Notes

Outline

Taxation of Special Needs Trusts Nancy Voils, CPA Stephen W. Dale JD LL.M

Third Party & Self Settled Special Needs Trusts Determination For taxation purposes, the tax professional must determine whether the trust is a self 3rd party trust or a self settled trust

Third Party & Self Settled Special Needs Trusts

Example of 3rd Party Trust Kathy’s Story Example Kathy has multiple disabilities and requires round the clock attendant care paid partially by IHSS, and supplemented by her parents with occasional assistance from her grandparents.

Kathy’s Story

Kathy’s Story Kathy’s parents home is placed in the living trust, and the living trust is made the owner or beneficiary of all of her parents assets.

Kathy’s Story Kathy’s parents home is placed in the living trust, and the living trust is made the owner or beneficiary of all of her parents assets.

Compliance Issues of 3rd Party SNTs Where a trust is created by a third party for the benefit of someone other than the grantor the trust will be a separate taxpayer. The trust will have its own taxpayer identification number require annual state and federal fiduciary income tax returns. To the extent that distributions have been made to the beneficiary, the trust will carry out income to the beneficiary and a K-1 given to the beneficiary. The K-1 will report that income has been paid to the beneficiary and will include the beneficiary's social security number.

Simple vs. Complex Trusts Non grantor trusts are categorized as either “simple” or “complex” trusts. A “simple” trust for federal tax purposes requires distribution of all income to or for the benefit of the beneficiary. A “complex” trust permits accumulation of income. A third-party SNT will almost always be treated as a “complex” trust for income tax purposes, and result in significant income tax liabilities for any undistributed income.

Kathy’s Story Home $500,000 Investments $500,000 Investment income 40,000 Trustee and Professional Fees $6,000 Real Estate Taxes $5,000 Medical Expenses $5,000

Kathy’s Tax Return Investments $500,000 Investment income 40,000 Trustee and Professional Fees $6,000 Real Estate Taxes $5,000 Medical Expenses $5,000

Kathy’s Tax Return Investments $500,000 Investment income 40,000 Trustee and Professional Fees $6,000 Real Estate Taxes $5,000 Medical Expenses $5,000

Kathy’s Tax Return Investments $500,000 Investment income 40,000 Trustee and Professional Fees $6,000 Real Estate Taxes $5,000 Medical Expenses $5,000

Example of Self Settled Trust Kens’s Story Example Ken was the victim of an automobile accident that left him with multiple disabilities and he requires round the clock attendant care for the remainder of his life.

Example of Self Settled Trust Kens’s Story The amount of the settlement came to $1,000,000, but Ken will be unable to secure private medical insurance until the award is completely spent down.

Ken’s Story

Self Settled SNT Trusts created by the beneficiaries for themselves, are usually grantor trusts for income tax purposes. This is most  often the case where the trust is holding proceeds from litigation stemming from injuries to the beneficiary. The income generated by a grantor trust is taxed to the grantor. All income generated by a grantor trust whether distributed to the grantor or not, will be reported on the grantor’s income tax return.

Self Settled SNT While this may sound like a disadvantage, it is actually a significant advantage: maximum income tax rates for trusts are reached at very low income levels, and the practical result of undistributed income in a non-grantor trust is a potential increase in income tax liability.

Income generated by a Self Settled Trust After settlement and payment of the proceeds into an Self Settled SNT, any income (interest, dividends, etc.) generated by the funds, including income arising from structured payments once they are paid out to the trust, will be subject to income tax. Under the grantor trust rules, assets held in the trust are deemed to be received by the beneficiary. Consequently, such income is taxed at the beneficiary’s rates.

Grantor Trusts The IRS maintains that Code §2036 covers a trust containing a litigation settlement. A litigation funded SNT is also likely to be considered a grantor trust for federal income tax purposes. A grantor trust's income, deductions, credits, etc. are includible by or allowable to the grantor in calculating his/her individual income tax.

Ken’s Tax Return 1041 Home $500,000 Investments $500,000 Investment income 40,000 Trustee and Professional Fees $6,000 Real Estate Taxes $5,000 Medical Expenses $5,000

Ken’s Tax Return Grantor Letter Home $500,000 Investments $500,000 Investment income 40,000 Trustee and Professional Fees $6,000 Real Estate Taxes $5,000 Medical Expenses $5,000

Ken’s Tax Return 1040 Home $500,000 Investments $500,000 Investment income 40,000 Trustee and Professional Fees $6,000 Real Estate Taxes $5,000 Medical Expenses $5,000

Ken’s Tax Return 1040 Home $500,000 Investments $500,000 Investment income 40,000 Trustee and Professional Fees $6,000 Real Estate Taxes $5,000 Medical Expenses $5,000

Conclusion - Taxation of Trusts Generally, it is preferable for the income; i.e., interest and dividends that the trust assets generate, to be reportable by the disabled individual instead of by the trust itself due to the lower tax brackets applicable to individual taxpayers.

Taxation of Trusts Similarly, there is a “compressed” tax brackets for irrevocable trusts compared with assets being held outright. The trust tax brackets quickly reach a 38.6% level on income retained by the trust in excess of $9,350. The trustee should plan around this occurrence. If the disabled person is not going to receive all of the net income of the trust every year at the trustees discretion and the trust is not a grantor trust for income tax purposes, then it would seem wise to plan the investments accordingly.

Taxation of Trusts For the trust income to be considered taxable to the disabled individual at a lower tax rate, the trust must be considered a grantor trust for income tax purposes. IRC §§671-677.

Grantor Trusts The grantor trust rules of the Internal Revenue Code are found at Sections 671-678. A grantor trust is a trust under which the grantor has retained some level of interest or control in the trust, causing the individual to be considered the owner of the trust property. For income tax purposes, the grantor of a trust can be the individual who furnishes the trust funds, not necessarily the individual named as grantor in the trust agreement.

Grantor Trusts Code Section 677 (a) provides that the grantor, shall in general be treated as the owner of any portion of a trust, if the income, without the approval or consent of any adverse party is, or in the discretion of the grantor or non-adverse party, or both, may be distributed to the grantor or the grantor's spouse or held or accumulated for future distributions to the grantor or grantor's spouses.

Grantor Trusts OTHER POTENTIAL GRANTOR TRUST PROVISIONS Generally self settled trusts will contain one or more provisions which will cause them to be treated as grantor trusts under these provisions. The most common provisions contained in special needs trusts that cause them to be considered grantor trusts are: Retention of a special power of appointment to direct to whom any accumulated income left in the trust shall be distributed (see IRC §674); The power to reacquire trust corpus by substituting property of equal value (IRC §675(4))

Income Reporting Requirements IRS Grantor Benefits Programs

Reporting of income Differences between Taxable Income and Benefits Income Concerns about income tax reporting of “income” causing problems with public benefits reporting requirements should not be a serious deterrent to seeking to secure grantor trust treatment, since public benefits program administrators are usually aware of the difference between definitions of “income” for income tax purposes on the one hand and program eligibility on the other.

Income Reporting Requirements to the Grantor The trustee must also furnish the grantor a copy of the grantor letter. This information will be necessary to complete his or her return; and provide an additional notice to the grantor that he or she must include all income, deductions and credits on his or her personal return.

Income Reporting for Benefits Purposes Benefits recipients, or their representative payees have an obligation to report the existence of trusts and any benefits income to the benefit recipient. Public benefits programs cross check the social security numbers of recipients with the IRS. Beneficiaries in receipt of taxable income will be revealed this cross check. If the trustee is the representative payee for the beneficiary, the trustee has a duty to report any distribution that meet the definition of income under that specific program.

Income Reporting for Benefits Purposes If the trustee is not the representative payee, then the trustee should retain evidence of all distributions to enable the beneficiary to prove that the taxable income reported by the trust to the beneficiary was not “income” under the program's definition of income.

Taxation of litigation recoveries Generally, a personal injury settlement or verdict is not subject to income tax. Such exclusion applies whether the recovery is paid in a lump sum or in periodic payments. IRC section 104(a)(2). The punitive and interest portion of damages, and any recovery for nonphysical injury or sickness, however, will likely be subject to income tax. Periodic payments made to a “grantor trust” are income tax free under IRC §104(a)(2).

Structured Settlement Annuities Many personal injury cases, medical malpractice cases and workers’ compensation cases, are settled using a structured settlement annuity. An annuity is a contract issued by a licensed insurance company providing for a stream of payments to the plaintiff. The payments are usually made monthly and continue for the life of the plaintiff. Payments can continue to an alternate beneficiary, if the plaintiff dies prematurely.

Structured Settlement Annuities These annuities must be bought and paid for directly by the defendant, in order to retain their income tax-free character. Actual receipts of the funds and subsequent purchase of an annuity by the plaintiff, or constructive receipt of funds, can compromise the income tax-free nature of the structure payments.

Structured Settlement Annuities The commuted value of any guaranteed payments remaining in a structure on the death of the annuitant is an item subject to estate tax. To calculate the estate tax, the IRS suggests including the present value of the future guaranteed payments. The present value is calculated by discounting the face value of the payments by an interest rate that is 120% of the federal mid-term interest rate then in effect.

Structured Settlement Annuities The trustee must make sure that the estate has sufficient liquidity at all times to cover the estate tax due on the commuted value of the annuity.

Medical expenses in excess of  7.5 percent of AGI Medical expenses are deductible during the taxable year for the medical care of the taxpayer, the taxpayer’s spouse and dependents, to the extent that the expenses exceed 7.5 percent of adjusted gross income (AGI). These expenses include amounts paid for dental treatment, drugs and medicines, nursing and attendant care, and certain transportation and travel required for medical care.

Example 8 (See 3 Step Article) Alice is the beneficiary of ABC Special Needs Trust and her only income for the year is $40,000 from the distribution made directly to medical providers that were essential to her medical care, and were it not for medical  reasons, the expenditures would not have been incurred.

Example 8 (See 3 Step Article) Alice has an AGI of $40,000.  $3,000 (7.5% X $40,000) of the qualifying medical expenses is not deductible because of the 7.5 percent floor. The remaining $37,000 is deductible ($40,000 minus $3,000) as the amount of qualifying expenses exceeding the 7.5 percent floor of $3,000. Alice’s taxable income is $3,000.

Examples of deducible expenses include An automobile adapted with special equipment to permit a handicapped person to enter and operate the car; A wheelchair, either manually operated or self-propelled (including cost of operation and maintenance); Hearing aids and component parts; Phone equipment for a deaf person (including repairs); Prosthetic devices;

Examples of deducible expenses include Excess cost of an automobile specifically designed to accommodate wheelchair passengers; Prescribed drugs or insulin; Premiums paid for coverage for hospitalization, surgical fees, and other medical expenses, as well as premiums paid for supplementary health insurance for the aged and voluntary payments to obtain Medicare benefits; Wages, meals, and lodging allocable to the nursing services paid to a nurse for the care of a person who has an illness;

Examples of deducible expenses include The costs of a sanitarium, rest home, nursing home, or any other name are medical care expenses if an individual is in the institution primarily because the individual’s condition requires the availability of medical care. Tuition at a special school recommended by a doctor for a child with severe learning disabilities caused by a neurological disorder where the school has a program to educate such children.

Examples of deducible expenses include A capital expenditure to the beneficiary’s residence if it is medically prescribed, used primarily for the alleviation of a physical defect or illness, and does not have the net effect of a permanent improvement or betterment of the taxpayer's property.

What is not deductible? An expenditure that is merely beneficial to the general health of an individual is not a deductible expenditure for medical care. Must establish that the expense would not otherwise have been incurred for non-medical reasons. Generally, vacation expenses are not deductible as medical expenses. Life insurance, maternity clothing, and auto insurance are not deductible.