow

Trusts can be an essential ingredient in the implementation of an asset protection plan for an individual with disabilities who is seeking medical assistance under the Medicaid program or Supplemental Security Income.

W
hile there are several types of Special Needs Trusts, two of the most common are the first-party special needs trust (hereafter sometimes referred to as a FP SNT) and third-party special needs trust (hereafter sometimes referred to as a TP SNT).

A FP SNT is funded using the assets of an individual with special needs as defined under the Social Security Act. The federal regulations require that the funds must be administered by a trustee for the beneficiary’s sole benefit and, at the creation of the trust, the beneficiary of the trust must be under the age of 65. FP SNTs also require a payback provision requiring the repayment to the state for any Medicaid benefits received by the beneficiary while the trust was in existence.

In contrast, a TP SNT uses assets of any third party (i.e., a spouse, a parent, grandparent, friend, etc.) for the benefit of an individual with special needs. The TP SNT is generally more flexible since it is not limited by many of the restrictions imposed on a FP SNT. Furthermore, since this trust is created by a third party, the trust may be created inter vivos during the grantor’s lifetime or by will at the grantor’s death.

This article will focus on the basic tax consequences of trusts in a special needs law practice with a focus on first-party and third-party special needs trusts. Each type of special needs trust will be considered from an income, gift and estate tax point of view.

Third-Party Special Needs Trusts
The third-party special needs trust (sometimes referred to as a third-party supplemental needs trust) is set up and funded by the grantor for the benefit of a person with special needs. For example, a parent may set up a trust for the special needs of a child. The trust instrument usually provides for discretionary trustee powers to utilize income or principal for the benefit of a primary beneficiary, without replacing or diminishing any government benefits. These powers must be drafted in accordance with applicable federal and state law in order to ensure that beneficiary’s government benefits are not adversely impacted. There is no payback requirement to reimburse the state(s) for Medicaid provided to the beneficiary.

Tax Consequences of Third-Party Special Needs Trusts

Income Taxation
Generally, a TP SNT will be taxed as a separate entity from the grantor. Since the typical TP SNT is a discretionary trust, it will be treated as a non-grantor complex trust for federal income tax purposes. This would always be the case with a testamentary TP SNT.

Hence, as a general statement, income will be taxed to the recipient of the income. If the income is not distributed in a calendar year, then the trust will be responsible for the tax at the trust income tax rates, which are generally higher than the individual income tax rates.1

However, if the TP SNT is an inter vivos trust (established during the lifetime of the grantor), then the trust can be classified as either a grantor trust or a non-grantor trust, depending upon the trust provisions. If classified as a grantor trust, then the trust income and expenses shall be reported by the grantor on their income tax return and not by the trust or the trust beneficiaries.

Important considerations should be given to the income tax rate applicable to a trust and to an individual (i.e. the grantor or beneficiary). For a single individual in 2018, the top tax rate of 37 percent is reached at $500,000. However, for a trust in 2018, the top rate of 37 percent is reached at $12,500.2 Therefore, the decision as to whether income will be taxed at the trust level or, in the alternative, to the grantor or beneficiary may result in considerable tax savings.

If the trust income is intended to be used for the benefit of the beneficiary with special needs who is receiving government benefits, then it is preferable to have the trust considered to be a non-grantor trust, because the income will be attributed to the beneficiary3 who would likely be in a lower income tax bracket than the grantor or the trust.

If the income retained by the trust is relatively small, then it may be better to set up the trust as a qualified disability trust,4 which is a non-grantor trust, so that undistributed income would be taxable to the trust. For example, if the trust is a qualified disability trust and retained trust income is less than the exemption amount ($4,150 in 2018),5 then a non-grantor complex trust would be preferred over a grantor trust for income tax purposes.

Gift Taxation
If the TP SNT is established under a will, then there are no gift tax consequences. If the trust is an inter vivos trust, then there may or may not be gift tax consequences, depending upon the provisions of the trust, such as whether the trust is revocable or irrevocable. For example, if the objective is to treat the transfer to an irrevocable TP SNT as an incomplete gift, then a limited power of appointment can be retained by the grantor.6

Estate Taxation
If the TP SNT is established under a will, then the trust assets will be included in the estate of the decedent.

In contrast, if the TP SNT was established during lifetime, then the trust may or may not be includible in the grantor’s estate, depending upon the trust provisions.7 For example, if the trust was revocable8 or the grantor retained a life estate with regard to property transferred to the trust,9 then the trust assets would be includible in the estate.

The benefit of inclusion for estate tax purposes would be to obtain step up in basis of the trust assets under IRC Section 1014. The step up will reduce or even eliminate capital gains taxes on the later sale of the trust assets.

First-Party Special Needs Trust
The first-party special needs trust (sometimes referred to as a self-settled or first-party trust)10 is available only to individuals with special needs who are under the age of 65 years. The trust must be funded with the assets of the individual who has special needs and must be created for his or her benefit by either an individual (who is the beneficiary); or a parent, a grandparent, or a legal guardian of the individual; or a court. The funding of the trust will not disqualify the individual for Medicaid and/or Supplemental Security Income (SSI) benefits.

Tax Consequences of First-Party Special Needs Trusts

Income Taxation
Generally, for income tax purposes, the FP SNT will be taxed as a grantor trust with respect to the beneficiary during his or her lifetime.11 This means that all income, deductions, and/or credits with respect to the assets of the FP SNT will be reported on the beneficiary’s individual tax return.

A FP SNT may be treated as a grantor trust for a variety of reasons under the grantor trust provisions of the Internal Revenue Code (IRC). For instance, under IRC Section 673, if the grantor retains a reversionary interest that exceeds 5 percent of the value of the trust property, then the trust (or a portion of the trust) may be considered a grantor trust with respect to such individual.12 The beneficiary of a FP SNT will be treated as the grantor since the trustee’s discretion to make distributions to or for the benefit of the beneficiary will be treated as a reversionary interest.13

Furthermore, under IRC Section 677(a)(1),14 the IRS considers a FP SNT to be a grantor trust with respect to the beneficiary if the trustee or any other person is a non-adverse party who must consent to distributions to the beneficiary.

Lastly, under 677(a)(3), allowing the trustee to pay insurance premiums on the life of the beneficiary, or beneficiary’s spouse, will also result in the FP SNT being classified as a grantor trust.

Gift Taxation
Generally, because the assets of the person with special needs are used to fund the FP SNT and the person with special needs is the sole beneficiary during his or her lifetime, the initial transfer to the FP SNT will be treated as an incomplete gift and therefore there are no gift tax consequences.15

Furthermore, if the FP SNT provides the beneficiary with a testamentary power of appointment over the property remaining in the SNT at death (after any Medicaid payback), then the funding of the FP SNT with the beneficiary’s own assets does not result in a completed gift for gift tax purposes.16

Estate Taxation
The FP SNT will be includable in the gross estate of the individual with special needs for estate tax purposes under IRC Section 2036, whether or not estate tax is actually owed. This is generally favorable since most beneficiaries do not have taxable estates.

As stated above, the benefit of inclusion for estate tax purposes would be to obtain step up in basis of the trust assets under IRC Section 1014.

In Conclusion
The above discussion presents a high-level overview of the taxation of first-party and third-party special needs trusts. Individuals who are looking to help a family member who has special needs can take advantage of TP SNTs to meet the needs of that family member without affecting the governmental benefits that are available to the individual. For individuals with special needs who are under age 65, the use of a FP SNT can ensure Medicaid and Supplemental Security Income eligibility with the trust assets being used to enhance the quality of life of the individual.

The opportunity is there for the special needs law attorneys to take the next step and incorporate tax planning in the use of special needs trusts to minimize income, estate and gift tax consequences.

Citations
1 In 2018, an individual pays the 37 percent rate of tax on income exceeding $500,000, whereas a trust would pay 35 percent tax on income exceeding only $12,500. See Rev. Proc. 2018–18, March 5, 2018.

2 See Rev. Proc. 2018–18, March 5, 2018.

3 IRC §662.

4 IRC §642(b)(2)(C).

5 Under the Tax Cuts and Jobs Act of 2017, a qualified disability trust receives a deemed exemption equal to that of a single taxpayer (even though personal exemption is no longer available as a tax benefit beginning 2018 and thereafter), which amount is equal to $4,150.

6 See Treas. Reg. § 25.2511-2(b).

7 See §1.03(1)-(3), supra.

8 See IRC Section 2038.

9 See IRC Section 2036.

10 For purposes of this article, we will refer to this type of trust as a special needs trust and a trust set up and funded by an individual for the supplemental needs of a third party as a third-party supplemental needs trust.

11 Generally, for purposes of the grantor trust rules, a grantor is the individual or entity that creates and funds the trust. However, for a FP SNT, the trust beneficiary is generally considered the creator or grantor of the trust even if he or she was not the actual creator of the trust agreement.

12 See IRC Sections 671-679.

13 When determining the value of the reversionary interest, such interest shall be determined by assuming the maximum exercise of discretion in favor of the grantor. See IRC Section 673(c).

14 The grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under section 674, whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a non-adverse party, or both, may be— (1) distributed to the grantor or the grantor’s spouse.

15 See IRC 2511.

16 See Treas. Reg. Section 25.2511-2(c).

About the Author
Vincent J. Russo, JD, LLM in Taxation, CELA, CAP, is a NAELA Past President and Fellow.

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