Special Needs Trust Tax Planning [updated 2011- first published- ElderLaw Report Nov. 1996]

Special Needs Trusts (“SNTs”) are trusts to supplement the basic support that government programs like Supplemental Security Income, Medicaid, group home placement, and day training programs provide to many seriously disabled people who have minimal income and resources. SNTs normally are established when an estate plan for a disabled person’s parent or other close relative is drawn or a litigation recovery, inheritance, or other substantial sum is about to be realized by someone with serious disabilities. Generally an estate planning SNT will not disqualify a disabled beneficiary for financial-need based government aid provided that the trustees have full discretion to accumulate or distribute principal and income, and the disabled beneficiary can’t require the trust to make distributions. However, a self settled SNT may jeopardize a disabled beneficiary’s government benefits if state fraudulent transfer law accords the beneficiary or his/her creditors a right to access the trust.

Some of the most complex principles of personal taxation apply when dealing with trusts. Nevertheless, elder law and estate planning attorneys should be familiar with trust taxation because SNTs are central to virtually all planning to benefit people with serious disabilities. The Internal Revenue Code provides extraordinary flexibility to determine how trust income and principal are taxed. Thus a client’s objectives can control whether SNT contributions are taxable gifts or the SNT is subject to estate and/or inheritance tax at the grantor’s death and whether trust income will be taxable to the grantor, the trust, or the disabled beneficiary. However, this flexibility is a double edged sword, as preparing an SNT without fully understanding its tax consequences practically invites a malpractice claim. Although the tax rules discussed below apply to all kinds of SNTs, this article focuses primarily on SNTs as employed in estate planning. Taxation of SNTs to be funded with a disabled person’s settlement proceeds is discussed at length in an article by Howard Atlas, Esq. and Vincent Russo, Esq. in the May, 1995 issue of The Elder Law Report. [Note, I have not reviewed the Atlas/Russo article to determine whether it continues to apply.]

Although SNTs may be established by Will, inter vivos SNTs usually are preferred for several reasons. A disabled person’s parents can establish a single life time SNT to act as repository for gifts and devises by all the child’s relatives. Some parents make regular contributions to an SNT as a convenient way to set aside funds for a disabled child. In addition inter vivos SNTs can play a role in estate tax planning whereas testamentary SNTs are funded with amounts remaining after settling death taxes. Consequently, this article concentrates on taxation of life time SNTs.

Gift, Estate & Inheritance Taxes

Estate tax issues rarely arise when an SNT is testamentary, as the assets that pass into the SNT are simply included in the decedent’s taxable estate. However testamentary SNTs often raise thorny issues in states that have inheritance taxes.

Inheritance tax rates vary depending on the relationship between decedent and recipient. For instance, New Jersey imposes no inheritance tax on amounts received by a spouse or descendant but taxes most other testamentary transfers at rates that can reach 16%.

Where trust beneficiaries have different degrees of kinship to the decedent/grantor, the inheritance tax due will depend on the percentage of the trust corpus that actually passes to or for each beneficiary. Because SNT trustees have full discretion to distribute corpus to the disabled beneficiary or retain it in trust for remainder beneficiaries, the actual inheritance tax due on a devise into an SNT can’t be determined until the disabled beneficiary dies. Where inheritance tax can’t be determined immediately, New Jersey will estimate the likely corpus split based on actuarial considerations and offer to compromise the inheritance tax accordingly. However, because an SNT trustee’s broad discretion over distributions precludes precise calculation of beneficiaries’ relative interests, estate attorneys have substantial tax planning opportunities. For instance, if a Will establishes a modest SNT for decedent’s child (inheritance tax rate 0%) with remainder to decedent’s close friend (inheritance tax rate 15%), the estate attorney could argue for no inheritance tax on grounds that the entire SNT should be exhausted during the disabled child’s lifetime.

Many families may have little need for federal estate tax planning due to the generous federal applicable exclusion from estate tax. Nevertheless estate tax planning still may be important to minimize tax in the many states such as New Jersey and New York that impose state estate taxes on much more modest estates.

Obviously, gift tax is an issue only with inter vivos trusts. A grantor’s contributions to a revocable SNT are without gift tax consequences because the grantor retains rights to reacquire the transferred assets or change their beneficiary simply by revoking the trust. Distributions from a revocable SNT are taxable gifts from the grantor to the beneficiary unless sheltered by the annual gift tax exclusion under Code §2503. A contribution to a revocable SNT by someone other than the grantor normally is a taxable gift to the grantor and eligible for the annual gift tax exclusion under Code §2503. In addition, the gift into SNT will be included in the grantor’s eventual taxable estate unless spent or otherwise distributed while the grantor is living. Thus, where grandparents fund a revocable SNT with parents as trustees, the grandparents make taxable gifts to the parents and increase the parents’ potential tax estates.

A contribution to an irrevocable SNT usually will constitute a taxable gift by the grantor unless the grantor retains a power of appointment or other right to determine who receives trust distributions. A grantor’s contribution to an SNT over which he/she is trustee may not be a completed gift if the grantor can determine who benefits from the gift by controlling distributions.

Contributions to an irrevocable SNT will be gifts of future interests that don’t qualify for the annual gift tax exclusion under Code §2503 unless the trust instrument grants the trust beneficiaries Crummey withdrawal powers. Under Crummey v. Commr., 397 F.2d 82 (9th Cir., 1968), gifts to a trust that permits beneficiaries to withdraw contributions from trust when they are made qualify for the Code §2503 annual gift tax exclusion. Crummey power design is an art unto itself with complexities arising from notice requirements, allocation of withdrawal rights among beneficiaries, attempts to employ annual gift tax exclusions from multiple donees and years, and efforts to prevent lapse of withdrawal rights from constituting release of a general power of appointment, all of which are beyond the scope of this article.

Granting Crummey withdrawal powers to a disabled beneficiary may disqualify the beneficiary for government benefits, which would defeat the primary purpose of most SNTs. Therefore, it is safer for SNTs to give Crummey powers only to beneficiaries who aren’t disabled, such as remainder beneficiaries. However, Crummey power beneficiaries should have a real interest in the SNT otherwise IRS may contest eligibility for the annual gift tax exclusion. See Cristofnai v. Commr., 97 T.C. 74 (1991) and its progeny.

Inter vivos SNTs can play an important role in estate tax reduction planning, but for a variety of reasons, many SNTs aren’t intended to save estate taxes. In the first place, many clients aren’t wealthy enough to be concerned with estate tax. Furthermore, an SNT obviously won’t save much estate tax unless it is substantially funded with investments or life insurance during the grantor’s lifetime, but even many wealthy clients don’t want to fund an SNT until they die.

Although a grantor must be willing to accept certain limitations to employ an SNT as an estate tax reduction vehicle, SNTs often are designed to save estate taxes for wealthy clients whose children have serious disabilities. Code §2038 requires an estate tax planning trust to be irrevocable, which prevents a grantor from amending an SNT should circumstances change. The grantor shouldn’t serve as trustee because the trustee normally determines how to divide the SNT between life and remainder beneficiaries, and Code §2036 includes in a decedent’s taxable estate assets that the decedent transferred while retaining the right to receive or designate who shall receive or enjoy the asset or its income. Similarly, Code §2033 would tax in the grantor’s estate any reversionary interest retained by the grantor.

Life insurance is often employed to fund SNTs. Although a thorough discussion of life insurance planning is beyond the scope of this article, an irrevocable SNT can shelter life insurance from estate tax provided that the insured (or an entity controlled by the insured) isn’t trustee or beneficiary of the trust and doesn’t own or have incidents of ownership over the insurance during the three years preceding the insured’s death. To avoid inclusion in an insured’s estate of life insurance benefits payable to an SNT, the trust instrument must fully satisfy Code §2035(b)(2) and Code §2042, which contain many traps for the unwary.

An SNT that contains the disabled beneficiary’s assets will be taxable in the beneficiary’s estate because Code §2036 includes in a decedent’s taxable estate assets that the decedent transferred while retaining the right to receive or enjoy the asset or its income. Consequently, IRS has claimed a litigation settlement SNT is taxable in the disabled beneficiary’s estate. Arrington v. U.S., 76 AFTR 2d 95-5453 (Claims Ct., 1995) and IRS Technical Advice Memorandum 95-06-004 (Nov. 1, 1994).

Income Tax

An SNT receipt is income for tax purposes in similar manner to income received directly by an individual. Thus, an SNT’s dividend income is taxable, but its tax free municipal bond income isn’t. SNT’s may be designed so that their income is taxable to the trust, the grantor, or the beneficiary.

Because income tax rates applicable to trusts are highly compressed, substantial income tax often can be saved by structuring an SNT as a grantor trust because income then will be taxed to the grantor rather than the SNT. Under Code §673- §677, various circumstances can cause a trust to be a grantor trust. Generally, an SNT will be a grantor trust if it is revocable, the grantor retains a reversion worth more than five percent of the value of the initial corpus, income may be distributed to or for the grantor or his/her spouse, or the grantor retains certain powers over beneficial enjoyment of the trust or its administration. Some normally prohibited powers will not cause a trust to be a grantor trust if they may be exercised only with the consent of a party whose interests are adverse to the grantor. In addition, Code §678 treats as owner of a trust a person who isn’t the grantor but who can vest the corpus or income in him/herself. Under Treas. Reg. §1.671-4(b) a grantor trust need not file tax returns provided that the grantor’s taxpayer identification number is reported to all payers of income to the trust and the trustee provides to the grantor information that he/she will require to properly include the trust income in his/her tax return.

Because taxation generally is based on substance over form, the person who funds an SNT may be considered the grantor for tax purposes even if the trust instrument designates someone else as grantor. In Rev. Rul. 83-25, 1983-1 C.B. 116, IRS ruled that the minor beneficiary of a trust established by court order to hold the beneficiary’s litigation recovery was the grantor for income tax purposes.

Tax Planning with SNTs

Estate tax planning trusts range from basic testamentary credit shelter trusts to sophisticated inter vivos trusts. Virtually any kind of trust that is intended to save taxes also may be drafted as an SNT to avoid disqualifying a beneficiary with serious disabilities for financial-need based government benefits. For instance an individual may reduce his/her potential taxable estate by making annual exclusion gifts for a disabled child to an SNT that grants Crummey withdrawal powers to non-disabled remainder beneficiaries. Similarly, life insurance benefits for a disabled child may be sheltered from estate tax if the insurance is owned by an SNT that also is an irrevocable life insurance trust.

To minimize federal or state estate tax, many estate plans call for funds to pass to a credit shelter trust that pays income to the surviving spouse and divides among the children when the surviving spouse dies. (For instance, leaving $675,000 in a credit shelter trust may save substantial New Jersey estate tax.) To avoid disqualifying a disabled child for government aid, the credit shelter trust may convert to an SNT at the surviving spouse’s death or pay the disabled child’s share to another SNT. By the same token, wealthy individuals who wish to save potential estate taxes while benefitting a disabled loved one also may employ SNTs when planning with family limited partnerships, grantor retained annuity trusts, qualified personal residence trusts, self cancelling installment notes, and private annuities

Where tax savings are a paramount concern, SNTs can be designed as grantor trusts to take advantage of generally lower individual income tax rates and permit the grantor to reduce his/her potential taxable estate by paying income tax that otherwise would be paid from the SNT’s income. Thus, a grantor trust expands the $13,000 annual gift tax exclusion because the grantor’s payment of tax on the SNT’s income has the same economic effect as an additional gift to the SNT but the grantor’s tax payment isn’t a gift for tax purposes. However, an SNT that is intended to minimize the grantor’s potential estate tax must not be includible in the grantor’s taxable estate and shouldn’t allow the grantor to revoke the trust, receive trust distributions, or designate trust beneficiaries.

Special Needs Trust Case Studies

1.
John and Mary Rich have two children, Nan (who has severe mental illness) and Julie (who doesn’t have disabilities). John and Mary both have high earning careers and have amassed a combined net worth of $2,500,000, which they ultimately want to divide equally between their two children. John also owns a $200,000 life insurance policy on his life that he took out many years ago when he and Mary had little assets.

To minimize potential estate taxes, John and Mary have made wills that leave the federal applicable exclusion to a credit shelter trust and the balance to the surviving spouse. When the surviving spouse dies, her estate and the credit shelter trust are equally divided between Julie and a special needs trust (“SNT”) for Nan. Because John and Mary plan to make annual exclusion gifts into the SNT, the SNT is irrevocable and grants Crummey withdrawal powers to remainder beneficiaries. Nan doesn’t have Crummey withdrawal powers because they could jeopardize Nan’s eligibility for financial-need based government aid. To avoid potential estate tax on John’s life insurance, John will assign his policy to Julie, and John’s will devises an amount equal to the insurance benefit to the SNT. To prevent dilution of the insurance equivalent devise, John’s will provides that death taxes as to the devise shall be paid from John’s residuary estate. John could have realized similar tax savings by instead assigning the insurance to a newly drawn irrevocable life insurance trust or an SNT drafted as an irrevocable life insurance trust, but in either case additional legal fees would have ensued.

2.

Jack and Ellen are the divorced parents of Jim, who has autism. To protect Jim, $750,000 life insurance policies payable to an SNT for Jack have been purchased on Jack and Ellen.

Because substantial estate tax would become due if Jack’s and Ellen’s insurance policies are includible in their estates, the policies were purchased by the SNT with funds provided by Jack and Ellen. For the same reason, the SNT is irrevocable. Because Jack and Ellen plan to pay the insurance premiums with amounts that they want to qualify for the gift tax annual exclusion, the SNT grants Crummey withdrawal powers to the remainder beneficiaries.

Conclusion

Special needs trust planning raises many issues of gift, estate, and income taxation. Although the rules governing taxation of trusts are very complex, they afford elder law attorneys many tools to save clients substantial tax when designing SNTs. With creative drafting, an SNT may be designed both to minimize potential taxes and avoid disqualifying a disabled beneficiary for financial-need based government programs.

Lawrence A. Friedman practices elder, disabilities, and tax law in Bridgewater, NJ. He has an LL.M. in Taxation from New York University School of Law, is Certified as an Elder Law Attorney by the A.B.A. accredited National Elder Law Foundation, and has chaired the New Jersey State Bar Association (NJSBA) Elder & Disabilities Law Section and is a member of the Board of Consultors of NJSBA Real Property, Trusts & Estates Law Section. He received the NJSBA’s Distinguished Legislative Service Award for drafting new law to protect elderly and disabled people. Mr. Friedman has been named to New Jersey Super Lawyers (published by Thomson Reuters) since 2006 and has held Martindale-Hubbel’s highest peer review rating of AV- Preeminent for many years.

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