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

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.

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 &

♦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.

♦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

♦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.

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,

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

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

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

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

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

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

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)

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.

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,

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

♦Debt of the Estate - Pay Back Amount

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

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.

♦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.

♦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.

♦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.

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

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.

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

♦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

♦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

♦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

SNTs - Gift and Estate TaxesPrivate Letter Ruling - 9437034

♦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

♦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.

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.

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