Pop-Quiz: Is This a Grantor Trust?

January 30, 2016 by Bob Mason 10 Comments

Pull out your pad of paper and #2 leads pencils. It’s time for a quiz!

Facts: Greta Grantor has three children, all with their peculiarities (she loves them all, but she trusts none of them with money). She has elected to fund an inter vivos trust for the benefit of her precious angels. During her life she wants to insure that principal and income are available to be distributed “as needed” from a common fund to the children. Distribution decisions are totally within the discretion of the trustee, subject only to the usual fiduciary standards of reasonableness and good faith. At her death the trust is to be distributed in equal shares for her grandchildren (with appropriate holdback provisions for the younger ones).

Goals: You have determined that it is important for this to be a grantor trust during Greta’s life (the reason really isn’t important to our inquiry). She is concerned about Medicaid qualification in the distant future and “just wants to get the five-year clock ticking.” It is also important that she have little to do with distribution decisions or significant retained powers with respect to the trust for Medicaid purposes.

Greta has asked you to name her nephew Chip (who is a CPA and very well-suited) as trustee.

OK, class, here’s the question: Have you accomplished your tax goals? Is this a grantor trust? By the way, do NOT assume the existence of any trust terms that I haven’t given you.

NO CHEATING!

WHEN YOU THINK YOU HAVE AN ANSWER, SCROLL DOWN.

Answer:

NOPE!

Analysis: How, you may ask, can this be? After all, the children are the only adverse parties, which would make Chip a nonadverse party with discretion to make distributions. Look at IRC § 672(a), (b) for definitions of adverse and nonadverse party. It’s straight-forward: An adverse party is one affected by the exercise or nonexercise of a power that he or she possesses; a nonadverse party is some who is not adverse.

As you may have known, the starting place is, indeed, IRC § 674(a). That subsection says simply that

The grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.

That’s all that is going on here, right? Well . . . no. The rest of IRC § 674 is essentially a laundry list of exceptions and exceptions to the exceptions.

Enter the “C” Trust

Subsection 674(a) does not apply to a power exercisable solely by an independent trustee (without the approval or consent of any other person) to distribute, apportion or accumulate income, or to distribute corpus among a defined class of beneficiaries. IRC § 674(c).

That’s it, pilgrims! This is NOT a grantor trust.

Why is this NOT a Grantor Trust?

Because Chip is an “Independent Trustee.”

IRC § 674(c) refers only to a trustees who are not “related or subordinate parties” who are not “subservient” to the grantor. The regulations flesh this out, as they are wont to do. Treas. Reg. § 1.674(c)-1 refers inquirers back to IRC § 672(c) for definitions of “related or subordinate parties” and “subservient.”

IRC § 672(c) says that a related or subordinate party is

the grantor’s spouse if living with the grantor . . . [or] any one of the following: The grantor’s father, mother, issue, brother or sister; an employee of the grantor; a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; a subordinate employee of a corporation in which the grantor is an executive.

Hmmm. Doesn’t look as if the Chip-meister fits this definition. So, he’s “independent.”

How to Bust a “C” Trust

By the way, if you are trying to AVOID grantor trust status but would like to maintain some flexibility, this is a great way to do it.

However, if you WANT it to be a grantor trust but you like these distribution provisions, or you really want it NOT to be a grantor trust and want to make sure you don’t accidentally cancel-out the “C Trust” status, you better understand a few extra rules.

First of all, the trustee’s discretion must be exercised “without the approval of consent of any other person.” IRC § 674(c). If you subject the discretion to the approval of some other nonadverse person who is NOT a trustee, you will have either “ducked a bullet” (if you wanted a grantor trust to begin with) or “messed up big time” (if you didn’t want a grantor trust).

By the way, why is the status of the other person as a trustee important? Because the beautiful (or offending) power applies only to the exercise by a trustee.

Similarly, if the grantor has the right to remove a trustee and replace the trustee with another trustee who might not be independent you have saved/dashed your plans. This one is REALLY buried in the regs: Treas. Reg. § 1.674(d)-2(a).

Finally, you can dash/save your plans be giving any person the power to expand the defined group of beneficiaries beyond after born children. Giving the trustee, or an adverse party, or a nonadverse party (including distant cousin Brunehilde) the authority to add some beneficiaries (perhaps, for example, in-laws) will do the trick.

Remember: You WANTED to go to law school!

By the way, this is just the type of thing we cover in the TrustChimp Trust Summits. Find out more and give one a whirl!

Drafting a Sole Benefit Trust for an SSI Beneficiary

January 3, 2016 by Bob Mason Leave a Comment

NOTE: The following is an edited version of an article first appearing in the July/August/September issue of NAELA News. I have rerun it now because (i) the topic was the subject of a lively discussion on the North Carolina NAELA chapter list serve (a very active list serve, I might add), and (ii) I will be conducting a NAELA Lunch and Learn (free if you’re a NAEA member) based on this article at 1 PM EST on January 19, 2016. If you are interested in registering, CLICK HERE.

SSI-SBT Missile — Mason Inspecting Secret SSI-SBT

What if I told you that you might be able to transfer assets to a trust for the benefit of an SSI recipient, free of a transfer sanction, free of a payback requirement, and free of danger to the SSI recipient’s benefits? Before thinking someone is pulling your leg, read on.

Under the right circumstances (and in the right state), “sole benefit trusts” (“SBTs”) are a great way to transfer assets free of a Medicaid transfer sanction and without state “payback” concerns that apply to so-called self-settled trusts.

I call such a trust an SSI-SBT, which really sounds like some sort of scary Cold War Era missile.

The Medicaid Transfer Statute

Pursuant to 42 USC § 1396p(c)(2)(B)(iii) and (iv) exempts from sanctions transfers “to a trust (including a trust described in subsection (d)(4) of this section) established solely for the benefit of” either an individual under age 65 or the transferor’s child of any age. Under the statute a transfer to a “payback” or D4A trust under 42 USC § 1396p(d)(4)(A) is but one type of transfer to a trust “established solely for the benefit of” an individual.

While subsection (d) of the statute clearly articulates requirements for a D4A trust (including the infamous payback provision), the statute is silent as to what requirements apply to the other types of trusts that might qualify as “solely for the benefit of.”

Actuarial Soundness OR Payback

Sections 3257 through 3259 of Chapter 3 of the CMS State Medicaid Manual (SMM)[i] is CMS’s explanation to state Medicaid directors of the trust provisions of OBRA ’93. To the extent the SMM does not contradict more recent statute, it is good law.

SMM Section 3257 B.6 of the Transmittal lays out the general requirement that a trust, to be considered “for the sole benefit of” an individual, must require distributions “on a basis that is actuarially sound based on the life expectancy of the individual involved.” However, the immediately following paragraph begins:

An exception to this requirement exists for trusts discussed in §3259.7 [the section dealing with D4 Trusts]. Under these exceptions, the trust instrument must provide that any funds remaining in the trust upon the death of the individual must go to the State.

Thus a transfer by a grantor to a trust for a child or other “under age 65” person with disabilities is not a sanctionable transfer for the grantor if the trust is either a D4 trust, or a trust that contains an actuarially sound distribution standard.

Actuarial Soundness

SSM Section 3258.9B. describes “actuarial soundness” as a distribution standard that will insure complete distribution of the trust within the beneficiary’s anticipated life expectancy (as determined by tables in the transmittal).[ii] Significantly, and as demonstrated by the example of actuarial soundness provided by HCFA at SSM Section 3258.9.B., the distributions may be made more rapidly. “Actuarial soundness” provides a minimum distribution standard that may be exceeded.

This interpretation leaves room for a few drafting choices.

First, you may structure the distributions as an annuity-like stream of distributions set to exhaust the trust corpus within the beneficiary’s actuarial life expectancy. In fact, the state may administratively insist that you set the “annuity term” for some period close to the beneficiary’s actuarial life expectancy (as opposed to allowing a faster payout). This option may not be attractive because it will force the trustee to have enough liquidity to meet the distribution obligations (or to distribute “in-kind” with fractional shares of illiquid assets such as real estate).

Second, you could structure distributions along two tiers: (i) “minimum required distributions”[iii] (MRDs) that are based upon some formula (such as trust balance as of the previous December 31, divided by the beneficiary’s remaining actuarial life expectancy as of that date), and (ii) discretionary distributions that exceed MRDs. This technique can allow the trustee to “dribble” distributions out to the beneficiary and perhaps control the nature of the distributions. Moreover, it gives the trustee the option to more rapidly distribute to the beneficiary if the distributions will not jeopardize benefits (such as SSI).

State Challenges

Regulators may attempt to rein in the use of sole benefit trusts with one of three administratively imposed requirements. If the trust beneficiary is not receiving Medicaid or SSI (she is receiving Social Security Disability Income only) and she doesn’t have excessive creditors waiting to claim against a potential estate, the bureaucratic add-ons make little difference. On the other hand, if the beneficiary is on SSI, Medicaid or has significant creditor issues, these added requirements can pose some concern.

First, some state Medicaid authorities insist on a payback provision. As demonstrated above, there is no legal support for such a position. The authority imposing such a requirement is attempting to treat a sole benefit trust as a D4A trust.

Second, some states require the beneficiary’s estate to be the sole remainder beneficiary.[iv] The ostensible reason for the imposition of this requirement is to ensure that the trust is solely for the benefit of the named beneficiary and cannot benefit any other individual. There are a number of problems with this line of thought. Neither the statute nor the SMM mention this feature. Also, as long as the beneficiary is alive the trust will not benefit anyone else. Finally, mandating the estate as the remainder beneficiary of this type of third party trust simply elevates creditors over other beneficiaries and does nothing to ensure the trust is “solely for the benefit of” the beneficiary while he is alive.

Third, some states require affirmative distribution language that the trust “supplement and not supplant” public benefits.[v] There is no federal statutory or other authority for such a mandate.

If you practice in a state without these extra-statutory, extra-regulatory hurdles, however, you are in a good position to assist a grantor with a sanction-free transfer and an SSI beneficiary with an “unavailable” trust that will be available to other family members upon the death of the beneficiary.

The SSI Challenge

With respect to structuring distributions for an SSI beneficiary, an understanding of the Social Security Supplemental Security Income asset and income rules under POMS will enable you to structure a distribution standard that will not jeopardize SSI.

First, cash received from the trust will reduce SSI benefits dollar-for-dollar.[vi] Second, in-kind distributions that would not constitute resources if retained past the month of distribution will not be income when received.[vii] Third, distributions that constitute in-kind support and maintenance (ISM) because they are food and shelter items (or payments to third parties for such items) will reduce SSI benefits by an amount not to exceed one-third of the federal benefit level ($244.33 in 2015), depending upon the beneficiary’s circumstances.

If the beneficiary is residing in the home of another and receiving food and not paying a pro rata share of those costs her benefits will be reduced $244.33 regardless of the value of the ISM received.[viii] This is called the “value of the one-third reduction” or VTR rule, and obviously the results are not pleasant for a beneficiary receiving less than $244.33 in SSI benefits. Any ISM will eliminate SSI eligibility for that month.

On the other hand, if the beneficiary does not fit the VTR rule, he is under the “presumed maximum value” or PMV rule and any ISM (of any value) received is rebuttably presumed to equal $244.33. The beneficiary with SSI benefits under $244.33 who received some small amount of ISM should avail himself of the ability to rebut the presumption and demonstrate the true value of the ISM. On the other hand, a beneficiary with SSI over $244.33 who has received a side of prime beef and a truckload of caviar may want to go with the presumption which will reduce his benefits by just $244.33.

Suggested SSI Distribution Language

Craft the distribution language as a two-tier scheme. One tier will address the MRD requirement, another tier will address the trustee’s discretionary “excess” distribution.

Now craft further instructions to the trustee that MRD distributions be satisfied (i) first with distributions that do not constitute income to the beneficiary under SSI rules, (ii) and if the MRD has not been satisfied under the preceding, then with distributions that constitute types and amounts of ISM that will not eliminate SSI, and (iii) only then consider making other distributions that could jeopardize SSI.

It should take a singularly uncreative trustee who could not think of any distribution in satisfaction of the “MRD tier” that would not constitute income for SSI purposes. For example, a $100,000 sole benefit trust for a beneficiary with a 20 year life expectancy will be required to make a MRD of about $5,000 in year 1. The trustee could purchase an auto, a very nice gaming system, pay educational expenses or medical expenses and exceed $5,000 very easily.

To Reiterate

If you practice in a state that, with respect to an SBT, does not require payback provisions, an estate as remainder beneficiary, or “supplement rather than supplant” language, you are free to draft an SBT for an SSI recipient along the lines discussed above.

Of course, there is no guarantee you will not be challenged. If you are challenged, however, you may be secure in the knowledge that I will be thinking about you.

Interested in spending 3 days learning about this and all sorts of other interesting trusts, taxation and Medicaid/SSI/VA benefit issues? Some of your colleagues have described the TrustChimp Trust Summit as the best (and most intense) CLE ever attended.

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[i] Also known by the transmittal number that issued it: “Transmittal 64.”

[ii] Transmittal 64 does not define “actuarially soundness” in the context of trusts; the definition discussed in section 3258.9B is in the context of annuities.

[iii] A term borrowed from distribution rules applicable to individual retirement accounts.

[iv] Ten years ago a CMS official also opined to this effect. Letter from Ginni Hain, Division of Eligibility, Enrollment and Outreach, CMS, to Mary E. O’Byrne, Esq. (June 27, 2005).

[v] See, e.g., Minn. Stat. § 501B.89 (effective 1/1/2016 replaced by identical Minn. Stat. § 501C.1205). Minnesota imposes the “may not supplant” requirement on both D4A and third party trusts. NAELA member Laurie Hanson has successfully “pushed-back” with respect to D4A Trusts. My thanks to Ms. Hanson for discussing this situation with me and providing me with other helpful information. See, also, Kan. Stat. Ann. § 39-709(e)(3).

[vi] POMS SI 01120.200E1.a.

[vii] Id.

[viii] POMS SI 00835.200

Use IRC Section 678 to Make a Trustee Very Angry

December 23, 2015 by Bob Mason 3 Comments

When she learns she will be taxed on the trust’s income she will not be a happy camper.

Two common planning scenarios could land you in a malpractice trap if you don’t know this rule.

SCENARIO 1: Don Kilroy is a veteran and wants to protect some real property and other income generating assets for future Medicaid and VA benefit planning. The best strategy seems to be a non-grantor trust (to avoid VA scrutiny . . . and maybe even your state’s Medicaid scrutiny), but also to insure estate inclusion to obtain stepped-up basis. The trustee will be given discretionary authority to make distributions of income and principal among Dad’s descendants. Don names his son as sole trustee.

SCENARIO 2: Ma Barker’s last will and testament leaves most of her assets to a testamentary trust for the benefit of her descendants. The trustee (one of Ma’s daughters) has discretion to sprinkle income and assets among Ma’s descendants until the youngest living at her death has attained age 25.

ONE BIG PROBLEM: In both scenarios the sole trustee is one of the children of the settlor/testator. Further, the trustee’s discretion is unlimited.

RESULT: Both trusts will be treated as owned by the trustee for income tax purposes. In effect, the trusts will be grantor trusts with respect to the trusts. This is not a good thing.

REMEDY: Either name co-trustees who must act jointly with respect to distributions, subject distributions to an ascertainable (HEMS) standard, or require the trustee to obtain some other party’s approval for a distribution.

WHAT THE . . . . ?

Look at IRC section 678.[i]

This section is the only grantor trust provision under which a person other than the grantor or a transferor to the trust could be the deemed owner of all or a portion of the trust for tax purposes. Note that each of IRC sections 673 through 677 begin “The grantor shall be treated . . .” and IRC section 678(a) commences with “[a] person other than the grantor shall . . .”).

IRC section 678 is poorly drafted and is the source of confusion. From the face of the statute, it appears that a person with “power exercisable solely by himself to vest the corpus or the income therefrom in himself” will be the deemed tax owner.[ii]

AN EXCEPTION TO IRC SECTION 678

However, IRC § 678(b) applies an exception:

Subsection (a) shall not apply with respect to a power over income, as originally granted or thereafter modified, if the grantor of the trust or a transferor (to whom section 679 applies) is otherwise treated as the owner under the provisions of this subpart other than this section.

In other words, is this statute to be read that if the grantor and the other person are both treated as the owner of trust income, the rules of IRC §§ 674 through 677 trump application of IRC § 678(a) to the third party? For example, if grantor has retained an income interest IRC § 678(a) might not apply . . . or so it might seem. On the other hand, a third person with some power over corpus would, in fact, be treated as tax owner notwithstanding that grantor also has powers over corpus because IRC 678(b) would not apply . . . or so it might seem. The statute actually is “something else.”^{^[iii]}

DECIPHERING THE TERM ‘INCOME’ UNDER IRC SECTION 678

The apparently correct reading of the section should be that if the grantor has retained any power over corpus or income under IRC sections 674 through 677, the power will trump application of IRC section 678(a) to the third party. The key to answering the riddle is in the definition of “income.”

In the context of IRC section 678, “income” likely refers to “taxable income” as opposed to “trust accounting income.” The former includes both income allocable to corpus (i.e., gains on sale or exchange of capital assets) and to trust accounting income (i.e., ordinary income); the latter includes ordinary income. If you have attended a TrustChimp Trust Summit this has been pounded into you.

Treas. Reg. section 1.671-2(b) specifies that for purposes of the grantor trust rules the term “income” refers to income for tax purposes and not trust accounting purposes and that if trust accounting income is being referenced the term “ordinary income” would be used. IRC section 678(b) uses the unmodified term “income” which refers to taxable income pursuant to the regulation. Accordingly, if a grantor and a third person are both deemed the owner of income allocable to either corpus or accounting income, then under IC § 678(b) the grantor would be treated as the owner (i.e., IRC sections 674 through 677 trump IRC section 678(a)).

IRC section 643(b) (which does not apply to grantor trusts) specifies that the term “income” refers to “income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law” (i.e., trust accounting income under a state’s principal and income act) for the purposes of Subparts B, C, and D of Part I of Subchapter J. The grantor trust rules are in Subpart E, clearly omitted from the IRC section 643(b) reference. Combined with the reference under Treas. Reg. section 1.671-2(b) discussed above, the meaning of “income” under IRC section 678(b) takes on some clarity.

DUCKING THE IRC SECTION 678 BULLET

Particularly in the context of veterans’ benefits planning, designing a trust to avoid application of the grantor trust rules to the grantor may be a sound strategy if a goal is to avoid trust tax attributes appearing on the grantor’s tax return. In connection with that strategy many may want to provide access to trust assets by allowing the trustee or some other person to make distributions to one or more individuals or a class of individuals.

As you now know, care should be taken to avoid application of IRC section 678(a) to an individual with the sole authority to order distributions to a class that includes herself. For example, a trust granting a trustee the authority to make distributions to descendants of the grantor “within the sole discretion of the trustee” will trigger application of the grantor trust rules to the trustee if the trustee is a descendant of the grantor.

There are two ways to address the issue.

Perhaps the easiest method is to subject the decision-maker’s authority to the approval of another person, perhaps a sibling or some other trust beneficiary.^{^[iv]} This approach not only avoids IRC section 678(a) issues, but may provide an added layer of security to trust assets by fettering an otherwise broad power residing in a single individual.
A second approach is to subject the decision-maker’s authority to an ascertainable or “health, education, maintenance and support” standard. But be careful here. The trustee may seem to be subject to an ascertainable standard, but it may be illusory if language provides that the determination is solely within the power of the trustee (“whose determination shall be conclusive for all purposes and blah, blah, blah”). In this case, the trustee’s authority is not really subject to any standard and we’re back to IRC section 678(a).

Crummey powers and inter vivos powers of appointment could also trigger this section with respect to a trust if the grantor has not retained powers under IRC sections 673-677 that would cause grantor trust status with respect to the grantor (even if the beneficiary is unable to exercise the Crummey power due to minority or disability).^{^[v]} But will save that little gem for another discussion.

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[i] Because this is not a law review article and is a post to my website, I can violate standards of citation if I want to. Take that.

[ii] IRC § 678(a)(1).

[iii] IRC § 678 reminds me of the motto of the State of North Carolina: Esse quam videri (“To be, rather than to seem”). The motto is a literal translation of a phrase from a sentence in Cicero’s On Friendship (De Amicitia, chapter 26). The complete sentence in Latin is: Virtute enim ipsa non tam multi praediti esse quam videri volunt, which means something along the lines of “Fewer persons actually possess virtue than those who would seem to possess it.” I still believe it could apply to IRC § 678, but I digress.

[iv] Example: “The Trustee may elect within her sole discretion to make distributions of principal or income to any of grantor’s descendants subject to the advance written approval of a proposed distribution or distributions by one of grantor’s descendants not then serving as Trustee.”

[v] See, e.g., Rev. Rul. 81-6, 1981-1 C.B. 385. If you enjoy self-testing, go through the ruling and determine why the trust in question was not a grantor trust with respect to parent. The Service does not tell the reader that (which would have made the ruling much clearer). Or you can take my word for it.

Fun Trust Tricks With Adverse and Non-Adverse Parties

July 1, 2015 by Bob Mason Leave a Comment

“Keep your friends close and your enemies closer”

Michael Corleone (The Godfather Part II)

Sound Familiar?

Greta Grantor wants to put her home into a trust to protect it from estate recovery in case she ever goes into a nursing home and onto Medicaid. At the same time she and her daughter agree that a time could come to sell the home and reinvest in an in-town condo. Grantor trust status is a paramount goal in order to preserve the tax free sale of the home, but Greta is very concerned about state Medicaid rules that could include any asset over which she has too much retained control.

Sam Settlor wants to move some assets to trust in order to qualify for VA benefits, yet he wants to insure that those assets receive stepped-up basis upon his death. Because the VA will likely question the existence of a grantor trust that generates tax activity that will show up on his Form 1040, avoiding grantor trust status is important. In spite of this concern he would still like to have some control over trust distributions and who may eventually inherit.

The answers for Greta and Sam might involve the intelligent use of people called adverse and nonadverse parties. Grantor trust status is achieved by the grantor retaining certain benefits or control mechanisms over trust assets (in this article these are called “Grantor Powers”). In many cases, however, a Grantor Power can be given to (or shared with) a nonadverse party without jeopardizing grantor trust status. On the other hand, a Grantor Power will not cause grantor trust status if it requires the cooperation of an adverse party, or if it can be blocked by an adverse party.

Who’s On Adverse?

An adverse party is someone with a beneficial interest in the trust that will be positively or negatively affected by the exercise or non-exercise of a certain power. For example, if Anthony has been given an income interest in a trust but Greta Grantor has retained a power to appoint the income interest, Anthony will be adverse with respect to that retained power of appointment. If Greta Grantor exercises her power to appoint the income of the trust, Anthony Adverse will be the loser.

The rules are simply based on an understanding of human nature and the propensity of an individual to act in his or her best interests during the course of navigating life’s many decisions. An adverse party is less likely to be subject to the influence of the grantor because she will be primarily motivated to take or withhold action to preserve her trust benefits. On the other hand, a nonadverse party is free of those motivations (“he doesn’t have any skin in the [trust] game,” so to speak, and is more likely to act on grantor’s behest). In fact, if trust design calls for the use of a nonadverse party the grantor will look around for someone who is not a beneficiary and who will likely return the grantor’s phone calls (if not do exactly what the grantor wants done).

Internal Revenue Code (“Code”) section 672 and the regulations thereunder recognize this very human tendency. Unfortunately, nothing is as simple as it may seem.

A Deeper Look

Code section 672(a) defines an adverse party as “any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or non-exercise of the power which he possesses respecting the trust.” Subsection (b) simply defines non-adverse party as anyone who is not adverse.

As usual, the regulations flush it out a bit, and that is where things become more interesting. If an individual is not a beneficiary, she will not be an adverse party.[1] On the other hand, it does not always follow that a trust beneficiary will be adverse. The regulations spell out a couple of examples.

Example

An individual can be adverse with respect to a portion of a trust only. Say a trust provides an income interest of three equal shares to Anthony, Betty and Charlie. Greta Grantor, however, has reserved a right to appoint the income interest to the North Carolina Zoological Park with the consent of Anthony. This is a Grantor Power because Code section 674(a) provides that a grantor will be the deemed owner of any portion of a trust over which he has retained a power to affect the beneficial enjoyment thereof, without the consent of any adverse party.

If you are paying attention, you must be thinking, “Wait, Anthony is adverse so how can this be a grantor trust?” You are half right (er . . . one-third right). Anthony is adverse with respect to Greta’s retained power of appointment, but only with respect to one-third (1/3) of the income of the trust. Anthony is nonadverse with respect to the other two-thirds of the income. In this particular case, the trust would be a grantor trust with respect to two-thirds of the income and a non-grantor trust with respect to a third.[2] After all, Anthony’s interests are not at all affected by the appointment of what would have been Betty and Charlie’s shares. He is, however, keenly interested in his one-third of the income.

In that case, two-thirds of the items of income, deduction or credit allocable to trust income under the terms of the trust agreement or the North Carolina Uniform Principal and Income Act will be deemed to be Greta’s and will appear in some form or fashion on her Form 1040. The trust will need to report the tax attributes allocable to one-third (1/3) of the trust corpus on its own Form 1041.

Yet another riveting example

A trust provides an ordinary income interest to Adella Adverse with a power in Adella to appoint the trust principal to Sam Settlor either during Adella’s life or upon Adella’s death with a testamentary power of appointment. Under the trust agreement (and, in the event the trust agreement had been silent, under the state principal and income act) any capital gains are to be added to trust principal. These powers, too, are potential Grantor Powers. Code section 677 provides that a grantor will be the deemed owner of any portion of a trust with respect to which the income may be distributed to grantor or held or accumulated for future distribution to grantor without the approval or consent of an adverse party.

In this particular case, Adella’s power is adverse to Sam to the extent that Adella can appoint the corpus during her life (after all, Adella’s income will be wiped out if she appoints the principal to Sam). In that case the ordinary trust income will not be reportable on Sam’s Form 1040 because the ordinary income can be controlled by Adella Adverse. Rather, the income will be reportable on the trust’s Form 1041. Had Adella been a nonadverse party her discretionary authority to distribute principal to Sam, Code section 677 would have required ordinary income to be reported on Sam’s Form 1040.

But wait . . . Adella’s power to appoint corpus to Sam upon Adella’s death will result in capital gains making an appearance on Sam’s Form 1040 because IRC section 677 says that any taxable income (capital gains is taxable income, after all) that could be accumulated for later distribution to grantor results in grantor trust status with respect to that trust portion. In this case, Adella (presumably) couldn’t care less what happens to trust income after her death which renders her nonadverse with respect to Sam and that specific trust portion. In this case, a nonadverse party (Adella) has the Grantor Power to accumulate income for potential later distribution to the grantor (Sam).[3]

A Potential Trap

The Regulations flatly state “[t]he interest of a remainderman is adverse to the exercise of any power over corpus of a trust, but not to the exercise of a power over any income interest preceding his remainder.”[4] This exposes a common planning trap.

The Code and Regulations say that a testamentary power of appointment does not in and of itself create a grantor trust. If, however, income is accumulated “in the discretion of the grantor or a nonadverse party, or both, without the approval or consent of any adverse party”[5] for later testamentary distribution by the grantor, then a grantor trust will be the result.

Because capital gains is most often not distributed, but rather added to corpus under the terms of the trust or the state principal and income act, it follows (one would think) that a retained testamentary power of appointment will create a grantor trust with respect to trust principal because income is being added to corpus for later disposition under grantor’s will.[6] But not so fast.

Many attorneys think they have locked in grantor trust with respect to principal (let’s say they want to insure favorable capital gains treatment under Code section 121) by simply adding a testamentary power of appointment (realizing that capital gains are being added to principal and thus satisfying the regulation). Here is the catch: The same attorneys may also add a provision in the trust distributions terms that principal may not be distributed to grantor, but may be distributed to some class of other beneficiaries within the discretion of the trustee or some other parties. These sorts of provisions are added to allow some mechanism to strip principal out of the trust without creating potential Medicaid availability issues for the grantor.[7]

If the consenting trustee or other consenting parties are from the pool of trust remainder beneficiaries, those consenting parties will be adverse. Because these adverse parties have control over distributions of principal, it follows that any accumulated capital gains added to corpus will be distributed via grantor’s will only with the tacit consent or approval of adverse parties. These consenting parties may simply elect to distribute the entire trust prior to grantor’s death.

In this particular case, if grantor trust status with respect to trust principal is important, look for some provision other than a testamentary power of appointment if any party has the ability to distribute corpus prior to the grantor’s death in a manner that could benefit herself. Possible solutions might involve subjecting discretionary distributions of trust principal to the discretion of a nonadverse party or allowing grantor or a nonadverse party to add or delete remainder beneficiaries (both of which are Grantor Powers under Code section 674(a)).

For example: Greta Grantor retains a testamentary power of appointment over trust corpus. Under the trust instrument and local law capital gains are added to principal. Greta’s son Anthony Adverse, the trustee and one of the named remainder beneficiaries, has the discretionary authority to distribute principal to or among Greta’s issue. Greta’s testamentary power of appointment is not a Grantor Power because an adverse party can at any time prevent the accumulation of income for later testamentary distribution simply by ordering a distribution of principal.

OK, Another Example: The facts are as above, except that trust principal may not be distributed during Greta’s life. Greta’s testamentary power renders the trust a grantor trust with respect to all items of income, deduction and credit allocable to corpus (i.e., capital gains) because income is being accumulated for later testamentary distribution by Greta.[8]

On the other hand, for some reason Greta does not trust herself with a testamentary power in her later years. The trust contains a “default” provision that on Greta’s death the remainder will be distributed per stirpes among Greta’s issue. But she also trusts her sister Nancy Nonadverse to respond to changing circumstances, so she provides that Nancy may order discretionary distributions of principal among Greta’s issue at any time. Nancy’s power is a Grantor Power under Code section 674(a) and is held by a nonadverse party, thus rendering the trust grantor trust with respect to all items of income, deduction and credit allocable to corpus.

Isn’t This Marvelous?

By wisely identifying available potentially adverse and nonadverse parties in the grantor’s universe, and by carefully designing trust provisions to meet grantor’s needs, a drafting attorney can control the tax status of the trust. This remarkable accomplishment will insure hero status in the client’s eyes and could very well be the stuff of later legal legend. ________________________________________________________________

[1] Treas. Reg. § 1.672(b)-1 (the regulation reads in its entirety: “A ‘nonadverse party’ is any person who is not an adverse party.” Certainly this must put it in the running for the shortest tax regulation.)

[2] See Treas. Reg. § 1.672(a)-1(b).

[3] See Treas. Reg. § Treas. Reg. 1.672(a)-1(c).

[4] Treas. Reg. § 1.672(a)-1(d).

[5] Treas. Reg. § 1.674(b)-1(b)(3).

[6] Id.

[7] 42 U.S.C. § 1396p(d)(3)(B).

[8] Id.

Should Special Needs Trust Beneficiaries Eat Their Pets?

August 22, 2014 by Bob Mason Leave a Comment

Recent Question: Bob, is it OK for the trustee of a special needs trust to purchase a $2,000 pure bred spaniel for the trust beneficiary, Edwina?

Recent Answer: Only if Edwina is not planning on eating the dog. I’ll explain. First, you’ll need to understand the SSI income rules and what In Kind Support and Maintenance (ISM) is. Distributions from a special needs trust might be income! The trick is in understanding how income is counted and what it does.

What is SSI?

Supplemental Security Income, or SSI, supplements the income of disabled persons or those aged 65 and over who meet certain low asset tests and have countable income from all sources less than $735 monthly (2017). SSI will insure that a person’s countable income from all sources, when combined with an SSI benefit, will equal the Federal Benefit Rate or “FBR” (which for a single person is $735). See the complete FBR chart on the Mason Law, PC website. For example, if a single person’s countable income is $500, then SSI will pay $235.

Usually the amount of SSI is not as important as the fact that someone is eligible to receive any SSI. In most states (including North Carolina and Georgia) receiving even $1 SSI will entitle the person to Medicaid (which for a disabled individual can be a life saver).

How Income Counts in SSI

An SSI eligible individual may not have countable income in excess of the FBR. Countable income will reduce the amount, dollar-for-dollar, that SSI pays. Income includes all amounts received from wages, other public benefits, annuities, gifts (in the month of receipt) and other noncash items such as food and shelter (or payments made for those expenses).

When calculating countable income, the first $20 of income from all sources is disregarded. Thereafter, the first $65 of earned income is disregarded, and after that one-half of earned income in excess of $65.

SSI Earned Income: Can Edwina Work A Little?

Maybe a little. For example, if Edwina, a disabled individual, occasionally answers phones at a local charity and earns $1,200, she will be eligible for $92.50 monthly SSI payments. Let’s do the math: Edwina earns (meaning she works for it) $1,200. Subtract $20 from $1,200 to get $1,180. Subtract the first $65 of earned income from $1,180 to arrive at $1,115. One-half of $1,115 will be the income excluded ($557.50). So, in other words, Edwina’s countable income is $642.50 ($1,200 minus $557.50). Accordingly, Edwina’s SSI benefit is $735 (the maximum SSI benefit) less $642.50 (countable income). She will receive a monthly SSI check equal to $92.50.

SSI Unearned Income: Can Edwina Receive Cash?

Maybe a little . . . a VERY little. Instead of working, say Edwina receives a $1,200 cash distribution from a special needs trust (or even from a well-meaning friend or relative). SSI considers this unearned income (after all, she didn’t earn it). That means there are no earned income exclusions. $1,200 cash distribution, less the general $20 disregard yields $1,180. That is Edwina’s countable income. $735 (maximum SSI benefit) less $1,180 yields . . . TOAST. Edwina is toast! No SSI benefit.

What happens if instead of cash, the trust pays for certain items for Edwina? Say, for example, the trust pays for clothing, food, computer equipment, prescription drugs or therapy, entertainment, travel . . . or even a pet.

In-kind Support and Maintenance (ISM): Can Edwina Receive “Other Stuff”?

Now to the matter at hand: Can the trustee of the special needs trust buy the fancy dog for Edwina? It depends. Is Edwina planning on Fricasse of Fido (er . . . a feast) or is she planning for the emotional comfort that can only come from the unqualified love of a furry companion? The answer to those questions will determine whether Fido is In-Kind Support and Maintenance or ISM.

Sometimes trusts and other people give a disabled beneficiary certain non-cash items, or pay for non-cash items on behalf of the individual. If such an item is classified as ISM it will reduce SSI benefits. The amount of the reduction may not matter . . . or it could result in the beneficiary losing all SSI (and Medicaid). Of course, if the item is not ISM, it doesn’t matter how much it is worth as long as it is a non-countable asset for SSI purposes.

Items related to food and shelter are ISM. For example, rent or mortgage payments (shelter), utility expenses (shelter), groceries (food), restaurant food certificates (food), property taxes (shelter), or a Christmas gift from Omaha steaks (food) are all ISM. (Interesting side note: Cable, phone, and internet are not ISM).

If Edwina is planning on eating Fido, Fido’s value ($2,000) will be ISM. On the other hand, if Edwina does not intend to eat Fido, he is not ISM.

What Does ISM Do To SSI Benefits?

It depends. One of two rules could apply, depending upon the beneficiary’s living arrangement. If the beneficiary is living in the home of another for at least one continuous month and receiving both food and shelter without contributing her pro rata share of those costs, her SSI benefit is lowered by one-third of the FBR (or $245 in 2017). This is called the “value of the one-third reduction” or “VTR” rule (I have no idea where they get “VTR”).

The problem with the VTR rule is it is “all or nothing.” If the rule applies, the beneficiary’s SSI is reduced $245 regardless of the actual value of the food and shelter received. If someone is receiving $735 SSI, the reduction to $490 might be a good deal (especially if the food and shelter is high quality).

Two conditions must be met for the VTR rule even to apply: (1) living in another’s home rent free, and (2) receiving free food. If those conditions aren’t met, the rule doesn’t apply.

If the VTR rule doesn’t apply, then the “presumed maximum value” or “PMV” rule applies. Under this rule, if the beneficiary receives any ISM during the month, the value of the ISM is “presumed” to be $245. “Presumed” means that if the beneficiary can prove that the ISM wasn’t worth $245, the SSI benefit will be reduced only by the actual value of the ISM. On the other hand, if the ISM is worth more, the value is still “presumed” to be $245 and the SSI will be reduced accordingly.

As For Fido . . .

So . . . if Fido (worth $2,000) is meant for the dinner table (gross), he is ISM. If Edwina’s SSI is more than $245 and she doesn’t have other offsetting earned or unearned income, then she’ll be OK (other than, I presume, a bit of indigestion). On the other hand, if Edwina’s SSI is less than $245 and Fido is ISM (food), she is . . . .

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