advanced snt drafting issues i: tax issues and drafting to hold iras academy of special needs...

Advanced SNT Drafting Issues I: Tax Issues and

Drafting to Hold IRAs

Academy of Special Needs Planners

Vincent J. Russo, J.D., LL.M., CELACopyright March 2007

Westbury, Islandia, Woodbury and Lido Beach

1-800-680-1717www.vjrussolaw.com

Overview♦Special Needs Trusts♦Pooled Trusts♦IRAs♦Supplemental Needs Trusts♦Income Taxation of Person

with Special Needs

Vincent J. Russo & Associates, P.C.©2007

First Party Special Needs TrustsRequirements

♦Set up by parent, grandparent, legal guardian or a Court♦To or for the sole benefit of a person

who is disabled and under age 65♦Funded with the assets of the person

who is disabled♦Payback required to reimburse the

State for Medicaid Paid♦ 42 U.S.C. § 1396p (d)(4)(A)


Tax ConsequencesFirst Party Special Needs Trusts

♦Gift Tax Treatment ♦On Funding

♦Income Tax Treatment♦On Income Generation

♦Estate Tax Treatment♦On demise of the beneficiary

Vincent J. Russo & Associates, P.C.

©2007

Gift Tax ConsequencesFirst Party Special Needs Trust

♦Johnny, age 6 ♦Receives a $4,000,000 medical

malpractice settlement♦If funding the SNT is taxable ...

♦Federal gift tax is $920,690 ♦Calculated: $1,266,490 less unified

credit -$345,800♦If funding the SNT is not taxable ...

♦Federal gift tax is $0♦Estate Tax Consequences

Vincent J. Russo &

Associates, P.C.©2007


♦Gift Guidelines:♦$1,000,000 and under

♦no federal consequences

♦Over $1,000,000 ♦Gift tax rates from 41% to 45%♦Unified credit amount is $345,800 ♦ (shelters the first $1,000,000 of taxable

gifts)♦State gift tax laws - NC, LA, TN and Puerto

Rico♦CT (as of 2005) no longer impose gift tax ♦NY (as of 2000) no longer impose gift tax Vincent J.

Russo & Associates, P.C.

©2007


♦Example #1:♦Donor transfers property to trust ♦Trustee to pay income to the donor

or accumulate it in the discretion of the trustee

♦Donor retains a testamentary power to appoint the remainder among his descendants

♦No portion of the transfer is a completed gift


©2007


♦Example #2:If the donor had not retained the

testamentary power of appointment♦Trust provides remainder to X or his heirs♦The entire transfer would be a completed gift.

♦Example #3: ♦If the exercise of the trustee’s power for

the grantor is limited by a fixed or ascertainable standard

♦Gift is incomplete to the extent of the ascertainable value of any rights retained by the grantor.


©2007

Income Tax Consequences

Who is Taxed on the Trust IncomeFirst Party Special Needs Trust

♦Trust♦Complex Trust

♦Someone other than the grantor♦Complex or Simple Trust

♦Grantor treated as the owner♦Overrides Complex or Simple Trust

Rules♦Grantor Trust Rules - IRC Sections

671 -678♦Ignore IRC §676 - Power to Revoke

Vincent J. Russo & Associates,

P.C.©2007

Who is the Grantor - Income TaxSpecial Needs Trust - Definition of Grantor - PLR

9437034♦Facts:♦The lawsuit arose from an

accident in which the plaintiff was seriously injured.

♦The settlement proceeds compensated the decedent for his personal injuries.

♦Plaintiff was the transferor of the funds


©2007

Who Pays the Income TaxFirst Party Special Needs Trust

♦General Rule♦Grantor should pay the tax♦Trust should never pay the tax

♦Exception: ♦ Qualified Disability Trust

♦Guideline: Less than $3,400 of income♦Example: $68,000 invested at 5% yields

$3,400


©2007

Who Pays the Income TaxFirst Party Special Needs Trust

♦Exception: Have some trust income taxable to trust and to beneficiary♦Must be a Complex Trust

♦Can not be a Grantor Trust♦One of the following:

♦Trust is required to accumulate income annually, or

♦Trust actually makes principal distributions, or

♦Trust may pay or permanently set aside or use Trust principal for charitable purposesVincent J. Russo &


Income Tax ConsequencesFirst Party Special Needs Trust

♦Trust is taxed on income♦Rates - 35% over $10,450♦Exemption Amount - $100 complex/$300

simple♦Qualified Disability Trust

♦Exemption Amount - same as standard deduction for a single person ($3,400 in 2007)

♦Grantor is taxed on income ♦Rates - individual rates apply - 35% over

$349,700 Exemption Amount -$3,400 (single)♦Beneficiary is taxed on income

♦Rates - individual rates apply - 35% over $349,700

♦Exemption Amount - $3,400 Vincent J. Russo & Associates, P.C. ©2007

Income Tax ConsequencesFirst Party Special Needs Trust

♦Trust is funded with $3,000,000 ♦Annual Income - $180,000 ♦Who Pays the Income Tax...

♦If Trust Pays - federal income tax - $62K♦If Johnny Pays - federal income tax - $45K

(54K if subject to Kiddie Tax)♦If Johnny’s Parents Pay - federal income

tax -$54K♦Assuming Johnny’s parents other taxable

income is $100,000 and married filing jointly

Vincent J. Russo & Associates, P.C. ©2007

Grantor/Beneficiary Pays the Income Tax

Special Needs Trust - Trust Provisions

♦How does the Grantor make it happen:♦Grantor may Exchange Property of

Equivalent Value in non-fiduciary capacity ♦IRC §675

♦Power to remove Trustee and replace with a non-adverse party who is related to or subservient to Grantor. In such case Trustees powers are attributed to Grantor and Trust is a Grantor Trust

♦IRC §672, IRC §674


©2007

Grantor/Beneficiary Pays the Income TaxSpecial Needs Trust - Trust Provisions

♦How does the Grantor make it happen:♦Income payable by nonadverse party to

the grantor♦IRC § 677

♦Adverse Party - any person who has a substantial beneficial interest in the trust which would be adversely affected

♦IRC §672♦Use Trust income to pay premiums of

insurance on life of Grantor or grantor’s spouse

♦IRC §677


©2007

Grantor/Beneficiary Pays the Income TaxSpecial Needs Trust - Trust Provisions

♦How does the Grantor make it happen:♦Reversionary Interest--at least 5% of

property♦IRC §673

♦Testamentary GPOA-causes Grantor Trust as a reversionary interest

♦IRC §673♦Testamentary LPOAs generally do not

create grantor trusts for income tax purposes

♦Exception: Capital Gains on principal - grantor taxed on the capital gainVincent J. Russo &


Income Tax ConsequencesSpecial Needs Trust - Grantor Trust

♦Tax Identification Numbers ♦Option 1- no TIN number

obtained♦Trustee providers Grantor (unless Grantor is Trustee) with a statement

♦Option 2 - New TIN for Trust ♦Trust Income Tax Return (IRS Form 1041)♦Check the box for Grantor Trust in entity type♦Generates a Grantor Statement (analogous to a ♦ Schedule K- 1)


©2007

Estate Tax ConsequencesSpecial Needs Trust - Arrington Matter

♦Valuation: Arrington v. United States♦Facts:

♦Parents file medical malpractice claim against doctor and hospital for injuries caused to their son.

♦Case was settled and an annuity was set up for the benefit of the son. In addition, a trust for the benefit of the son was set up to hold a lump sum certain. The son was the only beneficiary of the trust and the annuity.Vincent J. Russo

& Associates, P.C.

©2007

Estate Tax ConsequencesSpecial Needs Trust - Arrington Decision

♦Lump sum and the annuity was included in

son's estate under IRC §2031 and §2033♦Since the trust and the annuity were"beneficially owned" by the decedent-son

at his death.♦Beneficial ownership under the IRC

§2033 andIRC Regs 20.2033-1 is determined by

State Law.Vincent J. Russo & Associates,

P.C.©2007

Estate Tax ConsequencesFirst Party Special Needs Trust

♦Included in Estate for Estate Taxes Purposes

♦Decedent had a income interest and a vested remainder in the corpus of the trust and a present income interest and vested remainder in all of the annuity payments.

♦Decedent had a beneficial interest in the annuity and the trust under Texas law

♦The date of death value of the trust and the annuity payments were included in decedent's estate under IRC §2033


P.C.©2007


♦Debt of the Estate - Pay Back Amount

♦Deduction Against Gross Estate♦IRC §2053(a)(2)♦PLR 200240018


P.C.©2007

Estate Tax ConsequencesSpecial Needs Trust - TAM 9506004

♦Facts: ♦Decedent's parents reached a

settlement for medical malpractice which resulted in the establishment of two irrevocable trusts.

♦One trust was funded with settlement payments payable over ten years.

♦The second trust was funded with an annuity for A's lifetime. Vincent J. Russo

& Associates, P.C.

©2007


♦A had a testamentary limited power ofappointment of the assets of both

trusts.♦In default of appointment, upon

A's death, ♦The assets of the first trust were

to pass to his intestate beneficiaries♦The assets of trust 2 were to be

held in trust for A's parents and their issue.


P.C.©2007


♦The transfer by the parent (as guardian of A) did

not constitute a gift ♦A retained the right to change the

beneficiaries of the trust until his death ♦This rendered the gift to the trust

incomplete.♦The periodic payments were awarded by thehospital and the doctors in respect of A's

injuries. ♦The payments were A's property.Vincent J. Russo

& Associates, P.C.

©2007


♦A retained the right to change beneficialenjoyment of the trust for his

lifetime♦The trust assets were included in

his estate under §2036(1) and §2038 of the IRC

♦Valuation of Future Periodic Payments on Structured SettlementsVincent J. Russo

& Associates, P.C.

©2007

Pooled Trusts under (D)(4)(c)Tax Consequences

♦No Definitive Authority♦Generally taxed as Complex Trusts

♦Treas. Reg. §1.642(c)-5

♦Receive deduction for DNI distributed toparticipants

♦Participants receive Schedule K-1

Vincent J. Russo &


IRAs and SNTsThe Medicaid Rules

♦IRAs♦Available versus Not Available♦Permanent Pay Status♦Required Minimum Distributions♦Annuities

♦SNTs♦Trust Assets not available -

Medicaid


P.C.©2007

IRAs and SNTsIRA Tax Rules - Trust as Designated Beneficiary

♦IRC Reg. §1.401(a)(9)-4, A-5)♦Trust must be valid under state law♦Trust must be irrevocable or will, by its

terms, become irrevocable upon death of the participant

♦The beneficiaries must be “identifiable ... from the trust instrument”

♦Certain documentation must be provided to “the plan administrator” by 10/31 of the year following the year of participant’s death

♦All trust beneficiaries must be individuals


Designating SNT as IRA BeneficiaryCase Study

♦Bob’s only child, Krista, is 35 years old and has CP.

♦Option #1♦Bob creates a Living Third Party SNT for

Krista with nominal funding♦Bob designates SNT as beneficiary of the

IRA ♦Option #2

♦Bob’s Revocable Trust with SNT for Krista♦Bob’s Will with SNT for Krista♦Bob designates as his IRA beneficiary the

SNT for Krista under Revocable Trust, with the SNT under the Will as contingent beneficiary.

Vincent J. Russo & Associates, P.C. ©2007

IRAs and SNTsPrivate Letter Ruling - 200620025

♦Taxpayer A, age 69 died♦Four sons surviving; Child B is

disabled♦Sons are named beneficiaries of

the IRA


P.C.©2007


♦Strategy♦Separate Sub-IRAs established

for each child♦Annual RMDs are made♦Court authorizes establishment

of SNT♦Mother - Guardian of Child B -

disclaims interest in the SNT


P.C.©2007


♦Ruling♦SNT is a Grantor Trust

♦IRC §671♦If grantor is owner - income attributed

to grantor♦IRC §677(a)

♦Trustee (non adverse party) may distribute income to grantor, accumulated for future distributions or applied to the payment of life insurance premiums on the life of the grantor

♦Transfer of B’s share of the IRA to SNT is not a

taxable event Vincent J. Russo & Associates, P.C. ©2007


♦Letter Ruling Request♦Transfer of IRA X to SNT will be

disregarded for federal income tax purposes♦The Trustee of SNT may calculate the

annual distributions using Child B’s life expectancy♦Ruling

♦SNT is a Grantor Trust♦Transfer of B’s share of the IRA to SNT is

not a taxable event ♦Trustee may calculate the annual RMDs

based on life expectancy of Taxpayer BVincent J. Russo & Associates, P.C.©2007

SNTs - Gift and Estate TaxesPrivate Letter Ruling - 9437034


P.C.©2007

♦Decedent created an Irrevocable Trust

♦Funded with structured settlementproceeds with a guaranteed payment♦Special Needs Trust created to be

therecipient of the settlement proceeds

♦SNT Provisions♦For sole benefit of Decedent♦Testamentary Special Power of

Appointment

SNTs - Gift and Estate TaxesPrivate Letter Ruling - 9437034


P.C.©2007

♦Ruling:♦Included in Estate for Estate

Tax Purposes♦IRC §2038(a)(1)

♦Decedent has the right at death to alter disposition of trust assets

♦Incomplete Gift ♦IRC Reg. §25.2511-2

♦Donor retained special power to change the enjoyment of the trust assets

Third Party Supplemental Needs TrustsEssential Provisions

♦Set up by a third party for another person’s

benefit♦Funded with the third party’s assets♦No pay back required to Medicaid♦Can be Inter Vivos Trust or a Trust

under a Will♦Medicaid Transfer Penalty Rules

Vincent J. Russo &


Tax ConsequencesThird Party Supplemental Needs Trusts

♦Gift♦Complete versus Incomplete♦Control by drafting trust

provisions♦Income

♦Grantor♦Simple Trust♦Complex Trust♦Conversion from Grantor Trust

Vincent J. Russo &

Associates, P.C.

©2007

Estate Tax ConsequencesThird Party Supplemental Needs Trusts

♦Included in Estate of Grantor♦Strings Attached

♦Maintain Control or Beneficial Enjoyment

♦Excluded from Estate of Grantor♦No Strings Attached

♦No Control or Beneficial Enjoyment Retained

Vincent J. Russo &

Associates, P.C.

©2007

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