In New Jersey, Pennsylvania and Florida, the terms "Special Needs Trusts" and "Supplemental Needs Trusts" are often used interchangeably, although they should not be as it often results in serious problems. I personally try to use the term "Special Needs Trust" as a way to refer to a First Party Special Needs Trust (i.e. the money used to fund the trust belongs to the special needs person). I try to use the term "Supplemental Needs Trust" to refer to a Third Party Special Needs Trust (i.e. the money used to fund the trust belongs to someone other than the Special Needs Person).
Both a First Party Special Needs Trust and a Third Party Supplemental Needs Trust are intended to protect different public benefits. Most disabled individuals and special needs individuals receive Supplemental Security Income (SSI), Medicaid, vocational rehabilitation, subsidized housing and food stamps. The most important rule for all First Party Special Needs Trusts and Third Party Supplemental Needs Trusts is that the trust may not pay cash to the beneficiary and it may not pay to or for the benefit of the beneficiary for any medical needs covered by Medicaid, food, shelter, or any asset which could be converted into food or shelter.
A First Party Special Needs Trust and a Third Party Supplemental Needs Trust allow the beneficiary to continue to receive government benefits, but also have money for clothing, education, travel, cable and cell service, electronics, furniture, personal care, medical care not covered by Medicaid, and many other items that make life worth living.
Key features of a Third Party Supplemental Needs Trust:
1. It is a Discretionary Trust
A Discretionary Trust is a Trust that allows the trustee to give money for the benefit of the Special Needs Person as the trustee sees fit. If the trustee has complete discretion whether to make distributions for the beneficiary, the trust principal and income will usually not be counted as available to the beneficiary for purposes of obtaining government benefits.
2. Established using funds of someone other than the Special Needs Person
A Supplemental Needs Trust is most common when a parent, grandparent or other relative wants to leave money for the benefit of a Special Needs Person. Care must be taken to avoid giving that person money outright, otherwise he or she risks losing public benefits. The Supplemental Needs Trust is a way for third parties to provide a Special Needs Person access to money in a way that will not cause them to lose their benefits.
3. No government payback upon the death of beneficiary is required
After the Special Needs beneficiary passes away, Medicaid does not require reimbursement for the funds it expended during the lifetime of the beneficiary if the trust is funded DIRECTLY with the money of someone other than the beneficiary. Please note that if a parent leaves money to a child and then the child sets up a trust, that will be considered a First Party Special Needs Trust, and not a Third Party Supplemental Needs Trust. The key difference is that the third party must set up the trust AND fund it to qualify as a Third Party Supplemental Needs Trust.
4. A Supplemental Needs Trust can have more than one Beneficiary
While there are substantial restrictions on how the Special Needs Person can receive money, because the trust fund is not comprised of funds of the Special Needs Person, there are few guidelines on how the rest of the Supplemental Needs Trust can be administered. Accordingly, the sole benefit rule that applies to First Party Special Needs Trusts does not apply to Third Party Supplemental Needs Trusts. As government benefits are available only to those with financial need, the most important rule is that the beneficiary should never be entitled to the money in the trust.
5. Taxation of Third Party Supplemental Needs Trusts
A Third Party Supplemental Needs Trust can be established as a Grantor Trust while the Grantor is alive, a Qualified Disability Trust or a complex trust. If the trust is set up as a Grantor Trust, income generated by the trust will be allocated to the Grantor (or Creator) of the Trust during his or her lifetime. If the trust is taxed as a complex trust, the trust will pick up most of the tax consequences in these types of trusts. Designing the trust as a Qualified Disability Trust may offer a small tax break, but it offers less privacy. Often privacy is better than saving a few dollars in taxes as it can reduce confusion by government officials looking into the benefits and income of the Special Needs Person. When fewer people question the validity of the trust, that saves legal fees and aggravation.
Key features of a First Party Special Needs Trust:
1. It is a Discretionary Trust
A Discretionary Trust is a Trust that allows the trustee to give money for the benefit of the special needs person as the trustee sees fit. However, payments to any one person or entity in excess of $5,000 during a single calendar year requires government approval.
2. Established using funds of the Special Needs Person
A First Person Special Needs Trust is most commonly created when a person inherits money outside of trust or is awarded money in a personal injury settlement. Prior to actually receiving the money, the Special Needs Person can create this type of trust to avoid losing their public benefits.
3. There is a government payback at the death of the Special Needs Person
After the Special Needs beneficiary passes away, the government requires that the First Party Special Needs Trust reimburse Medicaid for expenses it has incurred. For this reason many trust specialists semi-jokingly recommend that the trustee of a First Party Special Needs Trust try to spend the last dollar of the Trust on the day the Special Needs Person dies.
4. A First Party Special Needs Trust must be for the sole benefit of the Special Needs Person
The sole benefit rule of a Special Needs Trust is very tricky and many states, including New Jersey, have changed their definition of this term many times over the years. For example, can payments be made for the care of a pet for a Special Needs Person? Many New Jersey officials say no, but most will also say yes, if it is a therapy animal. The biggest issue comes up over incidental benefits. For example, a First Party Special Needs Trust can pay for a Special Needs Person to go to an amusement park, but it shouldn't pay for the ticket of a family member caretaker even that caretaker has no interest in going to the park and is only going to assist the Special Needs Person.
5. Establishing a First Party Special Needs Trust.
Creation of a First Party Special Needs Trusts is much more complicated than the creation of a Third Party Supplemental Needs Trust. Usually (but not always), a First Party Special Needs Trust must comply with a federal law enacted in 1993. That law requires that most First Party Special Needs Trusts be established by a judge, a court-appointed guardian or the parents or grandparents of the beneficiary with notification being given to the government so that they can appropriately monitor it.(In some cases Social Security regulations may also require a judge to sign off on the creation of trusts). In addition, the trust must generally be created before the beneficiary turns 65 years of age.
6. Alternate names of a First Party Special Needs Trust
First Party Special Needs Trusts are frequently referred to as d(4)(A) Trusts because that is the section of the government statute that allows for these trusts. They are also frequently called self settled special needs trusts.
7. Taxation of First Party Special Needs Trusts
Because this is a grantor trust for IRS tax purposes, all income earned by the trust is taxable to the Special Needs beneficiary. There is no option to tax the trust itself. The trust is also includible in the gross estate of the Special Needs Person for estate tax purposes. However, the trust still need its own separate EIN and must file a federal Form 1041. (Note: This can be a very simplified form merely advising the IRS that the Grantor/beneficiary will be picking up all the taxable income on their personal income tax return.)
8. Other Issues with First Party Special Needs Trusts
Income generated inside a properly created 1st Party Special Needs Trust should not affect the beneficiary’s eligibility for government programs. However, while taxable income is not “countable” income for purposes of Medicaid or other government benefits, government agencies often get a “tracer” report from the IRS about the beneficiary's income, and may issue a notice that benefits will be terminated unless they receive proof that the beneficiary did not have countable income. The trustee must be prepared to explain that although the income was reportable to the IRS as the beneficiary’s income for tax purposes, the beneficiary only received "in-kind” distributions that should not be counted as income for purposes of SSI, Medicaid, or other programs. In other words, the Trustee will likely have to explain to many different people that the Special Needs Person is being taxed on income that the beneficiary never receives.
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