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Notes on Special Needs Trusts

By Peter Stern, Esq.

How many times have you heard a client express regret that her son has bipolar disorder, is on SSI, and she doesn’t know what to do in her estate plan other than leave everything to the two daughters, hoping they will take care of the son? This is not a refrain I hear much in my office any more, because special needs planning has become routine, if not a standard of practice, in the past decade. Our major treatises describe special needs planning as a subset of estate planning [CEB’s Will Drafting; Drafting Irrevocable Trusts; Lexis Nexis’s California Wills and Trusts treatise, among others] and provide exemplars and document assembly versions of special needs trusts. CEB provides annual CLE seminars on the special needs trust; NAELA conferences devote sessions to the special needs trust; and, of course, CANHR’s annual Elder Law Conference provides a panel on public benefits and special needs trusts.

A special needs trust may have many objectives. First, it is intended to provide for those needs of a disabled or impaired beneficiary that are not being met by government benefits. Some practitioners continue to believe that the primary purpose of such trusts is to protect eligibility for these benefits, but most planners realize that benefit eligibility is a small piece of the picture; the real objective is to enhance the life of a disabled or impaired person by providing better care, a better environment, supplemental medical needs, supplemental therapies, leisure and recreational opportunities, or other enhancements that the individual does not have the means to meet otherwise. Another goal might be to extend among the family members of the person establishing the trust the benefits of the family’s wealth: the special needs trust is there to help the disabled child, but when that child is dead, the trust is there to benefit the surviving children, or the issue of the disabled child.

Types of Special Needs Trusts

In its most elementary form, the trust holds income and principal, and the trustee pays from the trust for those things that government benefits do not pay for. The trustee is directed to decline demands for distribution by the beneficiary, or by any other person or entity — the trust is a spendthrift trust. And the trust instrument generally places severe restrictions on distributions for purposes that otherwise are covered by government benefits or by payments from other sources.

This brief survey will outline a number of basic types of special needs trusts.

1. Third Party Trusts in Estate Planning: A third party special needs trust is funded with assets of a third party to benefit a special needs beneficiary. These trusts can be set up during the lifetime of the settlor or established only as part of decedent’s estate plan, either by will or by trust. For example, a parent can provide for a child, as part of the parent’s estate plan, with a special needs trust to be funded only after the death of the parent. Where a couple’s estate plan is involved, the trust might not be set up until both spouses had died. Some persons prefer to establish a special needs trust during their lifetimes, often in order to induce other family members to make gifts to the trust, or to be sure that a trust exists to meet a beneficiary’s special needs, even during the lifetime of the parent. An intervivos trust can be revocable by the settlor, or can be irrevocable; those trusts funded at the death of the individual are of course irrevocable.

So long as the beneficiary cannot get to the income or principal of the trust, a third party special needs trust should be safe from challenge by a governmental entity. Drafting considerations, discussed in detail in the treatises referred to at the beginning of this article, should guide the planner in avoiding unfortunate distribution provisions that might place a trust in jeopardy.

[SSI rules regarding third party trusts, and first party trusts established prior to January 2000, are in the POMS at SI 01120.200; Medi-Cal regulations regarding third party trusts are in 22 CCR 50489.9.]

Examples of third party trusts include: Trusts for a child, established by a parent; trusts for a sibling, established by a sibling; trusts for a parent, established by a child, trusts for a spouse, established by will by a spouse. When individuals make gifts in order to qualify for public benefits, donees often arrange to fund precatory special needs trusts with the gifts.

Inclusion Of In Kind Support Provisions In Third Party Trusts: Beneficiaries of SSI are supposed to use their SSI payments, or other disability payments such as Social Security Disability, if any, for food and shelter; payment for these items from a special needs trust, or from any outside source, will reduce the amount of SSI paid, and if food and shelter payments exceed the presumed maximum value amount [for an SSI person living independently], SSI would be reduced to zero. The presumed maximum value amount for 2006 is $221.

The drafter faces the challenge of crafting language that will permit the trustee to supplement benefits with trust income or principal, where it is possible to provide substantial enhancement to the beneficiary’s lifestyle, without making the trust a support trust.

Language that clearly directs the trustee to look primarily to government benefits when they are available but offers discretion to supplement them should be sufficient; the following language, excerpted from the CANHR Elder Law Conference 2005 program materials, provides an example:

Further, and as an exception to the above restrictions, the Trustee may, in the Trustee’s sole discretion, make expenditures from the trust for in kind support and maintenance if, in the Trustee’s opinion, the benefit to the beneficiary is greater than the reduction of [the beneficiary’s] benefits.

Reformation of Support Trusts, or of Outright Distributions, to Special Needs Trusts: There may be a remedy for the situation in which a relative simply failed to provide a special needs vehicle for a beneficiary on public benefits. California courts have generally been receptive to petitions for reformation of trusts made irrevocable on the death of the settlor in which the settlor by oversight or by ignorance did not provide a special needs mechanism to hold the distribution directed to the special needs beneficiary.

Probate Code Section 15403 permits all beneficiaries to modify or terminate an irrevocable trust, upon petition to the court, so long as the modification or termination does not impede carrying out a material purpose of the trust. Section 15409 permits modification or termination in changed circumstances.

Most courts are receptive to a petition, supported by declarations relating to the circumstances of the settlor and of the special needs beneficiary, that provide evidence that the settlor would have used a special needs mechanism had he or she known of the circumstances of the beneficiary, or that the law permitted such mechanisms.

Avoiding a Payback Clause: One thing that would get the attorney into court quickly for reformation purposes is a third party trust with a payback provision. A third party trust is funded with assets of — a third party! What the parent or uncle or brother provides to the beneficiary is relevant to the state only to the extent that trust assets or income are actually distributed to a special needs beneficiary.

The inclusion of payback provisions first in California law (AB 3328, effective 1/1/93, codified at Probate Code Sections 3600 et seq.), then in the 1993 OBRA amendments (42 U.S.C. 1396p(d)), California regulations (22 C.C.R. 50489.9), and the Foster Care Independence Act of 1999, affecting trusts for SSI beneficiaries (POMS: SI 01120.201), apply to trusts containing the assets of the beneficiary, not to third party trusts.

Occasionally a drafter slips up and includes a provision to pay the state back from a third party trust for benefits received. This should be caught and corrected as soon as possible.

2. The First Party Special Needs Trust: When the special needs beneficiary has assets to shelter to maintain or establish eligibility for public benefits, he or she can establish, or have someone else establish, a first party special needs trust.

If an individual, or the spouse of the individual, sets up the trust himself or herself, the transfer of nonexempt assets to the trust creates ineligibility for Medi-Cal during the lookback period, and whatever can be distributed from such a trust is considered an available asset for the beneficiary.

Nevertheless, and individual or spouse can create such a trust as an income only trust, live off of the income during the lookback period, and then have the trustee switch to growth investments when the individual would otherwise become eligible for long-term care Medi-Cal. [These trusts are the only first party trusts known to this author that do not have required payback.]

Planners do not often have occasion to provide for this type of trust. The more conventional first party trust situations arise where a benefits recipient receives a settlement from a lawsuit; or is the beneficiary of a trust or testamentary disposition that has already been distributed; or receives a substantial back payment of SSI or social security disability and will lose eligibility if he or she retains the money in outright ownership.

It is a convention to analyze first party trusts as "d4A" trusts or as litigation special needs trusts. In fact, all first party trusts that are established to permit immediate eligibility for benefits must fit within the "d4A" requirements; and those that are established under Probate Code Sections 3600 et seq. have additional requirements.

Note that with passage of AB 1851 (effective 1/1/05), amendments to the special needs provisions of Sections 3600 et seq. provide opt-out opportunities for disabled but competent special needs beneficiaries, allowing such individuals to conduct normal settlement negotiations and agreements without the need to involve DHS in establishment of a special needs trust.

The major requirement for all such trusts is a payback provision. As stated in 42 U.S.C. 1396p(d), exemption to the trust exclusions of OBRA apply to "A trust containing the assets of an individual under age 65 who is disabled . . . and which is established . . . by a parent, grandparent, legal guardian of the individual, or a court if the State will receive all amounts remaining in the trust upon the death of such individual up to an amount equal to the total medical assistance paid on behalf of the individual [by Medi-Cal]." California regulations adopted this language [22 CCR 50489.9], and the Foster Care Independence Act of 1999, which reimposed penalties on transfers by SSI recipients, created an exception for transfers to trusts conforming to the "d4A" characteristics.

Although there was some dispute about the question in 1993, at the time OBRA was passed, it is now settled in the state and federal regulations that an individual for whom such a trust has been created and funded prior to reaching age 65 can still benefit from the trust after attaining age 65.

The structure of a first party trust resembles that of a third party trust in most regards. The beneficiary can have no control over the trust, except to exercise a special power of appointment; trustee restrictions are similar to those in third party trusts; and the trustee can be instructed to use the trust for in kind support, with proper drafting.

There are additional restrictions on trustee distributions after the death of the beneficiary: SSI regulations, and to a lesser extent Medi-Cal regulations and practice, require that the state be the primary payee and that no expenditures for burial and funeral expenses be made from the trust.

There is a particular irony to this prohibition in that it is possible for an SSI beneficiary to set up a burial trust and to prepay a burial site; but it is prohibited for the trustee to pay these expenses from the special needs trust after the death of the beneficiary.

The litigation trust compared to a d4a trust: When a person on public benefits is to receive a settlement or judgment and is either incapacitated or opts to use the mechanism of Probate Code Sections 3600 et seq., it is necessary to comply with the provisions of Section 3604 and the notice provisions of Section 3602 or 3611.

Under Section 3604, the court has to make findings that there is a substantial disability, that the individual will have special needs that cannot be met without the trust, and that the money to be paid to the trust does not exceed the amount that appears reasonably necessary to meet the beneficiary’s needs.

The trust must provide for payment of all claims by state agencies that have provided funds to the beneficiary, whereas the payback provisions of d4A trusts require that all money in the trust must essentially be tendered to the state, up to the amount paid for the benefits of the recipient. Shewry v. Arnold, 125 Cal. App. 4th 186, 22 Cal./ Rptr. 3rd 488, 2004, held that where a beneficiary of a litigation special needs trust was survived by a disabled child, no recovery is due from special needs trusts. The author considers this favorable holding questionable.

In examining the different requirements of d4A trusts and litigation special needs trusts, drafters should remember that all litigation special needs trusts are d4A trusts in the eyes of Medi-Cal and SSI.

Getting a first party trust set up: Although a disabled individual can transfer assets to his or her trust, the law does not permit the individual to be the settlor of the trust.

The statute clearly permits the court, or a parent or grandparent, or a guardian (conservator in California for someone over age 18) to be settlor of the trust. So it would be possible to use a Conservatorship and substituted judgment; or to set up the trust through the Section 3600 proceedings; or to have a parent or grandparent establish the trust.

For individuals under age 65 who have no parent or grandparent, who have capacity, and who want to avoid the expense of a Conservatorship, it is possible to name an attorney in fact with the power to create a trust and then have the attorney in fact get a court order passing on the proposed action of establishing the trust. By this procedure the court "establishes" the trust by approving the petition of the attorney in fact, who then settles the trust.

The statute for enforcement of powers of attorney applies: Probate Code Section 4500, and 4541(b). Some courts allow these matters to be done ex parte, since only the principal and the agent are entitled to notice. The agent is the petitioner, of course, and the principal can ratify the petition.

Complying with California Rule of Court 7.903: This rule of court, described in detail in the CANHR Legal Network News, Spring 2005, retains court jurisdiction over certain court-created and court-funded trusts, specifically those acted upon under Probate Code Sections 2580 et seq., 3100 et seq., and 3600 et seq. Trusts created under Section 4500 are not included. Drafters should read the rule of Court with care at the time they draft the trust, to avoid conflicts that would cause the court to reject the trust.

Anyone working in this area should review the fine series on d4A trusts written for the Net News by Gregory Wilcox, A (d)(4)(A) Q & A, (a four part series from 2002 and 2003 available on CANHR’s website). This four part series examines in detail questions relating to taxation of special needs trust, distribution possibilities, and most other aspects of the d4A trust.

Peter S. Stern, Esq. is an attorney in private practice in Palo Alto, California.