What is a “third party” special needs trust?

When someone uses his or her own money to set up a special needs trust (SNT for short) for another person, that’s called a “third party” SNT.

It’s the best kind of SNT for two reasons.

First, unlike a “first party” or “self settled” SNT (established with the beneficiary’s own funds) a third party SNT does not have to be a “payback” trust. A first party SNT must provide that when the beneficiary dies, any remaining funds in the trust have to go to the state to pay back any Medicaid costs paid for the beneficiary. Only after the SNT pays back those costs can any remaining funds go to other beneficiaries.

But a third part SNT can leave remaining funds to others with no payback requirement.

Here’s an example. Mary has one disabled child, Eric, and two others who are not disabled. She decides to leave, say, $100,000 to Eric. If Mary leaves the money to Eric outright, he could arrange to have it placed into a payback trust. If $40,000 remained in that trust when Eric died, the rest would go first to pay back any Medicaid costs the state paid for Eric while he was alive. If there was anything left after paying the state, the remainder could go to Mary’s other two children.

But if Mary’s will established a SNT for Eric, that would qualify as a third party trust. If $40,000 remained when he died, the entire amount could pass to Mary’s other two children.

Second, a third party SNT is easier to establish. A competent person wishing to establish a SNT for another person can simply sign the trust document.

On the other hand, a person wishing to set up a first party SNT with his or her own money cannot just go ahead and do that. For some unknown reason, the law requires a parent, grandparent, legal guardian, or court to establish the trust for such a person. That requirement can pose a difficult hurdle, and require additional legal expense, if the parents and grandparents are deceased or incapacitated, or there is no legal guardian.

Third party trusts require advance planning, but they’re worth it.

What can a special needs trust pay for?

You may know that a special needs trust generally pays for the supplemental needs of the disabled, in order to preserve access to means-tested public benefits.

But what are those supplemental needs?

Commonly paid items

Below is a list of items that are often paid for by special needs trust.

Education – tuition, tutors, books, supplies

Computer, printer, internet, technological support

Home care, if not paid by another program

Phone or mobile phone, voice and/or data plan

Entertainment

Cable TV

Clothing (wasn’t always allowed to be paid for, but has been since 2005)

Medical supplies and equipment, such as wheelchairs, hearing aids, etc.

Eyeglasses

Vacations, including tickets or other travel charges, hotel

Companionship

Exercise and physical therapy equipment

Furniture

Health insurance premiums

Life insurance premiums

Household supplies and cleaning products

Tools used for home repair and maintenance

Dental costs

House and vehicle

Two items that raise more complicated questions are the purchase of a house and a vehicle. Both may be beneficial and even necessary, and can often be purchased with funds from the trust. However, keep in mind that the purchase of such items raises complex questions of title and ownership, upkeep, insurance, and contribution by other family members.

Important caveats

Keep in mind that this list is not comprehensive. There any number of other items that will not reduce benefits and could be paid for by a special needs trust.

Check the terms of the trust. Even if an item is on this list, make sure the trust document itself allows the expenditure.

The general rule is that a special needs trust pays for items other than food and shelter. Such items could be paid for, but the purchase raises the issue of “in kind support and maintenance,” also referred to as ISM, which can reduce benefits. There may be reasons why the trust should make ISM payments, but that is a complicated topic for another blog post.

Check the rules of your local jurisdiction. Some states have rules that are more restrictive than others.

And of course, it’s best to seek competent professional advice before making distributions from a special needs trust. (Corporate trustees such as banks, trust companies, and nonprofits that are approved for handling special needs trusts, often serve as trustees of special needs trusts, rather than a family member or friend, because of the legal complexity.)

What is a “self settled” special needs trust?

A “self settled” special needs trust is a particular type of special needs trust (SNT). In this post I’ll explain what it is, and when and how it is used. (For an explanation of SNTs in general, read this prior post.)

First, some terminology. A self settled SNT is also called a “first party” SNT or a “payback” trust or a “(d)(4)(A) trust” after the U.S. Code section (42 U.S.C. § 1396p(d)(4)(A)) that exempts it from being counted as a resource that would disqualify the beneficiary from certain types of public benefits (more on that shortly). The “beneficiary” is the person for whom the trust is created.

It’s called a first party or self settled trust because it is created using funds the beneficiary has or may soon receive. The two most common examples are lawsuits and inheritances.

Lawsuit. Sidney has permanent brain damage after a careless driver struck him in a crosswalk. He can no longer work and survives on his Supplemental Security Income (SSI) and has medical benefits through Medicaid.

His lawyer reaches a settlement with the defending insurance company that will net Sidney about $400,000. If Sidney received the money outright, he would lose his monthly SSI payments and (perhaps more importantly) his Medicaid health coverage because both programs limit the amount of assets a person can own and still qualify for benefits.

But if the money funds a SNT for Sidney, he can keep his benefits. The SNT can then pay for other items that will help Sidney throughout his lifetime.

Inheritance. Tilly has had mental impairments since birth. Like Sidney, she is unable to work and gets by on SSI and Medicaid.

Her loving grandmother remembered Tilly in her will. Grandma recently died and Tilly stands to inherit $200,000. Though Grandma was well intentioned, she didn’t realize that it would throw Tilly off benefits to receive a $200,000 check.

A self settled SNT for Tilly provides the solution. By receiving distributions from the trust for the rest of her life, Tilly can benefit in many ways from Grandma’s generosity.

Payback requirement. Unlike some other types of SNTs, a self settled SNT must contain a “payback” provision. That is, the trust must provide that upon the death of the beneficiary, any funds remaining in the trust will pay back the state for whatever Medicaid costs the state paid on the beneficiary’s behalf.

In some cases, a payback requirement may make little difference. Take Tilly for example. If she is young enough, and has enough needs that can be met through the trust, its funds may be exhausted when she dies.

But if the amount were larger, or Tiller were older, or had few needs, a sizeable balance could remain when Tilly dies. Here’s where better planning on Grandma’s part could have helped. If Grandma’s will had said that Tilly’s $200,000 would go into a special needs trust, the law would have considered that a “third party” SNT. Unlike a first party trust, a third party trust does not require a payback provision. Grandma could have left the remainder upon Tilly’s death to her other grandchildren.

Age requirement. Another requirement of a self settled SNT is that the beneficiary must be under age 65 when the trust is created. If a disabled plaintiff or heir is approaching age 65, act quickly.

If a potential beneficiary is 65 or older, a “pooled” SNT could be an alternative. In Pennsylvania, state law purports to limit all SNTs to those under age 65, but a federal court recently ruled that requirement invalid as applied to pooled trusts. (The state has appealed the ruling.)

Creation. Here is an interesting technicality that sometimes causes confusion. You would think that the beneficiary of a so-called “self settled” or “first party” would be able to create the trust himself. But you would be wrong. No, a parent, grandparent, legal guardian or court must create this type of trust. Often a court is already involved, handling the estate that creates the inheritance or the lawsuit brought by the beneficiary, and a lawyer asks the judge to authorize creation of the SNT. Oddly, no one seems to know the reason for this creation requirement. Maybe someday Congress will eliminate it since it has no apparent purpose and just causes extra work (and sometimes legal expense).

What is a special needs trust?

People with disabilities often have particular needs for services and supports, beyond the basic necessities of life. One way for family and friends to support people with disabilities is to set up a trust to help provide funding for those needs, or to pay for things that will improve quality of life.

A special needs trust holds funds used to benefit a person with disabilities (called a “beneficiary”). It is governed by a trust document that specifies how those funds can be used. A trustee is named to manage the trust and make distributions to help the beneficiary.

Protecting access to public benefits

Special needs trusts often have provisions to ensure that the beneficiary will not lose public benefits.

That’s because some public benefits programs benefitting the disabled, such as Medicaid or Supplemental Security Income (SSI), have restrictions on how much a recipient can own, or receive in income. (These are called means-tested programs.)

Grandma may think she’s helping her Suzie, her autistic granddaughter, with a handsome inheritance, but the inheritance could cause Suzie to lose her medical benefits because she would have too much money. Suzie may have to spend down her inheritance to pay for medical care that was previously covered, and then go back on benefits with her inheritance exhausted.

If a special needs trust is set up the right way, Suzie can often keep her benefits and the trust can pay for a variety of supports and service that will improve Suzie’s quality of life for years to come.

Types of trusts

Trusts for the benefit of those with special needs come in different varieties. Most, however, fall into one of three categories.

First party trusts. (Also called “self settled” or “payback” trusts.) This type of trust is created when a person uses his or her own funds, or funds earmarked to go to that person, to establish a special needs trust.

For example, Joe was injured in a severe accident and is now a paraplegic. Joe may later receive an inheritance or a payout from a personal injury lawsuit. Joe may want to establish a special needs trust to avoid losing public benefits he receives now, or might receive in the future.

Keep in mind that a first party special needs trust for Joe can be established only if Joe is under age 65 at the time.

These trusts are sometimes called “payback” trusts because they must contain a provision that when the beneficiary dies, any amount remaining in the trust must go to pay back the state for the value of any public benefits the beneficiary received. If anything remains after that payback, it can go to other beneficiaries, such as family members.

Sometimes you will hear people call first party trusts “(d)(4)(A)” trusts, referring to 42 U.S.C. §1396p(d)(4)(A), which was part of the Omnibus Budget Reconciliation Act of 1993, or “OBRA ‘93.” That federal law exempts certain trusts from being considered the property of the beneficiary for public benefits purposes.

Third party trusts. When the funding for a special needs trust comes from someone besides the beneficiary, that’s called a third party trust.

The typical situation is for a parent, grandparent, or other relative to give the money for the trust. The person establishing the trust may do so while alive, or at death with a provision in his or her will.

Unlike a first party trust, a third party trust does not need to be a payback trust. Instead, any amount remaining when the beneficiary dies can go to others, perhaps the beneficiary’s brothers and sisters, with no requirement to pay back the state for public benefit costs.

Also unlike first party trusts, the beneficiary can be any age – even over 65 – when the trust is established.

Pooled trusts. A special needs trust can also be established as a “pooled” trust with an approved nonprofit association. Funds in this type of trust are pooled together with other special needs trusts for investment purposes, but a separate account is maintained for each beneficiary.

Funds to establish a pooled trust account can come either from the beneficiary or from a third party.

A pooled trust is often used when the amount of the trust is relatively small. Administrative fees for trust management can be lower due to efficiencies and shared costs, and the cost of establishing an account in a pooled trust are often minimal.

Nonprofits operating pooled trusts are permitted to retain funds of deceased beneficiaries to assist other persons with disabilities, but not all of them do. When a beneficiary dies, funds remaining in that beneficiary’s account go to pay back the state for any Medicaid benefits the beneficiary received, unless the trust retains those funds.

The legal shorthand for a pooled trust is a “(d)(4)(C)” trust, referring to 42 U.S.C. §1396p(d)(4)(C).

Which is the right one?

Whether to establish a special needs trust, and is so what type, can be a complicated decision, often taking into account such considerations as the amount of money involved, the source of the funds, the beneficiary’s age, type of disability, type of benefits (if any) the beneficiary receives now or could receive in the future, and a number of other factors. Objectives vary from client to client.

For this reasons, it’s best to consult an experienced professional in your jurisdiction before establishing a special needs trust.