(Continued - Part 4 of 4)
by Gregory Wilcox, Esq.
Author's Note: This is the last installment of a multi-part article.
The three previous parts appeared in the Spring, Summer, and Fall issues of
the Legal Network News (Vol. 13, Nos. 1, 2, and 3). Apart from an initial
short Addendum, this final Part deals exclusively with the income taxation of
Who is allowed to benefit from a (d)(4)(A) trust? (Addendum)
Obsessive compulsive readers of these articles may notice that I answered
this question in Part 2 last summer. However, I have something to add.
As I pointed out earlier, Medi-Cal trust
rules do not precisely require that (d)(4)(A) trusts be for the "sole"
benefit of the trust beneficiary. All they require is that such trusts
be for the beneficiary's "benefit". SSI trust rules in
turn approve trusts created according to Medi-Cal rules (42 U.S.C. §1382b(e)(5)),
specifically mentioning trusts created under 42 U.S.C. §1396p(d)(4)(A)).
So SSI trust rules do not technically
require (d)(4)(A) trusts to be for the "sole" benefit of the beneficiary
The only problem is that the SSI transfer rules only exempt transfers to trusts that are "solely
for the benefit" of an individual under age 65 (42 U.S.C. §1382b(c)(1)(C)(ii)(IV)),
specifically mentioning (d)(4)(A) trusts (even though they don't
in fact require "sole" benefit). So, as a result of the apparent
mistake in the SSI transfer statute, (d)(4)(A) trusts that are intended to satisfy
SSI requirements (in addition to Medi-Cal requirements), will have to be for
the "sole" benefit of the trust beneficiary after all.
But actually this extra requirement is not much of a problem. All the
trust language has to say is that the trust benefits no one other than the beneficiary
at the time the trust is established or at any time for the rest of the beneficiary's
life (pursuant to the discussion of "sole benefit" in POMS SI 01120.201
F.2.). Remainder beneficiaries are not only allowed to receive the trust
estate after the primary beneficiary's death and after repayment to Medi-Cal,
such beneficiaries should be individually named to avoid trouble with the Social
Security Administration (which were my main points last summer).
How are (d)(4)(A) trusts taxed?
Answering this question has turned out to be a bear -- and a fairly large
bear. Accordingly, to avoid having to write parts five and six of this
article, I'm limiting the following commentary to a few important points.
First, I'm only going to discuss income tax issues. The great majority
of (d)(4)(A) trusts don't have enough property to trigger gift and estate tax
issues (and those of you handling trusts of $1 million or more can afford to
hire someone to advise you individually). On the other hand, income tax
issues affect everyone. Second, I'm going to focus on just three income
tax points: two myths and one set of procedures.
A. Myth No. 1: (d)(4)(A) trusts are "grantor" trusts
Well, probably but maybe not. And what does it mean anyway? First
some background. A (d)(4)(A) trust is a "self-settled" trust,
also known as a "first party" trust. That is, the trust beneficiary
creates it with his or her own funds. From the point of view of state
trust law (Probate Code §15400) and from the point of view of federal tax
law, such trusts are therefore created by the trust beneficiary as the "grantor"
(keeping in mind that Medi-Cal and SSI rules nevertheless require that a third
party must still "establish" such trusts; see the Part 1 of this article).
However, knowing that a (d)(4)(A) trust is a "first party" trust
is helpful but not conclusive with regard to its income tax treatment.
That depends on whether or not the trust is a "grantor trust".
IRC rules typically do treat "first party" trusts as "grantor
trusts", but actually the drafter can decide whether or not a trust will
be a "grantor trust" -- depending on how he or she writes it.
Before we get to the question of what a "grantor trust" is, and
how to make one, let's look at the implications of being one.If the trust is
a "grantor trust", the IRS treats all of the trust's income, deductions,
and credits as if they were the trust beneficiary's (IRC §671) -- whether
or not any of the income was actually distributed to the grantor/beneficiary.
There are tax advantages if the grantor rather than the trust is liable for
the tax under this rule. First, (d)(4)(A) trust beneficiaries usually
have little or no other taxable income and are in very low tax brackets (and
where the funding is a personal injury recovery, or an annuity purchased with
such a recovery, the initial funding is not taxable income at all under 26 U.S.C.
§104(a)(2)). Second, the tax brackets for trusts are especially steep,
so that most planners seek to avoid having any trust income taxed to the trust
Okay, so let's assume for the moment that we want our (d)(4)(A) trust to be
treated as a "grantor trust". How do we arrange it? The
answer is made difficult by the fact that the "grantor trust" rules
at IRC §§671-678 are lengthy, detailed, and full of exceptions.
In addition, they are in a sense obsolete and backwards. Their original purpose
was to prevent taxpayers from transferring income-generating property into a
trust, and then having the trust pay taxes at lower brackets. But now
trust tax brackets are much higher, so it is actually the grantor who
often has the lower brackets. In any case, the IRS forces "grantor
trust" status on the grantor, and taxes the grantor as if he or she had
received the trust income, where the grantor keeps "too much" control
over the trust or has "too much" interest in it.
So if we want our (d)(4)(A) trust to be a "grantor trust" to take
advantage of the grantor's lower brackets, we must go through these rules to
make sure that the grantor keeps "too much" control and is therefore
"defective". That is, it must clearly violate one or more of
the many "grantor trust" rules that force the trust's creator to pay
tax on trust income. Even more challenging, we have to make sure that
the intentional "defect" does not fall into one of the many exceptions
that "relieves" the trust from "grantor
trust" treatment (but in actuality forces it to pay at the higher trust brackets).
Violating one of the "grantor trust" rules is fairly easy.
Indeed, many commentators simply assume that because (d)(4)(A) trusts are "first
party" trusts they are also "grantor trusts". In many cases,
this is a correct assumption. After all, IRC §677 says that "the
grantor shall be treated as the owner of any portion of a trust, . . . whose
income without the approval or consent of an adverse party, is, or in the discretion
of the grantor or a nonadverse party, or both, may be -- distributed to the
grantor or the grantor's spouse; [or] held or accumulated for future distribution
to the grantor or the grantor's spouse; . . .." What could be a clearer
description of a (d)(4)(A) special needs trust -- in which the grantor is also
the beneficiary at the discretion of the trustee? Next point . . ..
No, not so fast. The problem is that IRC §677 says the IRS will
only treat the trust as a "grantor trust" if the income may be distributed
"without the approval or consent of any adverse party". What's
an adverse party? It's a "person having a substantial beneficial
interest in the trust which would be adversely affected by the exercise or nonexercise
of the power which he possesses respecting the trust" (IRC §672(a)).
IRS regulations help illuminate this language by pointing out that "a trustee
is not an adverse party merely because of his interest as trustee" but
"ordinarily a beneficiary will be an adverse party . . .." (IRS Regs.
§1.672(a)-1(a) and (b)).
When this is all put together and applied to common (d)(4)(A) trusts, a potential
trap comes into focus. Often the trustee of a (d)(4)(A) trust is a parent
or other family member. Because of this, the trustee is often also named
as a residuary beneficiary of the trust after the death of the primary (public
benefits) beneficiary. So the trustee is not only a trustee, but also
an "adverse party" -- because the trustee will be adversely affected
as residuary beneficiary to the extent he or she exercises his or her power
to consent to distributions to the primary beneficiary. When the trustee
makes a distribution he or she logically has to make it with his or her own
consent, i.e., with the consent of an "adverse party". As a
result, the trust is "saved" from "grantor trust" treatment
and taxed at the confiscatory trust tax rates!
Well, if §677 won't work because the trustee is also a beneficiary, some
other violation of the "grantor trust" rules will have to be inserted.
One commentator has suggested three other methods: 1) giving the beneficiary
a special power of appointment (IRC§ 674), 2) allowing the beneficiary
to substitute property of equal value (IRC §675(4)), or 3) permitting the
beneficiary to borrow from the trust without giving adequate security (IRC §675(2)).
Robert Fleming and Stuart Morris, "Taxation of Special Needs Trusts",
NAELA Quarterly, Summer 2001, Vol. 14, No. 3.
The most popular "violation" seems to be a special power of appointment
(IRC §674). Such a power of appointment held by the grantor/beneficiary
also has the merit of preventing a completed gift to the trust for federal gift
tax purposes (an issue if the trust is very large), IRS Reg. §25.2511-2(b).
However, one must tread very carefully; IRC §674 is also full of exceptions
that must be avoided. First, §674 prevents a power of appointment
from triggering "grantor trust" treatment if the power may only be
exercised with the consent of an adverse party (so the power must typically
be exercisable unilaterally by the disabled grantor/beneficiary).
Second, the most tempting power of appointment is one exercisable by will,
in which the disabled grantor/beneficiary can determine who gets the trust estate
after his or her death. One advantage of this type of "intentional
defect" is that the beneficiary does not actually have to be physically
or mentally capable of exercising such a power for it to have the intended "grantor
trust" tax impact. However, IRC §674(b)(3) expressly exempts
powers "exercisable only by will" from "grantor trust" treatment!
This is exactly what we don't want. On the other hand, this provision
also seems to say that if the trustee can accumulate income for such appointment,
and the trustee is a family member residual beneficiary "adverse party",
the power may trigger "grantor trust" treatment after all. Planners
might be able to avoid all this, and guarantee "grantor trust" treatment,
by drafting in a nontestamentary inter vivos special power of appointment for the trust
corpus after death.
In any case, you are all by now properly convinced that these rules can be
surprisingly treacherous. Indeed, they are much too complicated to lay
out in detail in a general article about (d)(4)(A) trusts. What you should
take away is the conviction that you need to be able to point to one or more
IRC rules in §671-678 that clearly make your (d)(4)(A) trust a "grantor
trust". You can't just assume that it is merely because it is a "first
B. Myth No. 2: (d)(4)(A) trusts ought to be "grantor trusts"
All along we have been assuming that we ought to be trying hard to make our
(d)(4)(A) trusts "grantor trusts" so that the income is taxed as if
received directly by the beneficiary. Maybe we shouldn't.
The best way to show why is by example. Suppose a (d)(4)(A) trust receives
$2,000 per month of taxable income, i.e., $24,000 per year, and pays it all
out for the beneficiary's special needs. Suppose also that this particular
trust has an expensive professional fiduciary and also incurs accounting costs
because it is subject to court supervision. Let's say that these amount
to $4,000 per year. If the trust is a "grantor trust", all of
the trustee and accounting charges are passed through to the beneficiary along
with the income. However, the beneficiary has no other deductions to speak
of, and all of the trustee and accountant fees are "miscellaneous deductions".
These are subject to a two percent floor imposed on individual taxpayers (IRC
§67), and also replaced by the beneficiary's standard deduction if it is
higher. In 2003, the standard deduction for a single person is $4,750.
Accordingly, the trust beneficiary will not be able to use any of the itemized
deductions for trustee and accountant's charges, and will pay tax on $16,200
($24,000 minus $4,750 standard deduction and $3,050 personal exemption).
On the other hand, if the trust is not a "grantor trust", it will
be able to deduct its $4,000 in administrative charges, presumably the usual
$100 exemption for a "complex trust", as well as the remaining $19,900
in net income paid out to the beneficiary (IRC §§651 and 661).
The trust will than have zero taxable income and pay no tax. The beneficiary
will be able to deduct his $4,750 standard deduction and $3,050 personal exemption
from the $19,900 he receives -- and pay tax on only $12,100.
Is this contrast stark enough? It gets worse. The Victims of Terrorism
Tax Relief Act of 2001 (Public Law 107-134, enacted January 23, 2002) amended
the IRC provision on trust income tax exemptions. Starting with tax year
2002, a "qualified disability trust", whether taxed as a simple or
complex trust, can claim in lieu of the $100 or $300 exemption, an exemption
in the amount that a single individual taxpayer can claim, i.e., $3,050 in 2003
(IRC §642(b)(2)(C))). What is a "qualified disability trust"?
In the words of the Act, it is a "disability trust described in subsection
(c)(2)(B)(iv)" of 42 U.S.C. §1396p (Section 116). And what is
that? It is a "trust (including a trust described in subsection (d)(4)
of this section of this section) established solely for the benefit of an individual
under age 65 years of age who is disabled . . ." -- a (d)(4)(A) trust!
So, if our (d)(4)(A) is not a "grantor trust" it may deduct not
only the $4,000 in administrative charges, it may also exempt $3,050, and distribute
only a net of $16,950 to the beneficiary (and pay no tax itself). The
beneficiary will then apply against this his own $3,050 personal exemption and
$4,750 standard deduction -- and pay tax on only $9,150.
In such cases, drafters may want to consider how to ensure that the IRS will
treat their trust as a "nongrantor trust". Drafters will have
to go through the "grantor trust" rules to make sure that the trust
is not "defective", i.e., that none of the trust provisions
have violated any of the basic rules, or, if they have, that they have fallen
into one or more of the many exceptions. For example, if the trust has
an independent trustee who is not a family member remainder beneficiary, the
trustee's discretion to make distributions could be conditioned on the consent
of a remainder beneficiary as an adverse party to avoid IRC §677 treatment
as a "grantor trust".
When is a "nongrantor trust" going to be the
better tax deal? It seems to depend on how much the trust distributes
and what it pays for. If the trust distributes all the income each year
for the special needs of the beneficiary, the trust is not going to pay any
income tax whether or not it is a "grantor trust". However,
if it accumulates income, it risks facing stiff trust tax brackets if it is
a "nongrantor" trust. On the other hand, if the trust has
significant administrative costs, overall taxes will be lower if it is a "nongrantor"
trust that can deduct them before it distributes the income. However,
if the trust is paying for supplemental medical expenses that could be partially
deducted by the beneficiary on his or her tax return (above 7.5 % of AGI, IRC
§213(a)), a "grantor trust" may be preferred.
Although the optimal choice apparently depends on the specific factual circumstances,
some circumstances seem more likely than others. Remember that a (d)(4)(A) trust
will have to reimburse Medi-Cal with most or all of the trust estate after the
beneficiary's death -- so it will only be very large trusts that have any incentive
to accumulate income and pay taxes at high trust tax rates. In addition,
small to moderate size trusts will normally have no problem paying out all the
income -- and maybe even a fair chunk of principal -- each year for the beneficiary's
special needs. Accumulation should therefore be unusual. Furthermore,
most trusts have some administrative costs (even if only your attorney's
fees). So it should not be surprising that a "nongrantor"
trust is a better tax choice in many cases.
Finally, none of these distinctions will matter much when the income stream
gets small enough. Then the amount of tax will be de minimis or
even zero whether or not the trust is a "grantor trust". For
example, if the annual income of a (d)(4)(A) trust is only $6,000, it is all
paid for the beneficiary each year, and the beneficiary has next to no other
income, it won't matter whether or not the trust is a grantor trust. The
trust will pay no tax and the beneficiary will be able to shelter up to $7,800
in income with his or her $4,750 standard deduction and $3,050 personal exemption.
C. Tax return procedures
One advantage of grantor trusts is that the tax reporting could hardly be
easier. Although not legally required, the trustee should obtain a Tax
Identification Number (TIN) for the trust so that he or she can supervise the
receipt of the 1099s at the end of the year (if the 1099s are sent directly
to the beneficiary, there may be greater risk that they will be "mislaid").
Nevertheless, the trustee just files an "information only" 1041 telling
the IRS to look for the trust's income on the trust beneficiary's 1040 income
tax return. For example, it might say written across its face, "GRANTOR
TRUST, ALL INCOME AND DEDUCTIONS ARE TAXABLE TO THE GRANTOR, SOCIAL SECURITY
NO. XXX-XX-XXXX; INFORMATION RETURN ONLY". IRS regulations also require
a statement of income, deductions, and credits to be attached, §1.671-4(b)(2).
The trustee can also request and pay for preparation of the trust beneficiary's
1040 and 540 tax returns as one of his or her "special needs".
Further, if the beneficiary's returns show any actual tax, there is no reason
why the trustee can't simply pay it as an additional special need. For
a more detailed description of such tax reporting procedures, see Cynthia L.
Barrett, "Special Needs Trust Tax Issues; Part I: Practical Drafting Tips",
The ElderLaw Report, October 2002, Volume XIV, No. 3, and "The Taxation
of Special Needs Trusts: Considerations for Trustees", The ElderLaw
Report, March 2001, Volume XII, No. 8.
The author would like to thank Peter Stern, Esq., Cynthia L. Barrett, Esq.,
and Linda S. Durston, for their comments on an earlier draft of this article.
( Gregory Wilcox is an attorney in private practice in Berkeley, CA. Copies
of Mr. Wilcox's previous articles are available at www.canhr.org under
From the Spring 2003 Legal Network News
Gregory Wilcox, Esq., is an attorney in private practice in Berkeley,