Third-Party Special Needs Trusts: Asset Protection Benefits and Tax Burdens Presented by I. Richard Gershon University of Mississippi School of Law I. What is a Third-Party Special Needs Trust? A. Difference between first-party and third-party trusts. i. First-party special needs trusts First-party special needs trusts are funded with the assets of an individual with a disability who is typically participating in a means-tested government benefit program such as Supplemental Security Income or Medicaid. First-party special needs trusts generally receive the tax classification of a grantor trust. This tax classification means that all of the items of income, deduction and credit generated by the trust should be reflected on the personal income tax return of the individual with the disability, who is the trust beneficiary. (26 U.S.C. Subpart E ( 671-679).) In first-party special needs trusts, the grantor is actually the beneficiary because the law requires the trust be funded with the beneficiary s own assets. The law requires that the first-party special needs trust cannot be established by the beneficiary, even if competent, but rather must be established by a parent, grandparent, legal guardian or a court. 42 U.S.C. 1396p(d)(4)(A). First-party trusts are used to ensure that the disabled person s qualification under a means-tested government program will not be impacted by assets available to the beneficiary. First-party special needs trusts are subject to claw-back rules, which reimburse Medicaid for amounts paid to a beneficiary during her lifetime. SSI is not entitled to repayment. 1
ii. Third-Party Special Needs Trusts A third-party special needs trust is created and funded by someone other than the special needs person. They may be created as inter vivos trusts (during Settlor s lifetime) or may be created by will or will substitute. However, a third-party supplemental care SNT will be counted as a resource for the Settlor s spouse, unless it is created by will rather than a will substitute. 42 U.S.C. 1382(b)(e). Benefits of third-party SNT s include: the third-party special needs trust, rather than the child, owns the assets meaning that a properly drafted trust cannot be pursued by the beneficiary's creditors; the trustee is free to invest the funds with any financial advisor; the statute does not make any limitations on investment options; and at the beneficiary's death, the trust funds pass to whomever the trustee names. Third-Party SNT s are not subject to claw-back by Medicaid! II. Now Let s Talk Tax (YAY!) A. Taxation of First-Party SNT s, Generally First-Party, self-settled SNT s are not treated as separate entities for Federal Income Tax purposes. Instead, the grantor is treated as owning the assets, and is taxed directly on income earned by the trust. 26 U.S.C. Subpart E ( 671-679). Accordingly, income and deductions of the trust are reported on the settlor s 1040 for the taxable year. 2
B. Taxation of Third-Party SNT s, Generally Third-Party SNT s are treated as separate entities from the beneficiary and are therefore subject to Federal Income Taxation under 26 U.S.C. Subchapter J ( 641-685). The trustee of the trust will be required to complete and file Form 1041 at the end of the trust s taxable year. That is what this presentation is really about. III. The Specifics of Taxing Third-Party SNT s A. Why Subchapter J? Subchapter J was born out of 102(b) of the Internal Revenue Code (26 U.S.C. 102(b)). 102(a) of the Internal Revenue Code [can we please assume that all of my code section references will be to that code from this point forward? This is, after all, a tax presentation. Thank you!] provides that gross income shall not include gifts or inheritances of property. 102(b), however states that income from gifts or inheritances of property will be included in gross income: Where, under the terms of the gift, bequest, devise, or inheritance, the payment, crediting, or distribution thereof is to be made at intervals, then, to the extent that it is paid or credited or to be distributed out of income from property, it shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property. Any amount included in the gross income of a beneficiary under subchapter J shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property. IRC 102(b) the flush language. Example: In 2017, Matt Murdock gave Jessica Jones an apartment building worth $2 million. The gift was made out of a detached and disinterested generosity, and was thus the value of the property was excluded from gross income under 102(a). (see, Commissioner v. Duberstein, 363 U.S. 278 (1960)). In 2018, Jessica collected $80,000 in rent from the apartments. That $80,000 will be included in Jessica s gross income under 102(b) because it represents income 3
from property. If not for 102(b), it could be argued that the rent was also a gift, since it was generated by property given to Jessica. If that were the case, income from property would never be taxed again, once the property was transferred by gift or inheritance. The distinction between property and income from property is especially important in trust accounting and taxation. When a trust retains income, it is taxed on that income. When a trust distributes income to a beneficiary, the beneficiary is taxed on that income, and the trust gets a corresponding deduction. Thus, if the trust earned $170K of income in 2018 and it distributed $140K of that income to a beneficiary, the trust would be taxed on a net $30K ($170K-140K) and the beneficiary would be taxed on the $140K distribution. If, on the other hand, the $140K was a distribution of trust property and not trust income, there would be no tax consequences to the beneficiary, under 102(a), since that would be a gift of property and not income. Subchapter J ensures the proper characterization of a distribution as either income (taxable), principal (non-taxable) or a mix of the two. B. Simple Trusts v. Complex Trusts IRC 651 defines a simple trust as having governing instruments providing that all income is required to be distributed currently. ( 651(a)). Furthermore, no amounts of the trust s income can be permanently set aside for charitable purposes under IRC 642(c). On the other hand, a complex trust is one that often has discretion to pay out income or principal, or neither in a given year. It does not meet the 651 definition of a simple trust, because it is not required to pay out all of its income annually. Because the SNT is a trust designed to supplement income of the beneficiary based on that beneficiaries needs, and because distributions made by the trust should not disqualify the beneficiary s access to need-tested programs, a third-party SNT will be a complex trust. C. Filing Requirements for Third Party SNT s 4
A third-party SNT is presumptively a separate taxpaying entity and must have an EIN. It must also file a separate (fiduciary) income tax return using Form 1041 (see appendix A attached). All non-grantor trusts all fit into this category though it is important to note that even though the beneficiary of a trust may not be treated as a substantial owner (a grantor ), the original grantor may still be treated as the substantial owner. Assuming, though, that the trust does not have a living grantor for tax purposes, 26 CFR 301.6109-1(a)(1)(ii)(C) mandates that Any person other than an individual such as corporations, partnerships, nonprofit associations, trusts, estates and similar nonindividual persons) that is required to furnish a taxpayer identifying number must use an employer identification number. D. Calculating the Trust Income Tax Trust income is not subject to double taxation. Instead, the trust is taxed on income not distributed in a given taxable year, but it is allowed a deduction for any income distributed to beneficiaries. Because simple trusts are required to distribute all of their income annually, and they are entitled to a deduction under 651(a) for the income they actually distribute to the beneficiary. Accordingly, a simple trust should not have any retained income to report on a Form 1041. A simple trust is required to file a Form 1041 for the purpose of reporting how much income was received by a beneficiary during the year. An individual beneficiary would then report that income on his or her Form 1040 for the taxable year. 5
Complex trusts, on the other hand, would be subject to a separate income tax at the entity level, unless the trust distributes all of its income during the taxable year. The tax rates for estates and trusts for 2018 are (under IRC 1(e)): Income $0-$2,550 Tax Rate is 10% Income $9,150- $255.00 + 24% of the amount over $2,550. $9,150- $12,500 $1,839.00 + 35% of the amount over $9,150 $12,500 $3,011.50 + 37% of the amount over $12,500 E. Distributable Net Income (DNI) One of the major issues in reporting trust income on the Form 1041 is the calculation of Distributable Net Income (DNI) (IRC 643). The DNI calculation is important, because it establishes the amount of income the trust has available for distribution in a given year. When a trustee has discretion to make a distribution from either income or principal, the Code requires that distributions be treated as income distributions to the extent of available DNI (IRC 661). Any DNI not distributed in a taxable year, will be carried over as available DNI in subsequent years. DNI is defined differently from the terms Income, and Taxable Income. IRC 643(b) states: (b)income For purposes of this subpart and subparts B, C, and D, the term income, when not preceded by the words taxable, distributable net, undistributed net, or gross, means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, 6
determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income. This Income is typically referred to a Fiduciary Accounting or Trust Income (FAI). DNI is the amount of income distributable to the beneficiaries, after taking into account expenses allocable to that income. FAI and DNI include not taxable items, such as tax-exempt interest (IRC 643(a)(5)). Tax-exempt interest is distributable as income to a beneficiary, even though it is not calculated as part of taxable income. Example DNI and Taxable Income Calculations: EXAMPLE 1: A trust has dividend income of $5,000 for the taxable year and no other income. By its terms, the trust is required to distribute all of its income currently to its beneficiary. The trustee makes no distributions during the taxable year other than $5,000 of trust accounting income to the beneficiary. The trust is a simple trust for the taxable year. It will have adjusted total income of $5,000 and will receive an offsetting income distribution deduction in the same amount. The beneficiary will have $5,000 of dividend income for the year. The trust DNI was $5000. EXAMPLE 2: A trust has interest income of $3,000 and royalty income of $5,000 for the taxable year, and realizes $5,000 of capital gain (treated as principal) during the year from the sale of an asset. The trustee distributes $4,000 of trust accounting income to each of the trust s two beneficiaries during the taxable year and makes no other distributions. The trust is a simple trust for the taxable year. It will have adjusted total income of $13,000 and will receive an income distribution deduction of $8,000, resulting in the trust having $5,000 of taxable income (the amount of the capital gain), ignoring other deductions. Each beneficiary in turn will have $1,500 of interest income and $2,500 of royalty income for the year. EXAMPLE 3: A trust is required to distribute all income to W currently. Trust has $20,000 taxable interest income; $10,000 of capital gain attributable to corpus; and trustee s fees of $2,000, chargeable $1,000 to income and $1,000 to corpus. Trustee distributes $19,000 to W. DNI is $18,000; the trust s gross ordinary income ($20,000) less deductible expenses ($2,000). W picks up $18,000 of taxable interest on her income tax return. 7
Trust s taxable income: Gross Income $30,000 Less: [DNI Distribution ($18,000) Trustee s fees ($2000) Exemption $300)=Taxable Income: $ 9,700 EXAMPLE 4: Same facts above, except the trustee had discretion to allocate income between W and S, and distributed ¾ to W and ¼ to S. W would report $13,500 of interest income (¾ x $18,000), and S would report $4,500 (¼ x $18,000). EXAMPLE 5: A complex trust earned $5,000 of taxable dividend and interest income for the taxable year, and $2,500 of tax-exempt interest. The trustee made a discretionary distribution to the beneficiary during the year of $3,000. No other amount was distributed or required to be distributed during the taxable year. As a result of the distribution, the beneficiary is deemed to have received $1,000 of taxexempt income and $2,000 of taxable income from the trust and will accordingly include $2,000 of the distribution in his gross income. The trust, in turn, will have gross income of $5,000 and an income distribution deduction of $2,000. The trust DNI was $7500. 8
Form 1041 Department of the Treasury Internal Revenue Service U.S. Income Tax Return for Estates and Trusts 2017 OMB No. 1545-0092 Go to www.irs.gov/form1041 for instructions and the latest information. A Check all that apply: For calendar year 2017 or fiscal year beginning, 2017, and ending, 20 Decedent s estate Simple trust Complex trust Qualified disability trust Name of estate or trust (If a grantor type trust, see the instructions.) Name and title of fiduciary C Employer identification number D Date entity created ESBT (S portion only) Number, street, and room or suite no. (If a P.O. box, see the instructions.) E Nonexempt charitable and splitinterest trusts, check applicable Grantor type trust Bankruptcy estate-ch. 7 box(es), see instructions. Described in sec. 4947(a)(1). Check here Bankruptcy estate-ch. 11 City or town, state or province, country, and ZIP or foreign postal code if not a private foundation... Pooled income fund Described in sec. 4947(a)(2) B Number of Schedules K-1 attached (see F Check applicable Initial return Final return Amended return Net operating loss carryback instructions) boxes: Change in trust's name Change in fiduciary Change in fiduciary's name Change in fiduciary's address G Check here if the estate or filing trust made a section 645 election...... Trust TIN Income Deductions Tax and Payments Sign Here 1 Interest income........................... 1 2a Total ordinary dividends........................ 2a b Qualified dividends allocable to: (1) Beneficiaries (2) Estate or trust 3 Business income or (loss). Attach Schedule C or C-EZ (Form 1040)......... 3 4 Capital gain or (loss). Attach Schedule D (Form 1041).............. 4 5 Rents, royalties, partnerships, other estates and trusts, etc. Attach Schedule E (Form 1040). 5 6 Farm income or (loss). Attach Schedule F (Form 1040).............. 6 7 Ordinary gain or (loss). Attach Form 4797.................. 7 8 Other income. List type and amount 8 9 Total income. Combine lines 1, 2a, and 3 through 8............. 9 10 Interest. Check if Form 4952 is attached............... 10 11 Taxes.............................. 11 12 Fiduciary fees. If a portion is subject to the 2% floor, see instructions......... 12 13 Charitable deduction (from Schedule A, line 7)................ 13 14 Attorney, accountant, and return preparer fees. If a portion is subject to the 2% floor, see instructions 14 15 a Other deductions not subject to the 2% floor (attach schedule)........... 15a b Net operating loss deduction. See instructions................ 15b c Allowable miscellaneous itemized deductions subject to the 2% floor......... 15c 16 Add lines 10 through 15c...................... 16 17 Adjusted total income or (loss). Subtract line 16 from line 9... 17 18 Income distribution deduction (from Schedule B, line 15). Attach Schedules K-1 (Form 1041) 18 19 Estate tax deduction including certain generation-skipping taxes (attach computation)... 19 20 Exemption............................ 20 21 Add lines 18 through 20....................... 21 22 Taxable income. Subtract line 21 from line 17. If a loss, see instructions........ 22 23 Total tax (from Schedule G, line 7).................... 23 24 Payments: a 2017 estimated tax payments and amount applied from 2016 return.... 24a b Estimated tax payments allocated to beneficiaries (from Form 1041-T)........ 24b c Subtract line 24b from line 24a..................... 24c d Tax paid with Form 7004. See instructions.................. 24d e Federal income tax withheld. If any is from Form(s) 1099, check........ 24e Other payments: f Form 2439 ; g Form 4136 ; Total 24h 25 Total payments. Add lines 24c through 24e, and 24h............. 25 26 Estimated tax penalty. See instructions................... 26 27 Tax due. If line 25 is smaller than the total of lines 23 and 26, enter amount owed..... 27 28 Overpayment. If line 25 is larger than the total of lines 23 and 26, enter amount overpaid.. 28 29 Amount of line 28 to be: a Credited to 2018 estimated tax ; b Refunded 29 Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge. May the IRS discuss this return with the preparer shown below (see instr.)? Yes No Signature of fiduciary or officer representing fiduciary Date EIN of fiduciary if a financial institution Paid Preparer Use Only Print/Type preparer's name Preparer's signature Date PTIN Check if self-employed Firm's name Firm's EIN Firm's address Phone no. For Paperwork Reduction Act Notice, see the separate instructions. Cat. No. 11370H Form 1041 (2017)
Form 1041 (2017) Page 2 Schedule A Charitable Deduction. Don't complete for a simple trust or a pooled income fund. 1 Amounts paid or permanently set aside for charitable purposes from gross income. See instructions 1 2 Tax-exempt income allocable to charitable contributions. See instructions........ 2 3 Subtract line 2 from line 1........................ 3 4 Capital gains for the tax year allocated to corpus and paid or permanently set aside for charitable purposes 4 5 Add lines 3 and 4........................... 5 6 Section 1202 exclusion allocable to capital gains paid or permanently set aside for charitable purposes. See instructions. 6 7 Charitable deduction. Subtract line 6 from line 5. Enter here and on page 1, line 13..... 7 Schedule B Income Distribution Deduction 1 Adjusted total income. See instructions.................... 1 2 Adjusted tax-exempt interest....................... 2 3 Total net gain from Schedule D (Form 1041), line 19, column (1). See instructions...... 3 4 Enter amount from Schedule A, line 4 (minus any allocable section 1202 exclusion)..... 4 5 Capital gains for the tax year included on Schedule A, line 1. See instructions....... 5 6 Enter any gain from page 1, line 4, as a negative number. If page 1, line 4, is a loss, enter the loss as a positive number. 6 7 Distributable net income. Combine lines 1 through 6. If zero or less, enter -0-....... 7 8 If a complex trust, enter accounting income for the tax year as determined under the governing instrument and applicable local law. 8 9 Income required to be distributed currently................... 9 10 Other amounts paid, credited, or otherwise required to be distributed.......... 10 11 Total distributions. Add lines 9 and 10. If greater than line 8, see instructions....... 11 12 Enter the amount of tax-exempt income included on line 11............. 12 13 Tentative income distribution deduction. Subtract line 12 from line 11.......... 13 14 Tentative income distribution deduction. Subtract line 2 from line 7. If zero or less, enter -0-.. 14 15 Income distribution deduction. Enter the smaller of line 13 or line 14 here and on page 1, line 18 15 Schedule G Tax Computation (see instructions) 1 Tax: a Tax on taxable income. See instructions....... 1a b Tax on lump-sum distributions. Attach Form 4972.... 1b c Alternative minimum tax (from Schedule I (Form 1041), line 56) 1c d Total. Add lines 1a through 1c................... 1d 2a Foreign tax credit. Attach Form 1116............ 2a b General business credit. Attach Form 3800.......... 2b c Credit for prior year minimum tax. Attach Form 8801...... 2c d Bond credits. Attach Form 8912............. 2d e Total credits. Add lines 2a through 2d................... 2e 3 Subtract line 2e from line 1d. If zero or less, enter -0-............... 3 4 Net investment income tax from Form 8960, line 21................ 4 5 Recapture taxes. Check if from: Form 4255 Form 8611........... 5 6 Household employment taxes. Attach Schedule H (Form 1040)............ 6 7 Total tax. Add lines 3 through 6. Enter here and on page 1, line 23.......... 7 Other Information 1 Did the estate or trust receive tax-exempt income? If Yes, attach a computation of the allocation of expenses. Enter the amount of tax-exempt interest income and exempt-interest dividends $ 2 Did the estate or trust receive all or any part of the earnings (salary, wages, and other compensation) of any individual by reason of a contract assignment or similar arrangement?............... 3 At any time during calendar year 2017, did the estate or trust have an interest in or a signature or other authority over a bank, securities, or other financial account in a foreign country?.............. See the instructions for exceptions and filing requirements for FinCEN Form 114. If Yes, enter the name of the foreign country 4 During the tax year, did the estate or trust receive a distribution from, or was it the grantor of, or transferor to, a foreign trust? If Yes, the estate or trust may have to file Form 3520. See instructions......... 5 Did the estate or trust receive, or pay, any qualified residence interest on seller-provided financing? If Yes, see the instructions for required attachment......................... 6 If this is an estate or a complex trust making the section 663(b) election, check here. See instructions.. 7 To make a section 643(e)(3) election, attach Schedule D (Form 1041), and check here. See instructions.. 8 If the decedent s estate has been open for more than 2 years, attach an explanation for the delay in closing the estate, and check here 9 Are any present or future trust beneficiaries skip persons? See instructions............. 10 Was the trust a specified domestic entity required to file Form 8938 for the tax year (see the Instructions for Form 8938)?.................................. Yes No Form 1041 (2017)