Setting Up a Special Needs Trust for a Disabled Relative

Many of us have a family member or close relative with a disability. We’d like to leave a portion of our estate to help this family member but are unsure how best to do this. Should we just make an outright gift? What about a trust? Let’s take a look at some of the options.

The simplest method of assisting the family member is an outright gift, either during lifetime or via our will. However, if the disabled individual is already receiving government benefits such as SSI (Supplemental Security Income) or Medicaid, additional assets could cause them to become disqualified from those programs. On the other hand, some programs such as SSDI (Social Security Disability Insurance) are not “means tested,” i.e., are not affected by the assets or income of the recipient.

Since a person may not need to receive “means-tested” benefits today but may require them in the future, the safest route is to leave them your gift inside a trust. The trustee of the trust will hold your money, invest it, and distribute it to your intended beneficiary as needed, without causing disqualification from government benefits.

Such a trust is called a Special Needs Trust or Supplemental Needs Trust, since it is designed to supplement—and not replace—government benefits. It can be created today and funded with money or other assets now. Such a trust is called an “inter vivos” trust. You can serve as the trustee or permit someone else to serve as trustee; the trust can be revocable or irrevocable; and you can retain power to change the ultimate distribution of the trust assets or not. All of these decisions affect the income tax and estate tax treatment of the trust. If you choose to make the trust irrevocable, then it will have its own federal tax i.d. number and can be set up to be taxed either to you, the trust itself, or to the beneficiary.

You can also set up the trust within your will, to be funded upon your death. Such a trust is called a “testamentary trust.” In this case, you will not have a separate trust document, since the terms of the trust will be contained within the will itself.

Because the rules of each state vary as to whether the terms of the trust will cause or not cause disqualification, you really must work with an experienced estate planning or elder law attorney to draft this trust for you. The attorney will be familiar with both the federal and state programs that might be of benefit at some point to your family member, what the rules are under both federal and state benefits laws, how trusts work, the different income and estate tax ramifications of each trust option, and how best to achieve your objectives.

Examples of distributions that will not cause the beneficiary to lose or have reduced government benefits:

• new car
• attorney/accounting services
• alternative health treatments
• TV, DVD player
• public transportation pass
• camera
• computer hardware, software, internet fees
• courses and classes
• dental work not covered by Medicaid
• fitness equipment
• musical instruments
• non-food grocery items
• physician specialists not covered by Medicaid
• utility bills
• physical therapy not covered by Medicaid
• vacations

The above is by no means an exhaustive list, but is only intended to give you some idea of what your gift via trust can be spent on to make your family member’s life so much better, without causing disqualification. As you can see, your gift will have wide-ranging benefits for your family member and will improve their quality of life for many years.

The Inheritor’s Trust

Many times Baby Boomer client has parents who have a fair amount of money, as does the Boomer client. If the parents simply leave their money to the child as an outright gift under the parents’ wills or living trusts, that money will be includible in the taxable estate of the child and also be subject to creditors, divorcing spouses, etc.

Now, the child can certainly go to his or her parents and suggest they go back to their lawyer and pay the lawyer a hefty fee to draft up a trust to hold the child’s inheritance, but the parents may be reluctant to pay that money, don’t want to focus on the complexities of the trust, and may simply keep putting it off.

However, a better idea is for the child to hire his or her own lawyer to draft the trust, so that the trust contains provisions beneficial to the client. After this is done, the client–let’s call him Sam Jones–goes to the parents and says “I would like you to go to your attorney and make this simple change. I want you to add the following sentence to your wills (or living trusts, as the case may be): ‘Notwithstanding anything in this instrument to the contrary, any time a distribution is indicated to be distributed to my son, Sam, it shall instead be payable to the Sam Jones Irrevocable Trust dated August 14, 2006, to be held as provided therein.’”

Because it’s simple and won’t cost the parents much money to have the lawyer do it, and it doesn’t take much involvement or thought on the part of the parents, the parents are much more likely to get this small change done. The inheritance will now flow directly into the trust the child created, and have the following benefits:

• it will be excluded from the child’s taxable estate
• it will be outside the child’s probate estate
• it will be protected from lawsuits, creditors, and divorcing spouses
• it can still be controlled and managed by the child, who can serve as trustee (although even greater protection will result if the child is not a trustee, or is a co-trustee)
• it can still allow the child to decide how the remaining trust assets will pass after the child’s death

In other words, by having the child set up the trust, but having the parent fund it via a small change in the parent’s will or living trust, the child can still receive his or her inheritance, but in a form that will protect it as the years go by.

Medicaid and the Living Trust

You’ve probably gotten a postcard or seen an ad for a seminar on “Living Trusts” and all the benefits they supposedly offer you. Basically, a Living Trust is a trust you create and fund during your life and which you retain the ability to change and revoke at any time. They have their place and can be quite useful, in the right circumstances, but the question of today is whether they are useful if you may be applying for Medicaid.

The problem with Living Trusts for someone applying for Medicaid is that everything titled in the name of the Living Trust is considered an available asset, even if it was exempt outside of the Living Trust. For instance, your home is exempt (a single person’s home is almost always exempt up to at least $500,000), but if you deed it into your Living Trust, it suddenly loses its exemption. That alone can cause you to become ineligible for Medicaid, forcing you to deed your house out of the Trust back into your own name. The same would be true of your car or even your other personal property.

Now bank accounts and investments can certainly be titled in the name of the Living Trust, since such assets are countable whether they are titled in your name or in the Trust’s name. However, if you are single, you will have to spend down those assets in any case, in order to qualify for Medicaid, so that’s a dubious benefit.

Since you basically have to withdraw all the Trust assets and retitle them back into your own name, as you can see it makes absolutely no sense to pay an attorney to create a Living Trust for you if you are single and facing long-term care, and if you think that you may need or want to apply for Medicaid at some point.

If you are married, it is possible for the Community Spouse (i.e., the spouse not in the nursing home) to have assets titled in the name of a Living Trust, but there is usually little advantage to doing so if you reside in a state like Colorado which has relatively inexpensive and simple probate procedures.

As a matter of fact, there is a type of trust that the Community Spouse can set up to be funded after the death of the Community Spouse, which can hold assets for the benefit of the nursing home spouse yet not count against that spouse’s Medicaid eligibility. However, such a trust cannot be used in a Living Trust and can only be used in a Will.

So the lesson of all this is that Living Trusts may be useful for general estate planning purposes but are inappropriate–or worse–in a Medicaid planning situation.

Medicaid Planning with an Irrevocable Trust

You know that you, your spouse, or a parent is facing a nursing home stay. It’s not tomorrow, but it’s not 20 years away, either. Is there a good technique to protect your assets so that the nursing home won’t wind up with your life savings? Actually, yes…it’s called an “irrevocable trust.” Let’s take a look at how it works.

An irrevocable trust is one that cannot be revoked, amended, or changed once it is signed. Do not confuse this with a “Living Trust” done for probate avoidance purposes; that type of trust is revocable and will not work for Medicaid planning. Your elder law attorney would draft the trust for you and then assist you in transferring some portion of your assets into the trust. (I am omitting many details of how the trust is to be drafted, set up, and funded. For a detailed discussion of such trusts in the Medicaid planning context, see my book, “How to Protect Your Family’s Assets from Devastating Nursing Home Costs: Medicaid Secrets.”)

A transfer into such a trust is considered a gift for Medicaid eligibility purposes. Thus, the usual “penalty period” and “lookback period” rules apply to the gifts into the trust the same as they would with an outright gift.

For example, assume you create your new trust and immediately transfer $180,000 into the name of the trust, leaving you with only minimal other countable assets. Assume you do this on January 1 of Year 1. Also assume that the state you live in has a “penalty divisor” of $5,000, meaning that there is one month’s penalty for every $5,000 worth of gifts.

Here’s how the rules play out:

Penalty Period. Since the amount of the gift was $180,000, if you went in to apply for Medicaid the next day, there would be a “penalty period” (i.e., period of time that you would be disqualified from receiving Medicaid assistance) of 36 months ($180,000 / $5,000 = 36).

Lookback Period. For any gift made on or after February 8, 2006, if you apply for Medicaid within 5 years of such gift, there will be imposed a penalty period. So in our example, if you apply for Medicaid at any time before January 2, Year 6, you will be faced with a 36-month penalty period that begins on the date you apply! That’s right—even if you make the gift today and apply for Medicaid in 4 1/2 years, you will have to wait another 3 years because of the penalty! “Gee, I could have just waited another 6 months and I’d be out from under the lookback period and have no penalty!” Exactly. So be careful of applying too early!

But what if you might need nursing home care prior to Year 6? All your money is tied up in the trust, so how can you pay for the nursing home? Essentially, your family members will have to pay your expenses for that period of time. (It may be possible for the trust to be drafted so that money in the trust can be distributed to your family members for this purpose, but this must be very carefully done in order to avoid serious trouble.)

In that case, the big question is, when do you apply for Medicaid? Of course, you must actually have a medical need for nursing home-level care in order to apply. But if you require nursing home care in Year 1 or Year 2 and apply for Medicaid at such time, there will be a 3-year penalty period from the date you apply. In other words, you will be eligible to re-apply for Medicaid in Year 4 (if you apply in Year 1) or Year 5 (if you apply in Year 2). Obviously that is better than waiting for the expiration of the entire 5-year lookback period, which won’t occur until Year 6.

However, if you don’t need nursing home care until at least Year 3, you are better off not applying for Medicaid until after the complete expiration of the lookback period, i.e., in Year 6. That’s because if you apply in, say, June of Year 3, you will still be disqualified for an additional 3 years, i.e., until June of Year 6 (instead of only until January of Year 6). And if you apply in Year 5, you won’t be eligible until some time in Year 8!

It’s important to remember that the numbers above only apply to this particular example. You must work out the details with your elder law attorney, since the optimal time to apply will be governed by your health, your other (non-trust) assets, your family’s ability to cover your expenses, the amount you gifted into the trust, your state’s penalty divisor.

NOTE: For more information on this topic and other Medicaid planning techniques, see my book “How to Protect Your Family’s Assets from Devastating Nursing Home Costs: Medicaid Secrets” (2008 Second Edition available here: www.MedicaidSecrets.com).