Should the Parent/Donor Serve as Sole Trustee of a Third-Party Funded Special Needs Trust?

by Lynne Spangler, Esq.

Estates, Trusts and Wealth Transfer Group  • McAndrews Law Offices, P.C.

 

                Estate planning for parents of children with special needs more often than not will include the establishment of a Third-Party Funded Special Needs Trust (TPF SNT). This Trust may, and often does, remain “dry,” or unfunded, until the passing of both parents, at which time the share of the estate earmarked for the disabled child will pass directly to the Trust.

 

                In the typical situation where the TPF SNT is not expected to be funded until both parents are deceased, one or both parents are usually designated as the initial co-Trustees, and the Trust document sets forth the name or names of one or more persons or corporations who will serve as successor Trustees upon their deaths. Obviously, the parents/trustees will have no duties or responsibilities so long as the Trust remains unfunded.

 

                Sometimes, however, parents may decide to make gifts to such a trust during their lifetimes, rather than waiting until they pass. This may be done for a number of reasons, each of which may or may not have an impact on whether it is in their best interest to serve as Trustee.

 

                One reason some parents wish to make lifetime transfers to a TPF SNT is simply the peace of mind in knowing that the trust is funded and ready for use should the parents pass away unexpectedly. A delay in estate administration might result in the TPF SNT not being funded for a longer time than anticipated after death.

 

                In this situation, and assuming the parents are not in the federal estate tax bracket, one or both parents may be named as the trustee or co-trustees during their lifetimes. The parents will control whether the assets remain in the trust and grow, or are used from time to time for the beneficiary’s needs. When the parents  pass, the successor Trustee named in the document will immediately have control over the distribution of the assets for the beneficiary.

 

                But for a client whose assets are within the federal estate tax bracket, a lifetime transfer to a irrevocable TPF SNT, may, in addition to providing some peace of mind, be an attractive method to reduce his taxable estate. The opportunity exists to eliminate the appreciation on the transferred assets from the date of transfer to the date of death from the client’s estate tax base. However, to meet this goal, the client should not serve as sole Trustee but rather, should name an independent person or corporation to serve as sole or co-Trustee. Under the Internal Revenue Code, the grantor (donor) of an irrevocable trust who retains the power to make discretionary distributions from the income and principal of a trust to persons he has a legal obligation to support (unless subject to certain limitations), will be deemed to have made an incomplete gift, meaning that the assets are included in his taxable estate at his death. If the grantor/parent is the natural guardian of the trust beneficiary (i.e. because the beneficiary is a minor) or Court appointed guardian (i.e. because the beneficiary is an intellectually disabled adult), he has a legal obligation to support the beneficiary, and would fall under the purview of the statute.  Upon the grantor’s death, the fair market value of the assets (including the appreciation thereon) would be included in his taxable estate, thereby negating the intended benefit of the initial lifetime transfer to the trust.

 

                Moreover, the grantor would be considered the owner of the assets for income tax purposes, with the net income of the trust reportable on his own Form 1040 each year.

 

                However, it is interesting to note that even where estate tax exclusion is the grantor’s goal, he may nonetheless desire to be deemed the owner for income tax purposes only. There are several reasons for this: First, the payment of income taxes by the grantor will allow the trust principal to grow for the disabled beneficiary without being reduced by the payment of income taxes.  Second, the payment by an individual of the income tax imposed on a trust is much more tax efficient. This is due to the disparity in how taxes are assessed on an individual and on a trust, with a trust’s income tax rates being much more compressed. Indeed, a trust will be taxed at the highest individual income tax rate on just over $12,000.00 of income.  An additional consideration for a grantor in the federal estate tax bracket is that the payment of these income taxes is a way to further reduce his taxable estate.

 

                A question that many clients have asked when presented with the above information is whether a grantor can have the best of both worlds – that is, can he remove the transferred assets from the taxable estate while being deemed the owner of the trust assets for income tax purposes?

 

                The answer if “yes.” Under a complex set of IRS statues and regulations, a grantor of an irrevocable trust can make a completed gift to a trust (thereby removing the assets from his estate tax base) while at the same time being deemed the owner of the same assets for income tax purposes (thereby having any trust income subject to individual income tax rates).

 

                But beware: this dual benefit cannot be achieved if the grantor is serving as the sole Trustee with the discretionary powers to distribute the income and principal as described above. However, a carefully drafted trust document will name an independent trustee and give the grantor certain rights or powers which, according to the IRS, will result in the grantor being taxed for income tax purposes, despite having made a completed gift. The most popular power used to achieve grantor trust status is the power to substitute assets of equivalent value (that is, to make a trade or swap the assets already in the trust with other assets). Inclusion of such a trust provision in favor of the grantor results in the trust being classified as a “grantor trust” for income tax purposes. A grantor trust is considered to be a disregarded entity for income tax purposes. As a result, not only does the grantor report the income on his personal income tax return, the grantor can make sales to the trust without recognizing capital gains on the transaction.  The grantor trust rules and the advantages and disadvantages of invoking them in various situations is a topic addressed in much of today’s estate tax literature, and, other than as touched on above, is beyond the scope of this article.

 

                When discussing whether the grantor of  a TPF SNT should serve as the sole Trustee, the  grantor should discuss several intertwined issues with the estate planning attorney.  A general checklist of questions should include the following:

 

-Will the TPF SNT be funded by the grantor during his lifetime?

-If no, the grantor certainly can serve as trustee until his death

-If yes, does the grantor intend to make one or more completed gifts for estate tax purposes?

-If no, the grantor can serve as trustee until his death

-If yes, the grantor should not serve as sole Trustee

-Does the grantor want to be treated as the owner of the assets for income tax purposes?

-If yes, the document should include one or more of the powers to effectuate this outcome.

 

                When choosing a Trustee of  a TPF SNT, careful attention must be given to the donor’s intentions as well as to his or her estate and income tax goals.  Careful drafting of the trust will include provisions whereby the grantor who serves as initial trustee, but later decides that this may have negative estate tax consequences, will retain the right to resign and/or to name one or more additional or successor trustees.