Taxation of Special Needs Trusts Robert B. Fleming Fleming & Curti, PLC Tucson, Arizona www.elder-law.com

Taxation of Special Needs Trusts Five kinds of trusts: Self-settled (“d4A”) trusts Third-party trusts “Sole benefit” trusts Pooled trusts “Miller” trusts Three kinds of taxation: Income Gift Estate

Income Taxation Issues Taxation of trusts Separate taxpayer / EIN Compressed tax rates Deductions available to trusts Grantor Trust rules Internal Revenue Code (IRC) §§671-679 Logic of grantor trust rules Effect of grantor trust treatment You say “income,” I say “income” and she says “income”

Non-Grantor Trusts Who is the Grantor? Further distinction: “Simple” trusts “Complex” trusts Qualified Disability Trusts IRC §642 (“Victims of Terrorism Act of 2001”) Trust receives exemption (of $3400 in 2008) For “kiddie tax” trust, AMT may be avoided

Let’s Apply Those Principles: Self-Settled SNTs (almost) Always a grantor trust  (therefore): Separate EIN not required Separate return not permissible Extra trust-specific deductions not available Query: Can a self-settled SNT ever be a non-grantor trust? A Qualified Disability Trust?

IRC §673. Reversionary interests (a) General rule: “The grantor shall be treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of that portion of the trust, the value of such interest exceeds 5 percent of the value of such portion (c) Special rule: “For purposes of subsection (a), the value of the grantor’s reversionary interest shall be determined by assuming the maximum exercise of discretion in favor of the grantor.”

Belt / Suspenders Approach to Self-Settled (Grantor) Trusts Drafter might include (pick one): Power of appointment (§674(a)), but what about: Doctrine of Worthier Title? State as beneficiary / creditor / supercreditor? Capacity of beneficiary to exercise power? Power to “reacquire the trust corpus by substituting other property of an equivalent value” (§675(4)(C)) Selection of a “non-adverse” trustee (§677(a))

Let’s Apply These Principles (II): Third-Party SNTs Is the SNT still a grantor trust? Do we wish it was a grantor trust? If not a grantor trust, is it Simple, or Complex? Might it be a Qualified Disability Trust?

Qualified Disability Trusts (§642(b)(C)(ii)) … “ ‘qualified disability trust’ means any trust if – (I) such trust is a disability trust described in” 42 USC §1396p(c)(2)(B)(iv) That section, in turn, provides that “[a]n individual shall not be ineligible for medical assistance by reason of paragraph (1) to the extent that … (B) the assets – … (iv) were transferred to a trust (including a trust described in subsection (d)(4) of this section) established solely for the benefit of an individual under 65 years of age who is disabled….” Yes, that (d)(4) mention does reference (d)(4)(A), (d)(4)(B) and (d)(4)(C) trusts.

Let’s Apply These Principles (III): Sole Benefit, Pooled and Miller Trusts Sole Benefit trust: Is it a grantor trust? Probably not If not, is it a Qualified Disability Trust? Likely Pooled trust: Is it a grantor trust to the extent of the grantor’s interest? Can a pooled trust be partly Qualified Disability Trust and partly not? Miller trust – this one is easy, isn’t it?

Executive Summary Most of the Time: Self-settled SNTs are Grantor trusts Third-party SNTs are complex trusts (occasionally Grantor trusts to the Grantor) Sole benefit trusts are complex trusts (occasionally Grantor trusts to the Grantor) Pooled trusts are complex trusts (possibly Grantor trusts to the donor/beneficiary) Miller trusts are Grantor trusts

Gift Taxation Issues Gifts must be completed Annual gift tax exclusion (currently $12,000) applies to gifts not in trust Crummey (397 F.2d 82, 9th Circ. 1968) powers and special needs trusts generally Enter Cristofani (97 T.C. 74, 1991). Kohlsaat (T.C. Memo 1997-212), anyone? Is this simply too esoteric?

Too Esoteric (I): Application to Self-Settled SNTs Probably of no moment. Transfers to the trust might be completed, but retained interests probably exclude treatment as gift… …and that’s good, because there would be no annual exclusion available

Too Esoteric (II): Miller & Pooled Trusts Miller trusts should not have any gift tax issues, since only income can be assigned and the share of cost calculation continues to apply Pooled trusts should be subject to analysis comparable to self-settled ((d)(4)(A)) trusts

Too Esoteric (III): Third-Party and Sole Benefit SNTs Gifts from donors under the estate tax exemption equivalent amount ($2,000,000 in 2008) and/or the lifetime gift tax exemption amount ($1,000,000) may not need to consider the gift tax effect Gifts from wealthier donors should probably implement Cristofani, rather than Crummey, powers of withdrawal

Estate Tax Issues Estate tax exemption equivalent amount: $2,000,000 in 2008 $3,500,000 in 2009 Estate tax repealed in 2010 $1,000,000 in 2011 Assets subject to estate tax (whether tax imposed or not) receive stepped-up basis on death of taxpayer – often a significant income tax benefit to recipients

Application of Estate Tax Issues: Blessed Simplicity Self-Settled SNTs: Probably completely includible. Commutation provision for structured settlements? Third-Party SNTs: May be includible in grantor’s estate, but not in beneficiary’s Miller trusts: Shouldn’t be anything left Pooled trusts: beneficiary is a combination of the State and a non-profit (not always a charity). Shouldn’t be an issue Sole Benefit trusts: Hard to imagine transfer of a taxable estate to secure eligibility for the donor, but it could happen….