A special needs trust can be a crucial tool to protect the financial well-being of a disabled person. However, when considering the creation of a special needs trust, recent changes in the law are significantly impacting special needs trusts. Worryingly, gaps in the relevant new law leave many questions unanswered. This means that families should be carefully crafting special needs trusts, reviewing existing special needs trusts, and preparing for any legal changes yet to come. Let's discuss some issues families should be aware of.
The Basic Idea of the Special Needs Trust:
As a starting point, let's review the basics of the special needs trust to better understand the progression of special needs trusts over time.
The purpose of a special needs trust has remained the same: a way to set aside assets to provide lifelong financial support for a named beneficiary with special needs (whether due to physical or mental disabilities) or chronically ill and not disrupt means-tested governmental benefits.
Importantly, while the person with special needs is the trust's beneficiary, he or she is not in control of the trust assets which means the trust assets are not an available resource. Therefore, the trust doesn't impact the beneficiary's eligibility for means-tested, government assistance programs through the Social Security Administration (SSA) [e.g., Supplemental Security Income (SSI)] or Medicaid.
As with other types of trusts, once a trust is established and “seeded”, other friends and family members can donate to the trust. Common sources of special needs trust funding include investment retirement accounts (IRAs), life insurance policy payouts and real property. The trust is used as a supplemental resource to cover expenses that are not covered by governmental benefits such as medical services not provided by Medicaid, travel, entertainment, and normal living expenses not associated with food and shelter. Read more about special needs trusts and planning.
Types of Special Needs Trusts:
There are three types of special needs trusts:
- Third-party special needs trust: a trust created by a person (usually a family member planning in advance) to provide for another individual who has special needs;
- First-Party special needs trust: a trust created with the funds of the person who has special needs (also known as a “payback” special needs trust); and
- Pooled special needs trust: a trust administered by a nonprofit association that contains assets for more than one beneficiary.
The creation of a first-party special needs trust by the beneficiary is a long awaited major legislative change. Prior to the enactment of the 21st Century Cures Act in late 2016, mentally competent individuals with special needs were not allowed to create their own special needs trust. A parent, grandparent, legal guardian or court had to establish a first-party special needs trust. A mentally competent, but disabled individually no longer has to depend on others to establish the trust and is not forced to spend time and money in the courts.
Pooled trusts are growing in popularity, but some caution should be exercised before their use. Given the responsibility of having a trustee administer the special needs trust over sometimes decades of someone's life, people often do not want that responsibility. Acting trustees wonder if they can merge an individual special needs trust into a pooled trust, thereby allowing the nonprofit to take over the administration. Joining a pooled special needs trust does not constitute a transfer of assets disqualifying a beneficiary from their benefits (since the beneficiary is the same whether in an individual or pooled trust), but states still differ on whether there can be a tax penalty for this switch. Michigan requires that the asset transfers be made at full market value.
Changing Rules for Trust Administration
The rules that govern special needs trusts primarily come from the SSA. Often times the Social Security Administration will amend the Program Operating Manual System (POMS) with respect to trusts. The last major revisions were in April 2018. As an example, the revisions set forth two exceptions for disbursements that do not violate the sole benefit rule. First, trustees are permitted to pay expenses related to the administration of the special needs trust. Second, trustees may make limited disbursements for certain third-party payments. Also, while SSA and Medicaid still don't include special needs trusts for means-tested benefit eligibility, SSA can include a special needs trust in the calculation if the trust allows for early termination. To preserve the exemption, special needs trusts with early terminations must fulfill additional requirements.
Impact of the SECURE Act on Special Needs Trusts
In 2019, the “SECURE Act” (Setting Every Community Up for Retirement Enhancement Act) became law, and its application to IRAs became effective as of September 2021. One of its key provisions is that the statute accelerates the required payment of an IRA after the account holder's death. Before the passage of the SECURE Act, heirs to an IRA could stretch out distributions over the heir's lifetime. But SECURE requires IRAs to be paid out within ten years.
Since many people use IRAs to fund special needs trusts—specifically established to provide for someone with special needs over their entire lifetime—this compressed timeline of distributions could have serious repercussions for disabled beneficiaries.
To address this issue, SECURE created exemptions to the 10-year requirement. Under this provision, certain categories of people considered an “eligible designated beneficiary” (EDB) can still stretch the IRA over their lifetime. To qualify as an EDB, a person must be:
- a surviving spouse
- a minor child of the participant
- a disabled beneficiary
- a chronically ill individual or
- a beneficiary less than 10 years younger than the participant.
Crucially, status as EDB is determined at the time of the IRA account holder's death, meaning that someone cannot switch from the 10-year payout to the lifetime schedule, even if they've become disabled later on.
Is the Beneficiary “Disabled” or “Chronically Ill”?
Deciding whether a special needs trust is being created for someone who is “disabled” versus “chronically ill” may have enormous consequences. And the decision is not as clear-cut as one might think.
The SECURE Act has three requirements to establish disability:
- The impairment must prevent someone from working—i.e., earning a living
- The impairment must be long-term and indefinite or will result in death
- The beneficiary must be able to provide evidence that proves they have the relevant impairment.
The law does not explain what is required to prove the impairment, nor does it specify the arbitrator or procedure for reviewing that evidence.
Another serious consideration still to be determined (i.e., litigated): is the SECURE Act's definition of disability. It does not mirror the SSA's definition to determine eligibility for disability benefits. Instead, there are two notable differences. First, SSA's definition doesn't require someone's disability to be indefinite. It only has to persist for at least 12 months or result in death. Also, while SSA does require proof of a disability before receiving SSI disability benefits, that requirement is not part of the SSA's disability definition.
Since the SECURE Act doesn't define what proof is necessary to meet the evidentiary requirement, it's possible that SSA certification of someone's disability will be sufficient, or SSA could become responsible for reviewing trust-related claims of disability. Because the SSA's definition of disability isn't the same as the SECURE definition, this could confuse, rather than clarify, the requirement.
It's for reasons such as these that legal experts are warning people to resist the “kneejerk” impulse to categorize someone as disabled. Instead, you may want to categorize a beneficiary as “chronically ill.” To satisfy the “chronically ill” standard, a licensed health care practitioner must certify that the beneficiary:
- has needed assistance from others for at least two activities of daily living (eating, bathing, dressing, or continence), and this need has persisted for 90-days or more
- has a disability related to this functional impairment, or
- there is a need for substantial supervision to protect the beneficiary from threats to health and safety due to severe cognitive impairment
With no work requirement and a clearer way to certify eligibility, this may be a better option than the disability standard.
Status for Minor Children who are Disabled is Unclear
Minor children are exempt from the 10-year requirement, but only until they reach the age of majority. From then on, the 10-year rule applies. However, the statute is unclear how this would apply to a minor child who is also disabled or chronically ill.
It could be that children can switch to another relevant EDB category and preserve the lifetime payout schedule. But there is no clear indication if this will be allowed. Therefore, alternatively, you may choose to categorize a child's EDB eligibility under the chronically ill provision from the outset—rather than rely on being able to make a later change in status.
The disability provision's work requirement probably prevents minor children from becoming an EDB via the disability provision, but again, the law is unclear. For now, have your attorney analyze your beneficiary's situation before setting up the trust. Also, recognize that further changes explaining how to manage these hybrid situations are likely to come.
Changes in Taxation of Minor Children's Special Needs Trusts
Before 2017, first-party special needs trusts created for the benefit of minor children were taxed at the same rate as the tax paid by their children's parents. But in 2017, the Tax Cut and Jobs Act changed the tax rate and resulted in much higher tax liability for minor children who were beneficiaries of first-party special needs trusts.
The SECURE Act restored the application of parents' tax rate to their minor children's first-party special needs trusts. This change applies retroactively, so parents should consult with their tax attorneys and accountants to see if they should file amended returns for the tax years of 2018 and 2019.
Caring for someone with special needs is always a heavy responsibility, and planning for their future care and financial security is even more so. That's always been true, but these new laws complicate the situation. Have experienced counsel help you when creating a special needs trust, and it's worth revising any existing special needs trusts as well.
If you are considering setting up a special needs trust, or want to review an existing trust, call 1-888-554-5373, click, or email us at [email protected] to schedule a consultation with a GLFPE attorney.