IRAs Left to Special Needs Trusts
IRS Private Letter Ruling Allows Disabled Beneficiary to Re-designate an IRA to a Special Needs Trust, Tax Free
THE RULING
The IRS, in Private Letter Ruling 200620025, said that a disabled beneficiary of a parent's IRA could essentially re-designate and stretch the IRA, naming as beneficiary a newly-created special needs trust of which he was the sole beneficiary. In this instance, the trust was a self-settled trust with "payback" provisions The IRS said that (a) the transfer of the IRA to the trust was not taxable because the SNT was a self-settled "grantor" trust; and (b) the trust beneficiary's life would be the measuring life for minimum required distributions from the IRA.
The PLR involved a special needs trust created after the death of the IRA holder, as a way for the disabled beneficiary to remain qualified for Medicaid and other public benefits programs.
The question remains as to what degree practitioners are using the PLR as a basis for other estate planning designations, for instance by instructing clients to name a third party special needs trust as IRA beneficiary during life their lifetimes; such trusts are permanently exempt as resources for public benefits programs.
Natalie Choate, in her new edition of "Life and Death Planning for Retirement Benefits" has noted that the IRS has also ruled that annuity payments from a charitable remainder trust to a trust for the benefit of a disabled beneficiary can be treated as payment "to" that individual, if various requirements are met (both as to the disability and as to the form of trust). See Rev. Rul. 2002-20, 2002-1 I.R.B. 794.
Choate explains, under most forms of supplemental or special needs trusts (designed to benefit a disabled beneficiary without causing loss of the beneficiary's eligibility for need-based government benefit programs), the trustee has discretion regarding whether to distribute trust funds to or for the benefit of the disabled individual, but is prohibited from distributing funds for needs that are provided by the government programs such as support and health care. Such a trust would be considered an accumulation trust for minimum requirement distribution purposes, but would still qualify as a see-through trust if the trust principal passes outright at the disabled beneficiary's death to other now-living individuals, such as the disabled beneficiary's siblings. A charity cannot be named a remainder beneficiary and the chosen remainder beneficiaries should be individuals as close in age or younger than the disabled beneficiary.
TAX RULES APPLICABLE TO TRUSTS
Grantor trusts. One of the primary techniques used to qualify the poor, disabled, and elderly for federal poverty and disability programs is the use of trusts. The treatment of disability trusts for income, gift, and estate tax purposes can be very different.
Under IRC Sections 674(a) and 675, the grantor is treated as the owner of the portion of a trust "of which the beneficial enjoyment of the corpus or income therefrom is subject to a power of disposition, exercisable by the grantor or a non-adverse party, or both, without the approval or consent of an adverse party." Two basic issues raised under Section 674(a)are the scope of the power and the identity of the powerholder. A broad power to control beneficial enjoyment may not cause the grantor to be taxed on the trust income if the power to control enjoyment is assigned to another person.
The grantor's retained control of an irrevocable inter vivos trust will cause the trust to be included in the grantor's estate for estate tax purposes, based on Section 2036(a)(2) (relating to the right to designate the persons who will possess or enjoy the trust property or its income), or Section 2038 (relating to a power to alter, amend, revoke, or terminate the trust). These Code sections are the estate tax equivalent of Sections 674 and 675, which are income tax provisions. However, Sections 674 and 675 distinguish between direct and indirect powers over beneficial enjoyment, while the estate tax sections encompass the entire field of retained control over the beneficial enjoyment of trust assets.
The estate tax statutory provisions (i.e., Sections 2036 and 2038) do not contain the preciseness of the comparable income tax rules (i.e., Sections 674 and 675), and have had wide interpretation. For instance, trusts have been included in the gross estate of a decedent who retained the power to control the time and manner of enjoyment by a specified beneficiary.
The gift tax provisions, particularly Section 2511(a) and its definition of transfers, are completely silent about when a transfer is deemed complete for gift tax purposes.
A grantor of an irrevocable inter vivos trust, on the one hand, might accept the need, for tax reasons, to reduce or eliminate a personal benefit of the grantor from the trust assets. On the other hand, the grantor may be more reluctant to terminate all control over beneficial enjoyment. For estate tax purposes, Section 2038 will include in the donor's gross estate any transferred assets over which the donor retains until his death any power to alter, amend, revoke, or terminate the enjoyment of such property.
Under normal circumstances, the income tax rates applicable to trusts are higher than individual income tax rates. Therefore, it is preferable for a trust to be taxed as a grantor trust. This also means that self-funded disability trusts are treated as grantor trusts for income tax purposes so long as the trustee has the discretion to distribute income and principal without the intervention or consent of an adverse party. "Adverse party" is defined in Section 672(a) and includes only those who have a future or present interest in the trust.
A self-funded disability trust is included in the grantor's estate under Sections 2036 and 2038. A testamentary power of appointment could also create grantor trust status under Reg. 1.674(b)-1(b)(3).
The only types of self-funded disability trusts clearly delineated in the federal law are so-called D4A trusts. In order for a grantor to continue or be eligible for SSI and/or Medicaid benefits, the trust must clearly follow the provisions of 42 U.S.C. § 1396p(d)(4)(A). D4A trusts are typically created after medical malpractice or personal injury settlements have been awarded. The trusts are established for individuals who are already receiving or who may become eligible for SSI and/or Medicaid benefits. The public policy objective is to permit a person to qualify for or maintain government benefits, while at the same time allowing trust funds to be used to supplement but not replace public benefit programs. Supplemental benefits might include educational programs, vacations, transportation, telephone charges, cable television, and personal gift items—in other words, anything except basic food, clothing, or shelter which can enhance a person's quality of life.
D4A trusts cannot be created by the grantor himself, even though they are treated as grantor trusts under the Tax Code. Such trusts can be created by court order after a personal injury or medical malpractice settlement, or by parents or guardians who fund the trust with resources of the beneficiary—for instance, a large inheritance that was given outright to a disabled beneficiary without any consideration of the bequest's impact on public benefits received by the beneficiary. Some practitioners believe that limited cash distributions can be made for pocket money, but this should be avoided, if possible.
Two key features of D4A trusts include (1) a provision to pay the beneficiary's taxes directly to the government and (2) a payback provision at the beneficiary's death, which allows the state to reach the trust assets in order to recoup payment for services provided during the beneficiary's life. Because of this latter requirement, it is important to consider the beneficiary's life expectancy when making distributions from the trust in order to provide as little payback (if any) as possible.
Example
An SSI beneficiary, who is also receiving Medicaid health benefits, is involved in a car accident. To protect the SSI and Medicaid benefits, a civil suit must be initiated and the settlement agreement must include a provision that the net proceeds will be held in a D4A trust. In the case of a settlement where no suit has been filed, the plaintiff's attorney must coordinate a post-settlement suit and settlement agreement with a copy of the trust. In some jurisdictions, the court will allow the filing of the suit, a hearing on the complaint, and approval of the settlement within the same day.
A third-party trust for another where the grantor is not the beneficiary and where the trust corpus is not property owned by the beneficiary upon transfer has similar tax consequences. This form of trust can take advantage of the grantor trust rules in order to use the $250,000 principal residence exclusion ($500,000 for a couple) and thereby eliminate any capital gains tax on the sale of a home.
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