To Grant(or) Not? Choosing the Right Structure for Your Special Needs Trust

By:
Ashley Velategui, CFA
Published Date:
Sep 1, 2017

Raising a special needs child can be one of life’s greatest joys, but their parents face unique challenges—not the least of which is figuring out how to financially provide for the child after both parents have passed away. For many families, a special needs trust (SNT) will serve as the linchpin of their financial plan. If structured and administered properly, these vehicles can provide the necessary funds without jeopardizing access to essential government benefits, such as Supplemental Security Income (SSI) and Medicaid. SNTs also play a critical role in asset protection by safeguarding the beneficiary’s assets from creditors, financial predators, and even intra-family disputes.

Deciding to fund an SNT is only the first step. One must then determine which type of SNT to use and how to fund it: how much and with what assets. For families funding third-party SNTs, there are two additional considerations: when the trust should be funded and how the trust should be structured for tax purposes. As you might imagine, these are complex questions that each family must evaluate based on its goals and circumstances.

Third-Party Special Needs Trusts

While there are three primary categories of special needs trusts, the third-party SNT is the most common. These trusts are funded with assets owned by someone other than the disabled beneficiary—generally parents, guardians, or other family members. There is no limit on the amount of wealth that can be contributed to the trust and no age restrictions for establishing the trust. Unlike other types of SNTs, assets remaining in a third-party SNT are not subject to unfavorable “payback” provisions. Because of this, the trust is not required to reimburse the state for medical expenses following the death of the beneficiary. Rather, all assets remaining in the trust can be transferred on as a legacy for other family members.

It should be noted that third-party SNTs might not be available in all circumstances. In some cases, first-party special needs trusts (funded with assets owned by the beneficiary) or pooled special needs trusts (which combine the assets of multiple beneficiaries into a single portfolio managed by a nonprofit organization) might be more appropriate or required.

When to Fund a Third-Party Special Needs Trust

A third-party SNT can either be funded during the lifetime of the grantor or upon the grantor’s death. As with most estate planning strategies, there are pros and cons associated with each. It should be noted that funding an SNT during one’s lifetime is not always feasible, even for families with means. The assets might be needed to support the spending requirements of the grantor—often the beneficiary’s parent—and irrevocably transferring those assets to an SNT could cause undue financial stress. For this reason, along with others, many families opt to fund their special needs trust upon the grantor’s death.

The grantor can continue to provide financial support directly to the special needs beneficiary during his or her lifetime while retaining control of, and access to, all of the assets. In addition to preserving flexibility, delaying the trust funding also eliminates the complexity of having to administer the trust longer than necessary. For instance, in addition to filing a Form 1041 on behalf of the SNT, if the trust is making distributions, the trustee will need to issue a Form K-1 to the beneficiary and might need to provide detailed annual accountings to the beneficiary, the Social Security Administration, and Medicaid. Furthermore, SNTs are commonly funded, either in part or in whole, with the proceeds from a life insurance policy, making funding the trust upon the grantor’s death a logical choice.

On the other hand, many people find comfort in knowing that the SNT has been fully funded during their lifetime and that the assets are protected against future creditors of the grantor. Importantly, the trust need not begin making distributions immediately. If, during his or her lifetime, the grantor continues to support the beneficiary, the assets in the SNT can continue to grow, thereby reducing the initial required trust funding.

In addition to providing peace of mind, funding an SNT during the grantor’s lifetime could be an effective way to diminish the size of a large estate. While direct transfers to an irrevocable SNT are considered completed gifts, thereby utilizing a portion of the grantor’s remaining applicable exclusion, any future appreciation on those assets is also removed from the estate. For grantors who have used up their applicable exclusion or want to retain as much as possible to cover assets in their estate and receive a step-up in cost basis, other funding techniques can be considered. In these cases, families may engage in a variety of wealth transfer techniques that use little to no exclusion, such as Grantor Retained Annuity Trusts, whereby the remainders pass directly to the SNT.

One of the commonly cited drawbacks of funding an SNT during the life of the grantor is that the assets within the SNT might be subject to the compressed trust tax brackets. Provided the trust is structured as a non-grantor trust, income retained within the SNT will hit the top marginal federal income tax rate of 43.4% after just $12,500 of income, compared to $466,950 for a married couple filing jointly. There is, however, another option. The SNT could be structured as a grantor trust such that the grantor is considered the owner of the assets for income tax purposes and therefore responsible for paying income taxes on behalf of the trust.

Grantor Trust vs. Non-Grantor Special Needs Trust

If a grantor chooses to fund a third-party SNT during his or her lifetime, how does he or she decide whether the trust should be structured as a grantor or a non-grantor trust? The grantor trust has several potential advantages: the grantor may file taxes on behalf of the trust on his or her Form 1040, the grantor might have a lower effective tax rate than the trust, and paying taxes on behalf of the trust will reduce the size of the grantor’s estate while allowing the assets in the SNT to grow tax-free. Paying taxes on behalf of the trust is also not considered an additional gift. This enables the grantor to effectively transfer more wealth into the SNT without using valuable applicable exclusion. However, creating a grantor trust also means remaining on the hook for the income taxes of a portfolio that cannot be accessed by the grantor. Preserving exclusion becomes substantially less important if the grantor risks spending down his or her portfolio.

As you can see, choosing whether to structure the trust as a grantor trust or a non-grantor trust is a complicated question. Fortunately, we can help bring some clarity by quantifying the associated trade-offs. To demonstrate, let’s look at an example.

Audrey and Gavin are in their late 50s. They have two children: Julia, who has special needs, is in her 20s, and Conner is in his early 30s. Audrey and Gavin have recently decided to fund an SNT for Julia. While they considered funding the trust upon their death, it was particularly important for Audrey to see the SNT fully funded. She did not wish to worry about unexpected financial mishaps impeding their ability to fund the trust after she and Gavin are gone. Their attorney has suggested that they might benefit from structuring the trust as a grantor trust because it might reduce the amount with which they need to fund the trust, enabling them to preserve more of their applicable exclusion. Audrey and Gavin like the idea but are concerned that they won’t be able to afford the ongoing tax drag.

Their assets are currently valued at $14.0 million, which includes $8.0 million of highly appreciated real estate holdings. While Gavin recently retired, Audrey runs her own business and plans to continue working until 65. Until that time, their spending needs are fully met by their after-tax income. In addition, Audrey is making full use of her SEP IRA.  Once Audrey retires, their portfolio will need to support $250,000 in annual inflation-adjusted spending, including Julia’s needs. This spending will be partially offset by their annual pre-tax rental income of $50,000 and combined Social Security benefits of $40,000. Audrey and Gavin will continue to support Julia financially until they pass away. Based on their family history, they have a remaining life expectancy of around 30 years, at which point the SNT will need to provide Julia with annual inflation-adjusted spending support of $100,000, in today’s dollars, for the subsequent 20 years. (Note: If the trust is funded as a grantor trust, it will eventually become a non-grantor trust upon the grantor’s death).

The first step is to determine how much they would need to put into either a non-grantor SNT or a grantor SNT to ensure that the trust can support Julia’s future spending needs, even in the event of hostile market environments and periods of high inflation. To be very conservative, we need to solve for the required level of funding in each case such that over the next 30 years, the trusts will grow to an amount that can support Julia’s spending needs for the rest of her life with a 90% level of confidence. As shown in Display 1, we determined that the non-grantor trust will need to be funded with $2.0 million today while the grantor trust only needs to be funded with $1.5 million, assuming a moderate allocation. The required funding for the grantor trust is 25% less than that of the non-grantor trust because the grantor trust does not pay its own income taxes, which allows the assets in the grantor trust to grow completely tax-free.

Yet in order for the assets in the grantor trust to grow tax-free, Audrey and Gavin are stuck footing the bill. To evaluate the impact this has on their portfolio, we ran a comprehensive analysis in which we simulate the funding of each trust by taking into account the value of their real estate, their current liquid wealth, the required SNT funding amount, their projected income, spending needs, and tax burden associated with the grantor SNT. As shown in Display 2, regardless of whether they fund the grantor or non-grantor SNT, there is a very high likelihood that Audrey and Gavin will be able to meet their ongoing spending requirements over the next 30 years. And in median markets, we’d expect that funding the grantor trust has the dual benefit of reducing their liquid estate by $125,000 while also preserving an extra $500,000 of applicable exclusion, cutting their estimated estate tax liability by close to 25%!

Audrey and Gavin opted to fund the grantor SNT after seeing that this solution is likely to create both an optimal financial outcome while also meeting Audrey’s desire to see the SNT fully funded during her lifetime. 

Conclusion

There are many critical planning questions that must be addressed when planning for a special needs family member. And as you might imagine, there is no one-size-fits-all solution. Each family must carefully weigh the trade-offs associated with the various decisions they face. While the task might seem daunting, we believe that by working with a team of coordinated professional advisors who understand the intricacies of special needs planning, families will be able to construct the right plan to care for their special needs family member.

The Bernstein Wealth Forecasting System seeks to help investors make prudent decisions by estimating the long-term results of potential strategies. It uses the Bernstein Capital Markets Engine to simulate 10,000 plausible paths of return for various combinations of portfolios, and for taxable accounts, it takes the investor’s tax rate into consideration.

Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.


velategAshley E. Velategui, CFA, is an associate director in Bernstein’s Wealth Strategies Group and is based in the firm’s Seattle office. She works closely with high-net-worth families and individuals and their professional advisors on a variety of complex investment planning issues, including special needs planning, pre-transaction planning, multigenerational wealth transfer, retirement planning, and philanthropy and diversification planning for holders of concentrated portfolios. Ashley joined the firm in 2007 and began working with the Wealth Strategies Group in 2011, serving as an analyst and senior analyst before becoming an associate director in 2014. She earned a BA, magna cum laude, in mathematics and economics from Whitman College and is a Chartered Financial Analyst charterholder.

 
Views expressed in articles published in Tax Stringer are the authors' only and are not to be attributed to the publication, its editors, the NYSSCPA or FAE, or their directors, officers, or employees, unless expressly so stated. Articles contain information believed by the authors to be accurate, but the publisher, editors and authors are not engaged in redering legal, accounting or other professional services. If specific professional advice or assistance is required, the services of a competent professional should be sought.