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Principles of Self-Settled (“First Party”) Special Needs Trusts

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First-party special needs trust

SEPTEMBER 26, 2011 VOLUME 18 NUMBER 34
There is so much confusion about the difference between “self-settled” and “third-party” special needs trusts, that we want to try to explain and simplify some of the key concepts. Here are some of the most common questions (and misunderstandings):

What is the difference between “self-settled” and “third-party” special needs trusts?

This is one of the most perplexing concepts to explain to people, but it is also one of the most important. In general terms, there are two kinds of special needs trusts: “self-settled” and “third-party” trusts. Some people call the former “first-party.” Some make the distinction between “special needs” and “supplemental benefits” trusts. Some talk about “litigation” trusts. But most practitioners use the “self-settled” / “third-party” distinction, and so will we.

“Third-party” special needs trusts (the kind we’re not talking about here) are set up by one person (the third party — sorry about the illogical numbering) for the benefit of another (the first party) who is receiving benefits from the government (the second party in this scenario). Let’s make it simple: if you create a trust for your daughter (who has a developmental disability), and put your own money into the trust, that is a third-party trust. But if your daughter creates her own trust, to hold her money, that is a self-settled trust.

To make things more confusing, most self-settled trusts are not literally self-settled at all. You, for instance, might sign the trust document creating your daughter’s self-settled trust. A judge might authorize you to do so. Your daughter might not be involved at all — in fact, she could theoretically object and still be treated as if she had set up the trust. The key is this: was there a moment in time during which she had the right to receive the money in the trust outright? If so, it is probably a self-settled trust.

Most (but certainly not all) self-settled special needs trusts are set up to receive personal injury settlements or judgments arising from a lawsuit. That may be the easiest way to distinguish self-settled from third-party trusts: if the trust is the result of a personal injury or wrongful death lawsuit, it is almost certainly a self-settled trust.

The second most common circumstance in which a self-settled trust might be created is when a family member leaves money or property outright to an heir who has a disability. Because the recipient had a right to receive the money (or property) outright for at least a moment in time, that kind of trust will usually be a self-settled trust, as well — even though arising from an inheritance.

What difference does it make whether a trust is self-settled or third-party?

All the difference in the world. The former type of trust must have a “payback” provision, returning up to the full value of the trust to any state which provided Medicaid benefits upon the death of the beneficiary (or, in most states, upon the termination of the trust). Third-party trusts do not need to have a payback provision, and it is almost always a blunder to include one.

There are other differences: the self-settled trust will be scrutinized much more closely for types of expenditures (in most states — your experience may vary on this one). Third-party trusts usually fly largely under the radar of public benefits agencies. Self-settled trusts are usually supervised by a court (again, state experience may vary widely); third-party trusts almost never are court-supervised. In Arizona, any self-settled special needs trust must include very restrictive language about how it can be used; third-party trusts need not include that language. In general, if you had a disability or were a trustee you would much rather have your trust be third-party than self-settled.

Who is the “grantor” of a self-settled special needs trust?

This is a particularly fun question. There are at least three different concepts involved here, and they have different language. Everyone — including seasoned practitioners — tends to use the terms interchangeably and the result can be confusing.

Trust law recognizes that someone has to have set up a trust. In trust law that person is usually called the “settlor.” Sometimes you see “trust creator” or some similar language — but the sense is the same. The settlor is the person who said “I hereby create a trust.” Usually they say it in writing, but that is not actually required — or at least not in Arizona. But we digress.

Federal income tax law introduces a different kind of person — the “grantor.” The settlor might not be the grantor. There might be one, two or dozens of grantors for a given trust. But usually, the grantor is the person whose money was transferred into the trust. In the case of a self-settled special needs trust, that will always be the beneficiary — the person with a disability whose public benefits are being protected by establishment of the trust.

Along comes public benefits law and invents another role: the trust “establishor,” if you will. Federal law says every self-settled special needs trust must be “established” by one of the following: the beneficiary’s parent, grandparent, or guardian — or by the court. Notice anyone missing from that list? You’re right — the beneficiary isn’t on the list. [Important update: since this material was prepared (in 2011) the rules have changed. Beneficiaries now can sign their own special needs trusts. But the rest of the information here remains valid.]

So in many self-settled special needs trusts, there are three different people with three different roles:

  1. The grantor, who is also the beneficiary, who did not sign the trust document
  2. The establishor, who might be a judge and might not sign the document at all, and
  3. The settlor, who signed the trust document — perhaps at the judge’s direction.

Can there be more than one grantor in a self-settled special needs trust?

Technically, yes — but only technically. Some states (not including Arizona, happily) require that the establishor of a self-settled special needs trust put some money or property into a trust in order for it to exist. In those states a parent might sign a special needs trust, and staple a $10 bill to the trust to show that it has been legally created. That makes the parent a grantor for tax purposes — as to the $10 investment. The rest of the money comes from the beneficiary’s personal injury settlement (or inheritance, or savings), which makes the beneficiary the grantor for the bulk of the trust’s assets. So technically the parent and the beneficiary are both grantors. Sound like an absurd distinction? It is.

Does a self-settled special needs trust need a new tax identification number?

No. At least, not usually. The beneficiary’s Social Security number will suffice just fine. Some banks, brokerage houses and accountants may argue otherwise, but there is a special IRS rule for such trusts, even though the grantor/beneficiary is not the trustee. But because the trustee is not the beneficiary, it is permissible for the trust to get a separate number — it is called, incidentally, an Employers Identification Number (or EIN), even if the trust does not have any employees.

What can a self-settled special needs trust pay for?

Ah, that is a great question — and very difficult to answer. It depends on so many factors. One must look at the trust instrument itself, at state law governing self-settled special needs trusts and at the appropriate Social Security and Medicaid rules. Sometimes there are things that the trust could pay for that it should not. Sometimes there are things that the trust ought to be able to pay for, but that it can’t — even though everyone might agree that they would benefit the beneficiary. You might look at the Special Needs Alliance’s “Handbook for Trustees” for better guidance, but at some point you are just going to need to talk to an experienced and capable lawyer. The Special Needs Alliance might be able to help you there, too.

We hope that helps explain what a self-settled special needs trust is. Next week we plan on telling you about third-party trusts, and some of the rules governing them.

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Robert B. Fleming

Attorney

Robert Fleming is a Fellow of both the American College of Trust and Estate Counsel and the National Academy of Elder Law Attorneys. He has been certified as a Specialist in Estate and Trust Law by the State Bar of Arizona‘s Board of Legal Specialization, and he is also a Certified Elder Law Attorney by the National Elder Law Foundation. Robert has a long history of involvement in local, state and national organizations. He is most proud of his instrumental involvement in the Special Needs Alliance, the premier national organization for lawyers dealing with special needs trusts and planning.

Robert has two adult children, two young grandchildren and a wife of over fifty years. He is devoted to all of them. He is also very fond of Rosalind Franklin (his office companion corgi), and his homebound cat Muninn. He just likes people, their pets and their stories.

Elizabeth N.R. Friman

Attorney

Elizabeth Noble Rollings Friman is a principal and licensed fiduciary at Fleming & Curti, PLC. Elizabeth enjoys estate planning and helping families navigate trust and probate administrations. She is passionate about the fiduciary work that she performs as a trustee, personal representative, guardian, and conservator. Elizabeth works with CPAs, financial professionals, case managers, and medical providers to tailor solutions to complex family challenges. Elizabeth is often called upon to serve as a neutral party so that families can avoid protracted legal conflict. Elizabeth relies on the expertise of her team at Fleming & Curti, and as the Firm approaches its third decade, she is proud of the culture of care and consideration that the Firm embodies. Finding workable solutions to sensitive and complex family challenges is something that Elizabeth and the Fleming & Curti team do well.

Amy F. Matheson

Attorney

Amy Farrell Matheson has worked as an attorney at Fleming & Curti since 2006. A member of the Southern Arizona Estate Planning Council, she is primarily responsible for estate planning and probate matters.

Amy graduated from Wellesley College with a double major in political science and English. She is an honors graduate of Suffolk University Law School and has been admitted to practice in Arizona, Massachusetts, New York, and the District of Columbia.

Prior to joining Fleming & Curti, Amy worked for American Public Television in Boston, and with the international trade group at White & Case, LLP, in Washington, D.C.

Amy’s husband, Tom, is an astronomer at NOIRLab and the Head of Time Domain Services, whose main project is ANTARES. Sadly, this does not involve actual time travel. Amy’s twin daughters are high school students; Finn, her Irish Red and White Setter, remains a puppy at heart.

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Matthew M. Mansour

Attorney

Matthew is a law clerk who recently earned his law degree from the University of Arizona James E. Rogers College of Law. His undergraduate degree is in psychology from the University of California, Santa Barbara. Matthew has had a passion for advocacy in the Tucson community since his time as a law student representative in the Workers’ Rights Clinic. He also has worked in both the Pima County Attorney’s Office and the Pima County Public Defender’s Office. He enjoys playing basketball, caring for his cat, and listening to audiobooks narrated by the authors.