If you have a loved one with special needs, you have probably heard that a special needs trust is a way to provide financial support for them without jeopardizing their ability to qualify for needed government benefits such as Medicaid and Supplemental Security Income (SSI). You may not know, however, that there are different types of special needs trusts, each with their own rules, requirements, advantages and limitations.
The two principal types of trusts available for the support of persons with special needs are referred to as first-party and third-party special needs trusts. Let's take a look at the nature of each type of trust and when each might be called for.
One type of first-party special needs trust is known as a (d)(4)(A) trust, after 42 USC 1396(p)(d)(4)(A), the federal law that authorized their use to protect assets from being "countable" for the purpose of qualifying for means-tested government benefits.
What makes a special needs trust "first-party" is that it is funded with assets belonging to the person with special needs. A first-party trust may be established only by the beneficiary's parent, grandparent, legal guardian, or by a court (such as if the beneficiary was awarded damages in a lawsuit). Even if competent, the person with special needs cannot establish a (d)(4)(A) trust for himself or herself (but may be able to form a (d)(4)(C) "Pooled Trust" account though).
There are other restrictions on first-party trusts beside who may establish one. They may only be established for the benefit of a person who is under the age of sixty-five. First-party trusts may also need to be monitored by a court. Because the assets in a first-person trust belong to the person with special needs, any income generated by those assets also belongs to the beneficiary.
For tax purposes, first-party special needs trusts are almost always classified as "grantor trusts," with the grantor being the person with special needs (who is also the beneficiary). All income must therefore be reflected on that person's income tax return, even if they have no other income and would not otherwise have to file. And because the assets in the trust belong to the beneficiary, if the beneficiary dies, his or her estate may be required to reimburse Medicaid with assets remaining in the trust.
In contrast to first-party trusts, third-party special needs trusts are established by a donor who contributes funds to the trust for the benefit of the person with special needs. This donor may be anyone except the beneficiary.
Perhaps the greatest advantage of a third-party trust is the fact that trust assets do not belong to the beneficiary. Therefore, those assets cannot be claimed by Medicaid as reimbursement if the beneficiary passes away.
Other differences include the absence of an age limit for the beneficiary and the fact that there is typically no requirement that a third-person trust be monitored by a court. An advantage of a third-party special needs trust is that it can be drafted such that, while the donor is alive, trust income is taxable to him or her, not the beneficiary. This avoids the need to file a tax return for a beneficiary who otherwise would not need to file one.
Perhaps the greatest advantage of a third-party trust is the fact that trust assets do not belong to the beneficiary with special needs. As a consequence, if the beneficiary should die before trust assets are exhausted, those assets cannot be claimed by Medicaid as reimbursement.
If you are the parent or grandparent of a child with special needs and are looking to update your estate plan with them in mind, a third-party trust is what you need. However, there are some circumstances in which a first-party trust is also necessary. If a beneficiary has a third-party trust, it must not be "tainted" with any of the beneficiary's own assets. Therefore, if the beneficiary receives a judgment from a lawsuit or an inheritance from a probate estate, a first-party trust will need to be established for those assets.