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Income and estate tax planning for special needs trusts.

EXECUTIVE SUMMARY

* The CPA often plays an important role as a financial and tax adviser in the planning, implementation and management of special needs trusts.

* A special needs trust can provide for a disabled beneficiary's special needs, without tainting his or her ability to receive government benefits, such as Medicaid and SSI.

* There are many legal, tax and personal issues to be addressed in establishing the trust's terms; the tax adviser must anticipate the income and estate tax consequences.

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A special needs trust may be advisable when a client or family member is disabled and receiving government benefits. This article discusses the characteristics of such trusts and focuses on the income and estate tax planning considerations.

A client's son has been seriously injured in a motorcycle accident. Another client's newborn child has a genetic defect that will result in severe mental retardation. Such events will change the lives of clients and their families forever. After sorting through the immediate medical problems and grief, clients may seek their CPA's help. Because a family member will now require special care for the remainder of his or her life--the resources for which may come from family assets, insurance, a tort recovery and/or government benefit programs--the CPA's financial projections and assumptions on which advice was previously based will dramatically change.

If government benefits are available, a special needs trust may be advisable as part of the family's financial plan. This article discusses the general parameters of the special needs trust, focusing primarily on the particular income and estate tax considerations presented. Although an attorney will prepare the trust documents and provide advice on qualifying for certain government programs, the CPA is often the closest adviser to the family and can play an important role in implementing and administering the trust.

Definition

A special needs trust is created to invest and distribute funds for the benefit of a disabled beneficiary. Typically, it supplements the beneficiary's government benefits, without tainting his or her ability to receive them. Those benefits may include an apartment paid for by a state housing program, a monthly stipend from the Federal Supplemental Security Income (SSI) program, adult day programs provided by a state social services agency and medical care paid for by Medicaid. However, government programs will most likely not cover special needs such as birthday gifts, vacations, training programs, consumer electronics, furniture and medical procedures and equipment not covered by Medicaid. These special needs can be provided by the special needs trust, without reducing government benefits.

Government Program Qualifications

Many programs, such as Medicaid and SSI, specifically limit a beneficiary's income and resources. (1) Income, for these purposes, generally includes amounts received in cash or kind that can be used for food, clothing or shelter. (2) Resources include cash or other assets that can be converted to cash for support and maintenance. (3)

To avoid disqualifying a special needs trust beneficiary for government benefits, any payments to or for the beneficiary must not be deemed income, and the trust assets must not be deemed resources of the beneficiary. To avoid inclusion, payments or in-kind distributions should either be discretionary or only for the beneficiary's comfort and happiness. The trust document should specifically state that distributions should not be for support. Specific examples of anticipated needs may be cited in the trust document, such as supplemental dental expenses, a wheelchair-accessible van, training programs, personal items, holiday gifts or vacations. To avoid including trust assets as a resource, the trust document should not enable the beneficiary to request a distribution of trust principal.

Whether the trust will be deemed a resource for SSI and Medicaid purposes will depend on whether it is created by a third party from the third-party's assets (a third-party trust) or from the disabled individual's assets (a self-created/self-settled trust).

Third-Party Trusts

A third-party trust is one created and funded by someone other than the disabled individual, such as a parent or grandparent. It can be established during the grantor's life (inter vivos) or at his or her death (testamentary).

Tax Effects of Distributions

A third-party trust will be classified as a complex trust under Regs. Sec. 1.661-(a)(1), because it will not be required to distribute all of its income currently. The trust will be entitled to an income distribution deduction in computing taxable income under Sec. 661 for amounts distributed, paid or credited to the beneficiary. The beneficiary will then be required to include such amounts in his or her taxable income. Income not distributed by the trust will be subject to tax at Sec. 1(e)'s compressed rates (e.g., the maximum 35% rate is reached at taxable income over $9,750 in 2005). The trust may also be liable for state income taxes.

Determining the income distribution deduction may be problematic, because distributions generally are not made in cash to the disabled person. This avoids having to classify them as income of the disabled beneficiary for purposes of qualifying for government benefits. As indicated above, the trustee can supplement government benefits by paying expenses, purchasing items of personal property or allowing the beneficiary to use trust property. He or she can pay for personal items, such as training programs, vacations, recreation and medical or dental expenses, and not have them deemed income. Payments for food, clothing or shelter will be deemed income. For income tax purposes, all payments are deemed distributions for the disabled beneficiary's benefit. These payments may be taxable to the beneficiary and deductible to the trust, depending on the trust's income.

Distributions of property: The trustee can also purchase for and distribute to the beneficiary, property, such as a van, furniture, computer, television or other equipment. Property distributions do not generally result in the trust's recognition of gain or loss. Gain or loss is recognized only when the distribution is in satisfaction of a pecuniary (specific) amount to which the beneficiary is entitled. The trust can elect under Sec. 643(e) to recognize the gain or loss. The property's adjusted basis to the beneficiary equals the trust's adjusted basis, adjusted by the amount of gain or loss recognized by it. For purposes of calculating the income distribution deduction, the distribution is the lesser of the beneficiary's adjusted basis or the property's fair market value, under Sec. 643(e). Often, the property distributed by the trust has not appreciated or depreciated, because the trust purchased and distributed the property within a short period.

Beneficiary's use of trust property: A special needs trust can also permit a beneficiary to use real or personal trust property rent-free. Such use is not taxable to the beneficiary, nor deemed a distribution.

In Letter Ruling 8341005, (4) trustees purchased residential property in a resort area, allowed the trust's income beneficiary to occupy the property rent-free and used the income from other trust assets to pay the real estate taxes. No income was used to pay for electricity or other personal expenses. The rent-free use and the payment of real property taxes were held not to be income to the beneficiary. The taxes were deemed an expense of maintaining a trust asset, not a payment for the beneficiary's personal benefit. Although the trust in the ruling was not a special needs trust, the outcome should be the same. However, rent-free use of the property may indicate it is not being held for the production of income or profit; thus, expenses such as insurance and maintenance may not be deductible by the trust. (5)

Tax Minimizing Strategies

A special needs trust may end up not distributing all of the annual income--depending on the amount of income and the beneficiary's discretionary needs. As indicated above, if the income distribution deduction does not offset the trust's taxable income, the trust will be subject to Federal tax at the Sec. 1(e) rates. If the grantor is in a lower tax bracket, an inter vivos trust might avoid the high rates if the trust agreement includes provisions that make it a grantor trust under Sees. 673-678. However, it is important that the power given to the grantor does not cause the trust to be included in the grantor's taxable estate for estate tax purposes.

The option of creating a grantor trust, With the grantor taxed on the trust income, will not be available if the third-party special needs trust is a testamentary trust. An inter vivos trust will cease to be a grantor trust on the grantor's death. In both situations, planning should allow the trustee to distribute trust income to beneficiaries, other than the disabled individual, based on the trustee's discretion, to satisfy the other beneficiaries' specific needs. The trustee will then be in a position to weigh the potential tax savings from the distribution deduction, taking into consideration the entire family's tax situation, in determining whether to make an annual distribution.

Crummey powers: Another strategy would be to give beneficiaries, other than the disabled person, Crummey (6) powers--the power to withdraw a portion of the trust income or corpus. This results in the beneficiary being treated as the owner of that portion of the trust and taxed on the income under Sec. 678(a). Additionally, the power to withdraw may have estate and gift tax consequences for the beneficiary.

The decision to give the trustee the discretion to distribute income to a group of beneficiaries or to give beneficiaries Crummey powers will require an analysis of the income, estate and gift tax consequences, as well as the nontax consequences. Considerations include:

1. Are the trust income and corpus sufficient to provide for the disabled beneficiary and other beneficiaries?

2. Are the other beneficiaries competent adults with other sources of income who will be considerate of the disabled beneficiary's needs?

3. Does the trustee have a personal understanding of the beneficiaries and their needs?

Because of family considerations, there is no standard way to design a special needs trust to minimize the potential effect of the excessive trust income tax rates.

Beneficiary Taxation

Trust distributions to a disabled beneficiary may result in taxable income. The beneficiary will report as income his or her share of the income distribution deduction calculated by the trust. If the trust makes a distribution by paying the beneficiary's personal expenses, the expenses are not deductible by the beneficiary, unless they qualify as a reduction of adjusted gross income or as an itemized deduction. Qualified payments can include deductible medical expenses, such as the costs of prosthetic devices, adapting a car or van for a handicapped person, prescribed drugs, nursing services, a wheelchair or a hearing aid. The trust is entitled to an income distribution deduction for the payment of such personal expenses; however, it cannot deduct the payments of the beneficiary's medical expenses.

If not handled properly, trust distributions can result in the beneficiary being liable for the income tax without the cash to pay it. In 2005, a single beneficiary would be able to include up to $8,200 of income before incurring income tax, based on the standard deduction and personal exemption. The trust agreement can permit the trustee to pay the tax on the beneficiary's distributions. Those payments would be included in distributions when calculating the income distribution deduction. (7)

Estate Planning

A third-party special needs trust may be used in conjunction with a variety of estate planning strategies of the third party (usually a parent).

The trust may be an inter vivos trust funded with parental gifts. The parent may avoid including the trust in his or her estate by making it irrevocable and by not retaining powers over trust assets that would trigger their inclusion under Secs. 2031-2046. For example, if the parent as grantor retains the discretion as trustee to distribute or accumulate income, the trust assets will be includible in his or her estate under Sec. 2036(a)(2).

Gifts to the trust may include various types of assets, including cash, marketable securities, real estate or an interest in a family limited partnership. The gifts may qualify for the annual exclusion as a present interest if the trust provides for Crummey withdrawal rights. However, use of a Crummey power in a special needs trust may make the amount subject to withdrawal an available resource for purposes of government benefits, thus potentially disqualifying the beneficiary. Consideration should be given to providing remainder beneficiaries with the withdrawal right, to avoid this problem.

In Cristofani, (8) the Tax Court allowed a present-interest exclusion based on a contingent remainder beneficiary's right to withdraw a portion of a gift to the trust. However, the IRS continues to deny a present-interest exclusion if it believes, based on the facts and circumstances, that the substance of the withdrawal right is not a present interest. (9) If there is a prearranged agreement that the remainder beneficiaries will not exercise the withdrawal right, the right would not be, in substance, a present interest.

The grantor of a third-party special needs trust may structure it as a grantor retained annuity or unitrust, a qualified personal residence trust, an irrevocable life insurance trust or a charitable remainder annuity trust (CRAT) or unitrust (CRUT). The IRS has ruled that a CRUT or CRAT may qualify under Sec. 664 if the unitrust or annuity amount is payable to a separate trust for the benefit of a financially disabled individual. (10) A financially disabled individual is defined in Sec. 6511(h)(2) as one who is "unable to manage his financial affairs by reason of a medically determinable physical or mental impairment of the individual which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months."

A trust or an individual may be a beneficiary of a CRUT or CRAT, but annual payments to the trust beneficiary are limited to 20 years or less. This requirement could potentially disqualify a special needs trust as a beneficiary, because it might last for the disabled beneficiary's life. However, the IRS concluded that a special needs trust providing for discretionary payments to supplement government benefits was a permitted CRAT or CRUT beneficiary, because the use of the trust assets was consistent with the way in which assets directly owned by the financially disabled individual would be used.

On the disabled beneficiary's death, the remaining trust corpus and accumulated income may be held in further trust for, or distributed to, the grantor's descendants. Generally, the beneficiary's rights to the discretionary distribution of income or principal will not cause the inclusion of any value associated with the trust in the beneficiary's taxable estate. However, giving the beneficiary a testamentary general power of appointment may cause the trust assets to be included in his or her gross estate, under Sec. 2041. This may appear advisable if the estate tax is offset by the unified credit, because the assets may receive a stepped-up basis under Sec. 1014; however, the general power of appointment also may subject the assets to reimbursement claims by Medicaid or other government programs.

Self-Created Trusts

For SSI and Medicaid purposes, the law specifically considers a self-created trust an available resource. Under 42 USC Section 1396p(d)(3) (B), "if there are any circumstances under which payment from the trust could be made to or for the benefit of the individual," the trust assets will be resources of the disabled individual. This is true even if the payments are discretionary; however, there are exceptions. Assets of certain types of self-created trusts (sometimes referred to as "d4A" and "d4C" trusts), are exempt from inclusion in the disabled person's resources. (11) These exempt trusts are used when a disabled individual has a right to significant assets from a tort recovery, an inheritance or a divorce. A "d4A" trust must be created by a parent, guardian or the court from the assets of a disabled individual under age 65. Additionally, on the individual's death, the trust must be required to repay the state any amounts paid for medical assistance under Medicaid.

A "d4C" trust is a type of trust created from the pooled assets of disabled individuals. It must be managed by a nonprofit association. A separate account for each disabled person must be created and maintained by a parent, grandparent, guardian or court. Amounts remaining in the account must be retained by the trust or paid to the state for reimbursement of medical expenses on the disabled person's death.

Income Tax Issues

As discussed above, to qualify as a "d4A" or "d4C" trust, the trust must be created by a parent, guardian or court from the disabled individual's assets. Often, this type of trust is created by court order from the proceeds of a personal injury settlement. In these situations, the IRS considers the lawsuit or settlement proceeds to be the disabled beneficiary's property, although the nominal trust grantor may be a parent or guardian. As a result, the trust may be a grantor trust under Sec. 677(a), because the trust income and corpus will be distributed or accumulated for the grantor's benefit in the discretion of a nonadverse party. (12) The trustee would normally not be an adverse party, because he or she would have no beneficial interest in the trust that would be adversely affected by an exercise of discretion.

A self-created trust may also be funded with the proceeds of an inheritance. However, it is preferable for parents to create a third-party special needs testamentary trust to avoid the Medicaid reimbursement requirement after the beneficiary's death.

Because it is a grantor trust, the beneficiary will include in income all items of income, deduction or credit of the trust, as required by Sec. 671. Under Regs. Sec. 1.671-4(b), the trust may not need to file Federal income tax returns if the grantor and the trustee are the same. Obviously, if the disabled beneficiary is incapacitated, he or she could not act as a trustee.

Estate Planning

Although a special needs trust may not be a resource for government benefit purposes, the trust corpus will be included in the disabled beneficiary's gross taxable estate. In Letter Ruling 9437034 (13) and TAM 9506004, (14) the IRS held that the proceeds of a personal injury lawsuit transferred to a special needs trust were the injured party's property, because he was also the trust beneficiary. The decedent in both rulings possessed a testamentary power of appointment. The IRS ruled that the proceeds were includible in his gross estate under Sec. 2038, because the decedent was the transferor to a trust over which enjoyment was subject, as of his date of death, to being altered, amended, revoked or terminated by his exercise of a testamentary power of appointment. Additionally, in TAM 9506004, the IRS used Sec. 2036 as the basis for including the trust corpus in the gross estate, because the decedent had retained the right to enjoy the income from the property.

The self-settled special needs trust may contain a provision requiring the reimbursement of Medicaid on the beneficiary's death. Because the trust assets will be included in the gross estate, the debt owed to Medicaid will be a deduction from the gross estate under Sec. 2053(a) (4), to the extent of the trust assets included in the estate.

Conclusion

A special needs trust may be used in a variety of circumstances. It may be established from the funds of a third party in a testamentary or inter vivos trust, or as a self-settled trust from the beneficiary's assets. There are many legal, tax and personal issues to be addressed in establishing the trust terms. The tax adviser must anticipate the income and estate tax consequences associated with the trust's creation, investments, management, distributions and termination on the disabled beneficiary's death, so as to properly advise clients.

Editor's note: Prof. Savoth is of counsel to Carton, Arvanitis, McGreevy, Argeris, Zager & Atkins, LLC, in Asbury Park, NJ.

(1) See 42 USC Section 1382: it is beyond this article's scope (and CPAs' practice) to discuss the specific qualifications for the various government programs.

(2) See 20 CFR. Section 416.1102.

(3) See 42 USC Section 1382b(a).

(4) IRS Letter Ruling 8341005 (6/24/83).

(5) See Frederick H. Prince, 35 TC 974 (1961).

(6) "Crummey" powers are named after D. Clifford Crummey, 397 F2d 82 (9th Cir. 1968).

(7) See Sarah A. Bergan, 80 F2d 89 (2d Cir. 1935).

(8) Est. of Maria Cristofani, 97 TC 74 (1991).

(9) See IRS Letter Ruling (TAM) 9628004 (7/12/96).

(10) See Rev. Rul. 2002-20, 2002-1 CB 794; see also IRS Letter Ruling 9903001 (1/25/99).

(11) See 42 USC Section 1396p(d)(4)(A) and (C).

(12) See Rev. Rul. 83-25, 1983-1 CB 116.

(13) IRS Letter Ruling 9437034 (9/16/94).

(14) IRS Letter Ruling (TAM) 9506004 (2/10/95).

Paul G. Savoth, CPA, J.D., LL.M.

Associate Professor

Monmouth University

West Long Branch, NJ
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Author:Savoth, Paul G.
Publication:The Tax Adviser
Date:Jan 1, 2005
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