Bar Journal - Spring 2005
Special Needs Trusts in the Era of the Uniform Trust Code
By: Attorney Jan P. Myskowski
The enactment of the Uniform Trust Code in New Hampshire1 and recent developments in the treatment of distributions from special needs trusts by various public benefits programs make this an opportune time to review the issues involved in the creation, funding and administration of special needs trusts in New Hampshire. This article provides an overview of the types of special needs trusts, the mechanics for creating and funding special needs trusts, special drafting considerations, matters concerning distributions, tax issues, and creditor protection issues particular to special needs trusts.
The article discusses the effect certain sections of the Uniform Trust Code will have on special needs trusts, but this article should not be considered a comprehensive study of the Uniform Trust Code’s impact on New Hampshire trusts in general. [Editor’s Note: Additional commentary on the Uniform Trust Code will appear in a future issue of the Bar Journal] Experienced trust and estate practitioners more interested in the author’s comments regarding the impact of the Uniform Trust Code on special needs trusts will want to focus on the discussion in sections III and IV.
II. Creating and Funding Special Needs Trusts
A. Types of Special Needs Trusts
The terms "special needs trust" and "supplemental needs trust" are used interchangeably, along with other similar terms, to describe a trust that relies on a trustee’s discretion to insulate trust income and principal from the beneficiary’s countable resources for public benefits eligibility purposes. Occasionally, some practitioners will use the term "supplemental" rather than "special" to identify a trust that contains express language indicating the grantor’s intent that the trust be used to supplement and not supplant the beneficiary’s public benefits entitlements. That distinction is not universal, and for the purposes of this article, the term "special needs trust" will be used to describe all trusts used to manage assets in coordination with a beneficiary’s public entitlements.
Special needs trusts fall into three categories. For the purposes of this article, those categories will be referred to using the following terminology: "Self-settled" trusts are those trusts created to hold assets belonging to the intended beneficiary of the trust. "Third party" trusts are those created to hold assets belonging to someone other than the intended beneficiary of the trust. A "pooled trust" is a special arrangement with a non-profit organization that serves as trustee to manage assets belonging to many disabled individuals, with investments being pooled, but with separate trust "accounts" being maintained for each disabled individual. An account with a pooled trust is a hybrid form of self-settled trust since assets belonging to the disabled individual are used to establish the account.
The primary distinction between self-settled and pooled trusts on the one hand, and third party trusts on the other, is the source of the assets used to fund the trusts. This is an important distinction because, as will be seen below, a parent of a disabled individual may be the person to create a self-settled trust instrument, which can make it confusing to distinguish the types of trusts based upon the identity of the person creating the trust documentation.
2. Common Motivating Events
(a) Self-Settled and Pooled
(1) Spend down of existing assets
A disabled individual may already have significant accumulated resources when he or she becomes disabled. Those existing resources probably disqualify the individual from various public benefits programs and need to be reduced before the individual will qualify. In that event, the motive to establish a special needs trust would be to reduce the assets for public benefits purposes, while at the same time preserving the availability of the assets to the disabled individual.
(2) Receipt of personal injury or back benefit settlement
A disabled individual may be a plaintiff in a personal injury suit, or may be seeking a retroactive award of benefits, such as Social Security disability benefits, either of which may result in a significant lump sum receipt of cash when the disabled individual is already receiving public benefits. In that event, the motive to establish a special needs trust would be twofold: (i) to create a vehicle to receive the lump sum payment so as to prevent it from disqualifying the disabled individual from public benefits; and (ii) making the lump sum available to the disabled individual.
(3) Receipt of gift or inheritance while receiving benefits
The disabled individual may receive a gift or inheritance from a relative, creating a potential outright receipt by the disabled individual. The disabled individual may transfer such a gift or inheritance to a special needs trust in the same manner as discussed in (2) above.
(4) Non-trust transfers should be considered
Before establishing a special needs trust in any of the foregoing circumstances, the disabled individual should investigate whether there are other options available for reducing the resources. For example, Medicaid provides an exception to its asset transfer penalty provisions for transfers to minor or disabled children. See C.2.(a) below. It may make more sense for the disabled individual to transfer assets under such an exception than to establish a special needs trust for his or her own benefit.
(b) Third Party
(1) Lifetime gift
Third party trusts are typically created by the parent or parents of a disabled child. Parents usually support the disabled child from the parents’ own funds while the parents are living, coordinating that support with public benefits entitlements as needed. Special needs trusts are often not considered for creation until the deaths of the parents. However, as parents age, sometimes they are faced with tax planning or long-term-care planning incentives to part with property before death. In those situations, a special needs trust may be created to receive a lifetime transfer of assets. In addition, changes such as a divorce of the parents may create circumstances in which the lifetime funding of a permanent source of support for the child makes sense.
(2) Transfer on death
As mentioned above, many third party special needs trusts are created upon the death of the surviving parent of a disabled child to provide continued support for the child. Documentation of the special needs trust is often prepared when the parents’ other estate planning documents are prepared, while funding of the trust occurs at the parents’ deaths through distributions to the special needs trust from the parents’ wills, revocable trusts or life insurance policies.
B. Possible Conflicts with Public Benefits Programs
1. Countable Resources
Many public benefits programs, such as Medicaid and Supplemental Security Income ("SSI"), are needs-based programs, meaning that entitlement is conditioned in part on the applicant demonstrating that he/she has assets and income below certain allowable limits. As discussed above, the incentive for creating many self-settled or pooled trusts is often to reduce the disabled individual’s assets to meet such limits. Regardless of whether the special needs trust is self-settled, third party or pooled, a major concern is whether or not the disabled individual’s assets, having been transferred to a special needs trust, will be considered a countable asset for public benefits purposes from the trust beneficiary’s perspective. The primary utility of a special needs trust is to hold assets in a form that will not be countable.
2. Countable Income
Even if assets held in a special needs trust are non-countable under the asset tests of the various public benefits programs, distributions to or for the benefit of the beneficiary, whether paid from trust income or trust principal, may be considered countable income to the beneficiary under the income tests of the various programs.
3. Asset Transfer Penalties
Many public benefits programs penalize transfers of assets made with the intention of qualifying. Generally, asset transfer penalties do not apply upon the funding of self-settled special needs trusts.2 The conflict arises only in the context of third party trusts where the person transferring assets to the special needs trust, such as the disabled beneficiary’s parent, is concerned with qualifying himself or herself for public benefits. For example, an elderly parent may be entering a nursing home and may be applying for Medicaid in connection with the transfer of assets to a special needs trust for a child. In that case, the third party trust grantor must consider whether the transfer of assets to the trust will be disqualifying from the grantor’s perspective.
C. How Special Needs Trusts Minimize Public Benefits Conflicts
1. Self-Settled and Pooled
(a) Government reimbursement of benefits provisions
For the purposes of Medicaid and SSI, special exceptions have been created by statute allowing a disabled individual to transfer assets to a special needs trust for his or her own benefit without the transfer being considered a disqualifying transfer and without the trust principal being considered a countable asset under those programs.3 To be eligible for this special status, the self-settled trust must provide that upon the disabled individual’s death the government will be reimbursed from the remaining trust assets for benefits provided to the disabled individual.4 For pooled trusts, the portion of the trust assets allocated to the disabled individual’s trust account must either remain in the pooled trust upon the disabled individual’s death or be used to reimburse the government for benefits paid to the disabled individual.5 In either the self-settled or pooled trust context, assets may be paid to the disabled individual’s family or other intended beneficiaries to the extent the assets exceed the amount of the reimbursement paid to the government. Pooled trust sponsors may impose additional provisions for how remaining assets are to be used. (See the discussion of the Enhanced Life Options pooled trust agreement later in this article.) Other requirements of the statutes are also discussed in more detail in the following pages.
(b) Trustee discretion
Although self-settled special needs trusts are afforded special status by the government reimbursement statutes, trustee discretion still plays an important role in preventing trust principal from being treated as a countable asset. Poorly drafted trustee discretion provisions can cause trust principal to be countable despite the inclusion of government reimbursement provisions. Special needs trusts seek to avoid having trust principal counted as an asset available to the disabled individual who is the trust beneficiary by providing that a disinterested trustee will hold discretionary authority over trust distributions. So long as the disabled individual holds no power to demand any trust distributions of trust principal (and cannot compel distributions through judicial action), and so long as the disinterested trustee is not compelled to make any distribution of trust principal by the terms of the trust, in most cases no part of the trust principal will be a countable asset of the disabled individual for public benefits purposes, even if the trustee has the discretion to make distributions of trust principal. See the authorities discussed in section III.
If distributions of trust income are also exclusively within the discretion of a disinterested trustee, trust income will also not be counted as income for public benefits purposes, so long as trust income is accumulated and added to trust principal. To the extent the trustee actually makes distributions from the trust directly to the beneficiary, whether from trust income or from trust principal, the beneficiary’s receipt of those distributions will likely be considered countable income under the rules of most public benefits programs, and certain indirect payments to third parties for services or support provided to the beneficiary may be considered countable in-kind income.
A more detailed discussion of the role of trustee discretion in the countability of trust income and principal, including the impact of the Uniform Trust Code, is set forth in section III.
2. Third Party
(a) Government reimbursement not required
Generally, third party trusts need not contain any provisions for payments to the government on the beneficiary’s death. This is because the person creating and transferring assets to the trust is usually not receiving public benefits. Therefore, that person has no concern regarding transfer of asset penalties.
However, sometimes a third party grantor of a special needs trust will be applying for public benefits, such as when a parent of a disabled child is entering a nursing home and applying for Medicaid. In that event, the parent may wish to take advantage of asset transfer penalty exceptions, such as those set forth in the Medicaid program that allow a parent to make exempt transfers of assets to a totally and permanently disabled child.6 Such transfers can be made outright to the child, but such outright transfers will likely leave the child holding assets that would disqualify the child from public benefits. Therefore, the transfer penalty exception provides that such gifts may be made to a trust for the sole benefit of the child. In drafting, one issue that arises is whether a trust that provides a remainder gift to other family members upon the disabled child’s death would be considered for the sole benefit of the disabled child. Federal law provides a safe harbor approach: if the government will be reimbursed first before any remainder gifts are made, the trust will be considered for the sole benefit of the disabled child.7 Alternatively, distributions to the disabled child may be computed on an actuarial basis, but this may result in unwanted distributions.8
(b) Trustee discretion
The trustee discretion concerns are the same for third party trusts as for self-settled and pooled trusts. However, it is worth noting that in the third party trust context carefully drafted trustee discretion is the only line of defense against countability of trust principal, since the special status afforded by the government reimbursement statutes does not apply.
D. Mechanics of Trust Creation
1. Private Self-Settled (non-pooled)
Although a private, self-settled trust will be funded with the assets of the disabled individual who will be the beneficiary of the trust, the disabled individual will not be the person to create the trust instrument. Under the enabling statute, such a trust must be established by a "parent, grandparent, legal guardian of the individual, or a court…."9 No special agency authority is required to create the trust instrument. A parent, for example, need not be the court-appointed guardian of the child to create the trust. However, in many cases, some type of agency will be required to fund the trust. This is because a transfer of the disabled individual’s assets is required, and the individual may be incompetent. In those cases, a guardian or conservator may need to be appointed for the purpose of transferring the disabled individual’s assets to the trust. Such transfers will require a special petition under RSA 464-A:26-a for authority to engage in estate planning on behalf of the ward. In some (probably rare) cases, the incompetent, disabled individual may have appointed an attorney-in-fact under a general durable power of attorney before the individual became incompetent.
A private, self-settled special needs trust must be created and funded before the disabled individual reaches age 65.10 However, a trust meeting this requirement will continue to be non-countable after the beneficiary reaches age 65 so long as no additions are made to the trust after the beneficiary reaches age 65.11
A private, self-settled trust must be irrevocable. Section 6-602(a) of the Uniform Trust Code reverses the common law for trusts created after the effective date of the Code by providing that a trust is revocable unless made expressly irrevocable by its terms.12 Accordingly, all private, self settled trusts must now be expressly irrevocable.
Where the funds to be transferred to the trust consist of proceeds of a personal injury or other third-party liability claim, a practitioner must investigate whether any reimbursements are owed to the government for past public benefits paid, or to private insurers or medical providers. Presently, reimbursement is required in some situations for Medicaid but not for SSI.13 With respect to the claims of private insurers, see Great West Life v. Knudson.14
2. Third Party
A third party trust can be created by any conventional means used to create any other type of trust. Both testamentary and inter vivos trusts may be used. Generally, it is advisable to create the special needs trust through a separate inter vivos instrument. If funding on death is desired, the grantor can then provide for a pour-over gift to the separate special needs trust through the grantor’s will or revocable trust.
These trusts can be created for the benefit of disabled individuals who are age 65 or over because government reimbursement is either not required or, if required, is included only to support the argument that the trust is for the sole benefit of the disabled individual.
With a self-settled trust, the funding amount is usually fixed by the available assets of the disabled individual. With a third party trust, the third party grantor must give careful consideration to the anticipated needs of the disabled individual in determining the amount of the gift. Often, consultation with social workers and other professionals can be of great assistance. Third party grantors should always explore whether a life insurance policy can be used to supplement the funding of the trust on the grantor’s death. Often, an experienced life insurance professional will also have access to information that can assist in determining the optimum trust funding amount.
Third party special needs trusts can be revocable during the lifetime of the grantor, so long as the trust assets would not be payable to the disabled individual upon revocation.
Pooled trust accounts can be established for a disabled individual of any age. Like a private, self-settled trust, a pooled trust account can be established by the disabled individual’s parent, grandparent, guardian, or by a court; but unlike a private, self-settled trust, a pooled trust account may also be established by the disabled individual himself or herself.15
A copy of the Master Special Needs Pooled Trust established by Enhanced Life Options ("ELO") of Bedford, New Hampshire, can be obtained by contacting ELO’s Executive Director, Nina Hamburger, at 15 Constitution Drive, Suite 169, Bedford, New Hampshire, 03110. ELO is currently the only pooled trust sponsor in New Hampshire. Although a resident of one state may utilize a pooled trust sponsored by an organization located in any other state, the importance of having a close working relationship with the administrator of the trust probably weighs in favor of using a local sponsor.
With the ELO pooled trust, the disabled individual’s assets are transferred to the pooled trust, which is administered by First Financial Trust of Newton, Massachusetts under an agreement with ELO. The beneficiary’s assets are allocated to a separate account created in accordance with a joinder agreement, through which the beneficiary can make certain elections, such as the designation of non-governmental remainder beneficiaries. The trustee’s discretion to make distributions to the disabled individual is governed by the master trust agreement. First Financial Trust is the actual trustee, but ELO serves as an advisor to the trustee with the power to direct trust distributions. Nina Hamberger, who is very familiar with the eligibility requirements of the various public benefits programs, reviews all proposed distributions and maintains regular contact with all of ELO’s beneficiary clients. Upon the beneficiary’s death, trust assets are either paid to reimburse the state of New Hampshire, retained in the trust, or paid to the beneficiary’s named remaindermen, depending on whether the state’s claim exceeds the remaining assets in the beneficiary’s separate account. If the state’s claim exceeds the account value, the trust retains 45 percent of the assets and the government receives the balance. If the account value exceeds the state’s claim, the state is reimbursed in full, the trust retains 3 percent as an administrative fee, and the named remaindermen receive the balance. If the state makes no claim, the trust retains 3 percent as an administrative fee, and the named remaindermen receive the balance.
III. Drafting Considerations for Special Needs Trusts
A. Defining Trustee Discretion
For the purpose of discussing the various options for defining trustee discretion, no reference will be made to self-settled or third party trusts because the drafting principles with respect to trustee discretion are the same for all types of special needs trusts (this includes pooled trusts, although participants usually do not have control over the content of the operating instrument in the pooled trust context).
Two styles for drafting the provisions for the trustee’s discretion have emerged, both of which assume that the trustee will be disinterested. A disinterested trustee is a person other than: (i) the beneficiary, (ii) a person legally obligated to support the beneficiary, or (iii) a person who is subordinate to the beneficiary. The term disinterested is used by the author to denote a trustee who could not be compelled to make distributions to the beneficiary, and use of the term is not meant to implicate the standards of disinterestedness involved in gift and estate tax planning.
With the first style, the trustee is granted broad and unqualified discretion to determine whether trust distributions will be made. Traditional discretionary standards such as health, maintenance and support of the beneficiary are omitted to prevent the beneficiary from being able to compel trust distributions in accordance with those standards. Language expressly precluding the beneficiary from demanding distributions and limiting the beneficiary’s ability to seek court-ordered distributions may be included.
The other style calls for lengthy qualifications of the trustee’s discretion. A statement that the grantor intends the trust to be used to supplement, but not to supplant, the beneficiary’s public entitlements is included. A detailed list of the types of distributions that would be considered appropriate supplements of the public benefits is usually added as well. This list usually suggests distributions for purposes such as purchasing equipment (e.g., specially outfitted automobiles), purchasing entertainment electronics, providing other forms of recreation such as outings, club memberships, etc., paying for travel to visit friends and relatives, or to reimburse relatives and friends who travel to visit the beneficiary. Distributions directly to the beneficiary are sometimes expressly prohibited. Distributions for food, clothing and shelter are generally omitted from the list, and sometimes are expressly prohibited out of concern that such distributions would be considered income in-kind.16 See the discussion of the New Hampshire Department of Health and Human Services’ treatment of trust distributions in sub-section IV.A.1.(a) below.
In considering issues associated with the nature of the trustee’s discretion, it is important to keep in mind the distinction between potential distributions and actual distributions. The objective of drafting the trustee’s discretion is to ensure that trust principal and income will not be countable in light of the potential distributions that the trustee could make, and to minimize the impact of actual distributions. With respect to potential distributions, whether or not trust principal and income is considered non-countable for purposes of the asset limits of public benefits programs turns on whether distributions of any kind lie within the exclusive discretion of the disinterested trustee. Courts in other jurisdictions have consistently held that if the trustee can be compelled to make distributions in compliance with a standard of support expressed in the document then income or principal may be countable for public benefits purposes to the extent the trustee can be so compelled.17 The generalized statement that the grantor’s intent is to "supplement but not supplant" public benefits and the addition of other detailed lists qualifying the trustee’s discretion developed in response to these cases, and are intended as a means of preventing the trustee from being compelled to make distributions that would jeopardize public benefits. If the trustee can be compelled, then trust income and principal may be countable as an available asset even in the absence of actual distributions.
The question is whether such qualifications are needed to negate a standard of support to which the trustee can be held. Arguably, a pure grant of discretion, without any language regarding support or maintenance, and including an express prohibition against the beneficiary filing an action to compel distributions, should suffice to preclude countability from the public benefits perspective. If that is correct, then detailed qualifications add nothing to enhance the non-countability of trust income or principal, but do add substantive limits on the trustee’s discretion. If a detailed list of permissible distributions is included, the trustee may be precluded from making distributions that are not on that list, even if the trustee concludes that such distributions would be in the beneficiary’s best interests despite the interference with public entitlements. Without the detailed qualifications, and assuming a pure grant of discretion as discussed above, the trust income and principal should be non-countable as an asset and countable as income only to the extent that the trustee actually makes a distribution. The trustee can make such distributions on a case-by-case basis taking into account the anticipated impact on public benefits.
This area of the law will be subject to further development with the enactment of the Uniform Trust Code in New Hampshire. RSA 564-B:5-504 provides that a beneficiary’s creditors, presumably including government entities that have provided benefits, will not be able to compel a trustee to make distributions in accordance with a standard, with limited exceptions such as for child support obligations of the beneficiary. However, 5-504(d) provides that this limitation on a creditor’s right to compel distributions will not limit the right of a beneficiary to file a judicial action alleging abuse of discretion or failure to comply with a standard. The official comments to section 5-504 provide "Under subsection (d), the power to force a distribution due to an abuse of discretion or failure to comply with a standard belongs solely to the beneficiary. Under Section 814(a), a trustee must always exercise a discretionary power in good faith and with regard to the purposes of the trust and the interests of the beneficiaries."18 Section 8-814(a) provides, "Notwithstanding the breadth of discretion granted to a trustee in the terms of the trust, including the use of such terms as ‘absolute,’ ‘sole,’ or ‘uncontrolled,’ the trustee shall exercise a discretionary power in good faith and in accordance with the terms and purposes of the trust and the interests of the beneficiaries."19 In the case of a special needs trust, the inability of the beneficiary to compel trust distributions is, in fact, consistent with the purposes of the trust and the interests of the beneficiary. A provision in the trust instrument negating the beneficiary’s right to file a judicial action to compel distributions, or providing that such an action can be maintained only with a showing of bad faith on the part of the trustee, should be sufficient to negate any rights suggested by the provisions of section 5-504(d). Some drafters will feel more comfortable supplementing such statements with a declaration of the grantor’s intent to supplement but not supplant public benefits, but, as discussed above, consideration should be given to the substantive limits such statements impose on the trustee’s discretion.
The motive to add detailed qualifications and lists of suggested permissible distributions comes in part from the desire to give the trustee instructions regarding the beneficiary’s special support needs. One approach to educating the trustee regarding the beneficiary’s special needs without complicating the trustee’s discretion is to use a "side letter." This is a letter from the grantor addressed to the trustee in which the grantor can express all manner of special concerns that the grantor would like the trustee to consider. The letter can be easily modified from time to time without formality. Here, the grantor can request that the trustee meet with the beneficiary on a regular basis and that the trustee consult with experts in the medical and social services field. The grantor can also describe the beneficiary’s particular preferences and personal needs. If carefully drafted, this letter can guide the trustee on how best to exercise his or her discretion. Care must be used in drafting such a letter, however, since the letter could be used as evidence to interpret the grantor’s intent in a judicial context. Phrases that tend to direct the trustee to make particular types of distributions should be avoided. A reference in the trust to the fact that such a letter may exist, along with the expression that such a letter be non-binding on the trustee, will help preclude such complications.
It should be noted that one other disadvantage of omitting detailed qualifications of the trustee’s discretion is that it may be difficult to find institutional trustees willing to accept the role of trustee with so little guidance as to how the discretion should be exercised. Where an institutional trustee is desirable to bring asset management skill to the table, the trustee’s reluctance to serve can usually be solved by assigning the discretionary authority over trust distributions to a non-institutional co-trustee (see the discussion of co-trustees below). Where an institutional trustee is needed because there is no other individual available to hold the discretionary authority over distributions, adding guidance in a side letter may satisfy the trustee’s concerns.
B. Co-Trustees, Trust Protectors
In addition to side letters, a grantor’s concern regarding trustee awareness of the beneficiary’s special needs can be addressed through the selection of the trustee. Where the person with the best knowledge of the beneficiary’s needs is not suitable to serve as a sole trustee, either because that person does not meet the definition of a disinterested trustee, or because that person lacks the financial skill to manage trust assets, that person could be appointed as a co-trustee with another trustee selected to address the other concerns. Where the need is to add a disinterested co-trustee, care must be used to assign all discretionary authority over distributions to the disinterested co-trustee. Drafters should also review the provisions of section 7-703 of the Uniform Trust Code, which covers such issues as majority action and delegation of duties.20 The provisions of section 7-703 are default provisions that can be waived or superseded by the trust instrument.
Alternatively, the person with the knowledge of the beneficiary’s needs can be named as a non-fiduciary "trust protector." This might be desirable where that person is willing to be involved with the care of the beneficiary, but does not want any of the fiduciary responsibility of serving as a trustee. In these cases, the role of trust protector must be carefully defined to avoid any imputation of fiduciary status. Drafters should review section 8-808(d) of the Uniform Trust Code and specify that the trust protector may only advise the trustee and may not direct the trustee to take any particular action.21 To enhance the effectiveness of the trust protector, a common drafting feature is to require a regular in-person meeting between the trustee, the trust protector, and the beneficiary.
C. Special Trust Distributions and Trust Termination Provisions
Third party trusts that are settled by a grantor who does not have his or her own public benefits concerns, and which, therefore, do not contain any provision for reimbursement of the government, may contain provisions for distributions other than to (or for the benefit of) the disabled individual who is the primary beneficiary of the trust. The alternative distribution provisions discussed below can help build flexibility into the trust to accommodate changes in the law and changes in the primary beneficiary’s circumstances. Any combination of the alternative distribution provisions can be incorporated. With the possible exception of the provisions discussed in subsection 3 below, these types of provisions should not appear in a trust with government reimbursement provisions.
1. Multiple Beneficiaries
So long as the disinterested trustee retains all control over distributions to or for the benefit of the disabled individual who is the primary beneficiary of the trust, any number of additional beneficiaries can be named, and any combination of distribution provisions for the benefit of those other beneficiaries can be included. For example, the trustee could be given the discretion to make distributions of trust income or principal, including the whole of the principal, to a sibling of the disabled individual. The standards for distributions to beneficiaries other than the disabled individual should be as broad as possible. A particular distribution that would be disqualifying if made to the disabled individual may not be problematic if made to the sibling (although possible in-kind and deemed income conflicts would still need to be carefully evaluated, especially if the siblings reside in the same household). If maintenance of the trust for the benefit of the disabled individual becomes impractical for any reason, distribution of the remaining trust property could be made to the sibling, effectively terminating the trust.
Note that multiple beneficiaries cannot be added if a parent is transferring assets to a trust for the sole benefit of a disabled child for the purpose of avoiding asset transfer penalties from the parent’s perspective. See the discussion at II.C.2.(a) above.
2. Trustee Discretion to Terminate and Distribute Outright
Provisions may be added that empower the trustee to evaluate the practicality of the continued maintenance of the trust, and to terminate the trust and distribute the remaining trust property if continued maintenance becomes impractical. Such provisions could permit outright distribution to the disabled individual who is the primary beneficiary of the trust, which might be desirable if there is a possibility that the individual will recover from his or her disability. More commonly, such a provision would permit distribution to another individual who has a close relationship with the disabled individual, such as a sibling as discussed above. This type of clause can be used in conjunction with the addition of a trust protector, and may allow the trustee to make such a terminating distribution to the trust protector.
Where this type of clause will be included, the drafter should consider expressly waiving the provisions of section 8-817(a) of the Uniform Trust Code.22 Section 8-817(a) may imply a right of the beneficiary to object to a proposed termination, which could impede the utility of this type of clause in a special needs trust. The power to exercise the termination should either lie exclusively with the trustee or be drafted in the form of a power of appointment held by a beneficiary other than the disabled beneficiary. In the latter case, if the power will be a general power of appointment exercisable in favor of the power holder, drafters should consider the provisions of sections 5-505(a) and (b)(1) of the Uniform Trust Code, which can subject the trust assets subject to such power to the claims of the power holder’s creditors.23
3. Power to Appoint to Secondary Trust
Occasionally, the motive to terminate the trust may be that a change in program rules causes a conflict with an isolated provision in the trust. In such a case, it might be desirable to transfer the trust assets to another trust with very similar provisions, but with modifications necessary to accommodate the change in the law. The original trust can be drafted to include a power of appointment that would allow an individual other than the disabled individual to appoint trust property to the trustee of such a secondary trust. It may be desirable to include language negating the applicability of section 8-808(d) of the Uniform Trust Code to such a power holder.24
4. Exculpatory Clauses
Many special needs trusts contain language that nullifies a beneficiary’s interest or a trustee’s power if the interest or power will cause a reduction in the beneficiary’s public entitlements. Such provisions, sometimes referred to as exculpatory clauses, should be avoided. Such clauses will probably be disregarded for purposes of public benefits programs.25 For example, the trustee may be given the direction to make payments for items that include food, clothing or shelter, with a proviso that such distributions will cease if they would cause a reduction in public benefits. If the public benefits rules disregard the proviso, a difficult conflict can arise. The beneficiary may be deemed to have a countable source of income, even though the trustee may be prohibited from making the distributions because the proviso is binding on the trustee under general trust principles.
D. Special Trustee Powers
1. Power to Invest in Unproductive or Wasting Assets
The grantor may want to provide a residence for the beneficiary. Often, the beneficiary is a child of the trust grantor and lives in the grantor’s home. The grantor may want to transfer the residence to the trust so that the child will be able to continue to reside in the home after the grantor’s death. To accommodate this, the trustee should be given the power to invest in unproductive real estate to relieve the trustee of the usual fiduciary responsibilities with respect to management of trust assets. Because housing may be considered in-kind income under some programs, the decision to allow the beneficiary to live in a residence owned by the trust should be discretionary with the trustee. In that way, the trustee can evaluate whether the beneficiary’s occupying the house will cause a reduction in public entitlements, and whether such a reduction is tolerable.
The grantor may want to provide other use benefits, such as the use of tangible personal property, automobiles, etc. To accommodate such intentions, the trustee should also be given the power to invest in wasting assets.
The default "prudent investor rule" of section 9-901(b) of the Uniform Trust Code should be expressly modified to accommodate the foregoing powers.26
2. Power to Accumulate Trust Income
To help negate the beneficiary’s ability to compel trust distributions, the trustee should be given the power to accumulate trust income and to add the same to trust principal.
3. Power to Amend to Conform to Law
Given the frequency of change with respect to public benefits program rules and the fact that it may be difficult to determine at the time of drafting which programs the beneficiary may utilize, giving the Trustee the power to amend the trust may be advisable. Such a power must be carefully drafted to avoid unintended tax consequences, such as inclusion of the trust principal in the taxable estate of the trustee if the trustee dies in office. It may be important for such a power to be limited to making technical changes that do not substantially alter the scheme of beneficial interests. Alternatively, the power could be assigned to a co-trustee who is a disinterested trustee as that term is defined for gift and estate tax purposes. Also, it is important to expressly state that such a power cannot be used to omit a government reimbursement requirement.
E. Miscellaneous Uniform Trust Code Issues
1. Beneficiaries’ Entitlement to Notices and Copies of Trust Instruments
A full discussion of the new notice requirements of the Uniform Trust Code is beyond the scope of this article. However, drafters should review carefully the provisions of section 8-813 and its interplay with sections 1-105(8) and (9).27 Some of the notice and document production requirements can be waived in the trust instrument. The author does not foresee any greater or lesser need to waive notice requirements in the special needs trust context than in other trust contexts, but drafters should be particularly mindful of the notice requirements when considering adding beneficiaries other than the disabled beneficiary. Moreover, for trusts with government reimbursement requirements, government entities that have provided benefits will be considered qualified beneficiaries entitled to any required notices.28
2. Trustee’s Duty to Investigate and Know Events
Given the highly personal nature of special needs trusts, drafters may want to consider the duty of trustees to investigate the happening of events and the standard for such investigation imposed by section 10-1007 of the Uniform Trust Code.29 It may be desirable to categorize certain types of events and assign responsibility for knowledge of those events to a co-trustee appointed for that purpose. Corresponding provisions exculpating the other co-trustee(s) with respect to the duty to investigate those events should also be included.30
3. Place of Administration; Choice of Law
Where the grantor and the disabled beneficiary of a third party special needs trust do not both reside in New Hampshire, drafters should consider the place of administration, choice of law, and reciprocity provisions of the Uniform Trust Code.31
IV. Tax and Creditor Protection Issues
A. Tax Considerations
1. Income Taxation
Although a self settled trust document will be created by someone other than the disabled individual who is the beneficiary of the trust, the disabled individual usually will be considered the grantor of the trust for purposes of the income tax grantor trust rules because he or she usually will be the one to transfer assets to the trust.32 For purposes of the grantor trust rules, a person who makes a gratuitous transfer of assets to a trust is considered a grantor, whereas a person who creates a trust document but does not transfer assets to the trust is not considered a grantor, even if that latter person is ostensibly the grantor for purposes of the trust document.33 Because income of the trust will be payable to the disabled individual, his or her status as a grantor of the trust under the grantor trust rules will result in the trust income being reportable by him or her under Internal Revenue Code § 677. This could result in complications in the administration of the trust, since the beneficiary is unlikely to have resources to pay the income tax. If the trustee makes distributions to the beneficiary to provide him or her with funds to pay the taxes, those distributions could be countable income under a given public benefits program. Therefore, the trustee should pay taxes directly to the taxing authority, which should help preclude the payments from being countable income for public benefits purposes.
With regard to the latter, however, drafters should be aware of the position of the New Hampshire Department of Health and Human Services with regard to the Medicaid program. DHHS takes the position that all distributions from special needs trusts, whether made directly to the beneficiary or to a third party for the benefit of the beneficiary, constitute countable income from the beneficiary’s perspective, unless the distributions are for the medical care or education of the beneficiary, or are for expenses associated with the administration of the trust. This policy is loosely based on He-W 654.04(B)(10), which provides, "Payments of income from a trust or similar legal device or payments from the corpus of a trust or a similar legal device made to, for the benefit of, or on behalf of the individual shall be considered income to the individual." The Department’s interpretation of this regulation to permit distributions for medical care, education, or trust administration expenses is not based upon a written policy available to the public, so definitions of the terms "medical care," "education," and "trust administration expenses" are unavailable. Although litigation challenging the validity of HeW 654.04(B)(10) and the Department’s application of that regulation is likely, for the time being drafters must be concerned that payments directly to taxing authorities may be considered countable income to the beneficiary for purposes of the Medicaid program (but not the SSI program) if those payments relieve the beneficiary of a tax liability.
Where the trust is likely to generate significant income, the drafter should consider providing a person other than the disabled individual with an income interest under the trust, and vesting that additional beneficiary with discretion over income distributions to the disabled beneficiary. Trust income will not be reportable by the disabled individual under § 677 if the disabled individual’s income interest is subject to the control of such an "adverse party."34 Note, however, that such provisions permitting income distributions to a beneficiary other than the disabled beneficiary may conflict with the government reimbursement provisions of a self-settled trust. Since there is no regulatory authority covering the interrelation of this obscure income tax issue with the public benefits statutes, the author recommends having such provisions reviewed by the caseworker for the disabled beneficiary’s SSI or Medicaid file prior to funding the trust.
(b) Third party
The nominal grantor of a third party trust is likely to be the person who makes a gratuitous transfer of assets to the trust, and therefore the nominal grantor is likely also to be the grantor for purposes of the income tax grantor trust rules. However, because the grantor usually will not have an income interest in the trust, income of the trust will not be taxable to the grantor under § 677. Instead, trust income will either be reportable by the trust and taxed at the higher trust rates, or it will be carried out to the beneficiary as DNI, either of which may be undesirable. To avoid these outcomes, the grantor will need to retain one or more powers that will result in trust income being reportable to the grantor despite the lack of an income interest. These potential powers include the power to revoke the trust (I.R.C. § 676), certain powers to control beneficial enjoyment of the trust property (I.R.C. § 674), and certain administrative powers, such as the powers to borrow without adequate interest or to substitute trust assets (I.R.C. § 675).
Consideration should be given to I.R.C. § 642(b)(2)(C), which permits a "qualified disability trust" to claim an exemption equal to the exemption allowed for individual taxpayers (which is much higher than the exemption ordinarily allowed to be claimed by trusts). For trusts generating modest amounts of income, relying on this exemption rather than grantor trust status may be more advantageous than having trust income taxed to the grantor. Grantor trust status will negate the availability of the special exemption under I.R.C. § 642(b)(2)(C).
Whether trust income is taxed to the trust or carried out to the separate beneficiaries will be determined by the pooled trust sponsor.
2. Gift Tax
In most cases, the disabled beneficiary of the self-settled trust will make a completed gift upon transferring his or her assets to the trust because he or she will have parted with dominion and control over the property transferred. The fact that the disabled beneficiary will have beneficial interests in the trust is not sufficient to negate a completed gift. If the disabled beneficiary has no power to demand or compel trust distributions, the IRS is likely to conclude that a completed gift has been made unless the beneficial interests are coupled with a power to change the disposition of the trust property.35 For example, the beneficiary might be granted a testamentary power of appointment. However, care must be taken in drafting such testamentary powers to preclude exercise in such a way as to defeat government reimbursement provisions required by 1396p(d)(4). In addition, the disabled beneficiary will be deemed to have retained such a power to change disposition if his or her creditors can reach the trust assets.36 Whether a completed gift has occurred will require careful case-by-case analysis. In most cases, the amount transferred to a self-settled trust will be well below the federal gift tax exemption of $1 million, so a completed gift will simply trigger the need to file a gift tax return for reporting purposes. However, in those cases where a large personal injury settlement or other fund exceeding the gift tax exemption will be transferred, special care in drafting will be required to avoid a completed gift, since an out-of-pocket gift tax would be due if a completed gift of that size would result.
In most cases, the disabled beneficiary’s eligibility to receive discretionary trust distributions will be sufficient to cause inclusion of the trust property in the disabled individual’s taxable estate under I.R.C. § 2036.37 This will likely be true even in those cases in which a taxable gift does occur upon funding the trust. In most cases, the size of the trust will not cause the disabled individual to have a taxable estate for federal estate tax purposes, but in those cases where an estate tax will be due, that tax will have priority over any claim for government reimbursement.
(b) Third party
In the case of a third party trust, whether a taxable gift has been made when the grantor funds the trust will depend on a variety of factors, including whether or not the trust is revocable or irrevocable, and whether the grantor has retained any use or enjoyment or power to control future distribution of trust property. Many of the powers that might be retained to trigger grantor trust status for income tax purposes, especially those under I.R.C. § 674, will be sufficient to preclude a completed gift.38 A careful balancing of the grantor’s gift and estate tax concerns with the income tax concerns is required. Note that the disabled beneficiary will not be given any withdrawal rights that would comply with the requirements of the Crummey case, and, therefore, no annual exclusion will be available to offset such gifts unless the trust has other beneficiaries who hold such withdrawal rights.39 This will also be the case with transfers to self-settled trusts that are completed gifts.
Because the question of a completed gift is very fact specific, the issue will vary significantly depending on the terms of the master agreement for a given pooled trust. The advice of the pooled trust sponsor should be sought with regard to gift tax reporting associated with the establishment of a pooled trust account.
3. Integration With Other Estate Planning (Third Party Trusts Only)
(a) Credit Shelter Gift to Special Needs Trust on First Spouse’s Death
For husbands and wives with estates large enough to be subject to estate tax, assets will usually be held in revocable trusts providing that the first deceased spouse’s estate will be divided into a non-marital gift roughly equal to the federal estate tax exemption and a marital gift eligible for the federal estate tax marital deduction. The non-marital gift will usually be directed to a credit shelter trust benefiting the surviving spouse and other family members in a form that will avoid inclusion in the surviving spouse’s taxable estate. Parents of a disabled beneficiary may not wantto wait until the death of the surviving spouse to fund the special needs trust. In those cases, part or all of the non-marital gift can be diverted to the special needs trust, because the special needs trust will not be includible in the estate of the surviving spouse. If the surviving spouse may need support from the non-marital gift, he or she can be added as an additional beneficiary of the special needs trust. If the surviving spouse will be a trustee of the special needs trust, care should be used to assign to another co-trustee the discretion to make distributions to the spouse, or to add an ascertainable standard applicable to distributions to the surviving spouse.
(b) Use of Special Needs Trust as Generation Skipping Tax Tax-Exempt Trust
Because the special needs trust will likely hold trust assets for the lifetime of the disabled beneficiary, it is also an excellent vehicle for generation-skipping transfer tax ("GST tax") planning. Usually, the disabled beneficiary of a third party trust will not be granted powers that would cause the trust property to be included in his or her federally taxable estate upon his or her death. Therefore, allocation of part of the third party grantor’s GST tax exemption to the trust can leverage the exemption and reduce or eliminate transfer taxes upon trust termination. Trusts to which GST tax exemption will be allocated should contain provisions allowing the trustee to hold GST-exempt assets separately from GST non-exempt assets.
(c) Use of Special Needs Trust as Irrevocable Life Insurance Trust
For the reasons discussed in subsections 1 and 2 above, the special needs trust is also a good vehicle to hold a life insurance policy, because the special needs trust can function much like a traditional irrevocable life insurance trust ("ILIT"). However, note again that the trust will not grant the disabled beneficiary Crummey withdrawal powers. Where the special needs trust will be used to function as an ILIT, it will be necessary to consider adding beneficiaries who hold Crummey withdrawal powers to allow annual exclusions to be available to offset gifts to the trust.
B. Special Statutory Protections
1. Protection from Creditors
Under the Uniform Trust Code, a spendthrift clause will not protect the assets of a non-special needs self-settled trust from the claims of the grantor’s creditors.40 However, section 5-505(a)(2) of the Uniform Trust Code creates an exception for special needs trusts created under 42 U.S.C. 1396p(d)(4).41 Therefore, the assets of a self-settled special needs trust will be protected from the claims of creditors of the disabled beneficiary. The provisions of RSA 564-B:5-505(a)(2) may protect such trusts even without a spendthrift clause, but the inclusion of a spendthrift clause is the better practice because other states’ laws may apply to the trust if the trustee changes the place of administration. The traditional spendthrift clause of a third party special needs trust will also be recognized, but drafters should review carefully the new requirements for spendthrift clause language under the Uniform Trust Code.42
2. Trusts by Guardians of Minors Beyond Age 25
Under RSA 463:19(II), a guardian of a minor may, with court authorization, create a trust for the benefit of the minor that will terminate at a date after the termination of the guardianship. Such trusts must terminate no later than the minor’s 25th birthday, except special needs trusts referred to in RSA 564-B:5-505 (i.e., 42 U.S.C. 1396p(d)(4) trusts), which may continue beyond that date.
The single most important feature that distinguishes a special needs trust from any other type of trust is the nature of the trustee’s discretion with respect to trust distributions. Drafters need to pay careful attention to the provisions of section 5-504(d) of the Uniform Trust Code, and should draft the trustee’s discretion so as to limit as much as possible a beneficiary’s ability to compel a trustee to make any distributions. Because this area of the law will be subject to further developments, a practitioner should include a power to appoint the trust property to a beneficiary other than the disabled beneficiary or to a secondary trust created for the benefit of the disabled beneficiary with provisions consistent with changes in the law. A trustee’s power to make technical amendments to the trust is also advisable. Statements concerning the grantor’s intent to supplement public benefits may help preclude a beneficiary from compelling distributions that would interfere with public benefits, but should be included only after careful consideration of the substantive limits they may impose on the trustee’s discretion. Alternatives, such as language directly negating the beneficiary’s right to compel distributions through judicial action in the absence of a showing of bad faith on the part of the trustee may be preferable.
- RSA 564-B.
- No specific statutory provisions exempt the funding of self-settled special needs trusts from asset transfer penalties. Rather, the ability to fund such trusts is implied in the statutes permitting the principal of such trusts to be held as non-countable assets.
- 42 U.S.C. 1396p(d)(4)(A) and (C) and 42 U.S.C. 1382b(e)(5). New Hampshire Department of Health and Human Services, Division of Family Assistance, Adult Assistance Manual ("AAM") at 411; Social Security Administration Program Operations Manual System (POMS) at SI 01120.203. The AAM can be found on line at http://www.dhhs.state.nh.us/DHHS/DFA/LIBRARY/Manual/ProgramPolicy.htm. The POMS can be found on line at http://policy.ssa.gov./poms.nsf/aboutpoms.
- 42 U.S.C. 1396p(d)(4)(A) and 42 U.S.C. 1382b(e)(5); AAM at 411; POMS at SI 01120.203.
- 42 U.S.C. 1396p(d)(4)(C) and 42 U.S.C. 1382b(e)(5); AAM at 411; POMS at SI 01120.203.
- 42 U.S.C. 1396p(c)(2)(B)(iii); AAM at 415.15.
- Department of Health and Human Services, Health Care Finance Administration (now Centers for Medicare and Medicaid Services), State Medicaid Manual, Transmittal No. 64 (November 1994) (more commonly referred to as HCFA Transmittal No. 64) at 3257(B)(6).
- 42 U.S.C. 1396p(d)(4)(A).
- 42 U.S.C. 1396p(d)(4)(A) and 42 U.S.C. 1382b(e)(5); HCFA Transmittal No. 64, at 3259.7(A); AAM at 411; POMS at SI 01120.203.
- HCFA Transmittal No. 64, at 3259.7(A); AAM at 411; POMS at SI 01120.203.
- RSA 564-B:6-602(a).
- See RSA 167:14-a.
- 122 U.S. 708 (2002) (denying on ERISA grounds a private insurer’s proposed lien).
- 42 U.S.C. 1396p(d)(4)(C).
- See e.g. POMS at SI 01120.201.I.1 with respect to in-kind income under the SSI program. An excellent discussion of the treatment of trust distributions in the SSI context can be found in David J. Lillesand and Gina M. Nguyen, SSI Trust and Transfer Rules, 17 NAELA Q. 3-18 (Spring, 2004).
- See e.g., Torgerson v. Barkema (In re Trust of Barkema), No. 138/03-1836, 2004 Iowa Sup. LEXIS 316 (Iowa, 2004); Corcoran v. Dep’t. of Soc. Servs., 271 Conn. 679, 859 A.2d 533 (Conn., 2004); Commonwealth Bank v. Dept. of Public Welfare, 598 A.2d 1279 (Pa. 1991); Bohac v. Graham, 424 N.W. 2d 144 (N.D. 1988); Bureau of Support v. Kreitzer, 243 N.E.2d 83 (Ohio, 1968).
- The comments can be viewed on line at www.nccusl.org.
- RSA 564-B:8-814(a).
- RSA 564-B:7-703.
- RSA 564-B:8-808(d).
- RSA 564-B:8-817(a).
- RSA 564-B:5-505.
- RSA 564-B:8-808(d).
- See e.g. HCFA Transmittal No. 64 at 3259.5.
- RSA 564-B:9-901(b).
- RSA 564-B:8-813; RSA 564-B:1-105(8)-(9).
- See RSA 564-B:1-103(12).
- RSA 564-B:10-1007.
- See RSA 564-B:10-1008.
- RSA 564-B:1-107; RSA 564-B:1-108; RSA 564-B:4-403.
- Treas. Reg. § 1.671-2(e)(1). Rev. Rul. 83-25.
- Treas. Reg. § 1.671-2(e)(1).
- I.R.C. § 677(a).
- Treas. Reg. § 25.2511-2(b).
- See e.g., PLR 9837007 (completed gift found where the trust spendthrift language and state law combined to insulate trust assets from the claims of the grantor’s creditors). See the discussion below regarding creditor protection for self-settled trusts under the Uniform Trust Code. See also Rev. Rul. 54-342 and PLR 9644053 for examples of other retained rights that will negate completed gifts.
- See PLR 200240018.
- Treas. Reg. 25.2511-2(b).
- Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).
- RSA 564-B:5-505(a)(2).
- RSA 564-B:5-505(a)(2).
- See RSA 564-B:5-502.
AuthorAttorney Jan P. Myskowski is a member of the Estate Planning and Probate Group at Wiggin & Nourie, P.A. in Manchester. He is a member of the Board of Directors of the New Hampshire Estate Planning Council, the National Academy of Elder Law Attorneys, and of the estate planning and probate law sections of the American and New Hampshire Bar Associations.