By Thomas D. Begley, Jr., CELA

Trusts for disabled individuals who have not reached age 65 and are funded with assets of the disabled person are authorized under OBRA-93.(1)  The trust is for the benefit of disabled persons.  The person much be under 65 at the inception of the trust.  While the trust must be established and funded prior to the beneficiary attaining the age of 65, it may continue after 65.  If the trust is funded with a structured settlement prior to the beneficiary attaining the age of 65, the trust remains viable even though payments from the annuity are received after age 65.

The trusts must be established by a parent, grandparent, legal guardian, or court. Curiously, they cannot be established by the disabled individual. However, there is legislation in Congress that would permit the individual beneficiary to establish his or her own trust.

By statute, transfers to the trust are not subject to the transfer of assets rules. The trust should be drafted so that the resources are unavailable. The trust should be administered in such a way that the income is not counted as income to the beneficiary.

The trust must provide that on death the funds remaining in the trust go first to reimburse Medicaid and then for the benefit of other beneficiaries.

The assets used to fund the trust must be the assets of the beneficiary, not the assets of a third party, except that a token amount is permitted to be contributed by a third party to seed the trust, i.e., S10 or S20.  If a trust is funded with assets of a third party, it is considered a Third-Party Special Needs Trust and the rules are very different.  Generally a Self-Settled Special Needs Trust, or First-Party Special Needs Trust is used in connection with:

• A personal injury settlement
• An inheritance
• Child support
• Alimony

When drafting a Self-Settled Special Needs Trust, it is always good practice to use a professional trustee. Family members are always well intentioned, but do not have the necessary expertise with respect to public benefits law, tax law and investments and do not know how to navigate the disability system. Family members frequently have a conflict of interest with the beneficiary. Family members are often uncomfortable in naming a professional trustee. A way to make everyone happy is to appoint family member as trust protector. The trust protector is given the authority to monitor the trustee and to remove and replace the trustee, if the trust protector is dissatisfied with the trustee’s performance. The trust protector’s power to remove and replace could be limited to cause, which would be spelled out in the trust document, or the power could be exercised without cause. If a family member serves as trust protector, it is inappropriate to provide for compensation for the family member. The document should provide that if the trust protector removes and replaces the professional trustee, the new trustee must also be a professional trustee. The professional trustee could be a corporate trustee or a disability organization. It is good practice to set a limit on the dollar amount under management by the new trustee. Fifty million dollars might be appropriate, so that disability organizations can qualify.

Established by

A Self-Settled Special Needs Trust must be established by a parent, grandparent, guardian or court.  The Social Security Administration (SSA) is now taking the position that if a parent establishes a trust, they must fund the trust with 510 of the parent’s money. This position is based on a court case, Draper v. Colvi11.(2) The rationale seems to be that the person who “first funds” the trust is the establishor. If the parent signs the trust, but funds it with the personal injury settlement, inheritance, child support or alimony, then that money belongs to the beneficiary of the trust, so the court

and Social Security are taking the position that the first funding comes from the beneficiary and the beneficiary is not permitted to establish a Self- Settled Special Needs Trust.

The same rationale would apply to a trust established by a grandparent. Self-Settled Special Needs Trusts are seldom established by a guardian, because court action is required to authorize the guardian to establish the trust. As a practical matter, it is easier to simply have the court establish the trust. The judge will not want to sign the trust, so the trust document must state that the trust is approved, required and established and the judge directs another individual to sign the trust. Typically, the individual signing the trust is the parent, but the first funding doctrine does not apply, because the trust is actually being established by the court. It is not good practice to simply incorporate the trust in the court order by reference. It is important that the judge direct someone to sign the trust. If a parent or grandparent is not available, it could be any other family member or even an attorney.

In establishing any trust to be used in a Medicaid context, there are seven planning considerations:

1. Availability. Because the trust language gives the trustee total discretion as to distributions, the assets in the Self-Settled Special Needs Trust are not considered available for Supplemental Security Income (“SSI”) and Medicaid eligibility purposes. It is important to carefully draft the trust with appropriate special needs language.
2. Transfer of Asset Penalty. There is no transfer of asset penalty for SSI and Medicaid, because there is a statutory exemption under 42 U.S.C. § 1392b and 42 U.S. C. § 1396p(d)(4)(A).
3. Payback. A payback to Medicaid is required by law. The payback is for all medical assistance received by the beneficiary since birth. It is not sufficient to pay back Medicaid benefits received from the date of the establishment of the trust to date. In the case of a personal injury settlement, the Medicaid payback is not limited to medical assistance related to the personal injury.

4. Funding. Self-Settled Special Needs Trusts are generally funded by personal injury recoveries, inheritances, equitable distribution, alimony or child support. However, any asset can be used to fund a Self-Settled Special Needs Trust.
5. Tax Considerations
   1. Income. A Self- Settled Special Needs Trust is considered a granter trust. Therefore, the income earned by the trust is taxed to the beneficiary at the beneficiary’s tax rates.
   2. Gift. Transfers to a Self-Settled Special Needs Trust are not completed gifts.
   3. Estate tax. Assets in a Self-Settled Special Needs Trust are included in the estate of the beneficiary.
6. Estate Recovery.  There is no Medicaid estate recovery against a Self-Settled Special Needs Trust, but a payback provision has the same effect.
7.  Elective Share.  Assets in a Self-Settled Special Needs Trust would be considered subject to the elective share.
   

   Irrevocability

   While the above-referenced statutes do not mention irrevocability, the POMS do require that a Self-Settled Special Needs Trust be irrevocable.

   Spendthrift Clause

   The Social Security Administration requires that a Self­ Settled Special Needs Trust have a spendthrift clause. The purpose of this clause is to prevent the beneficiary of the trust from assigning trust assets. If the beneficiary had the right to assign the corpus of the trust the assets would be available and the trust would not qualify as a Special Needs Trust. Even though the trust contains a spendthrift provision, it is not immune from claims of the beneficiary’s creditors, unless it is established in a state that has a Domestic Asset Protection Trust statute. A First-Party Special Needs Trust is a Self-Settled Trust and, therefore, subject to claims of creditors. New Jersey does not have a Domestic Asset Protection Trust statute.

   1   42 u.s.c. § 13 96p( d ) (4)( A).

   2 Draper v. Colvin, DSD Civ. 12-4091-KES Ouly 10, 2013); U.S. Cou rt or Appeals 5th Cir. No. 13-2757 (Mar. 3, 2015).

[This article is a continuation of an article appearing in last month’s issues of The Barrister concerning protection of assets from creditors.]

Many lawyers and other professionals and owners of business are subject to suit by creditors, often because of the nature of the business activities in which they engage. This series of articles is designed to discuss various steps that can be taken to protect assets from claims of these creditors. Under the Fraudulent Transfer Act, it is critical that steps be taken well in advance of any incident that may lead to a claim or to the filing of a claim itself. Last month’s article discussed insurance, titling of assets, retirement plans, and assets used in a profession or business. This article will discuss Domestic Asset Protection Trusts (DAPTs) and reasons not to use Off-Shore Trusts.

DOMESTIC ASSET PROTECTION TRUST

Fifteen states have adopted legislation authorizing DAPTs. These include the following: Alaska, Delaware, Hawaii, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia and Wyoming. Statutes in each of these states vary. For purposes of this discussion, it will be assumed that the DAPT is established under the laws of Delaware.

The DAPT must be:^[1]

• The trust must be irrevocable.

• Spendthrift Clause. The trust must contain a spendthrift clause.

• The situs of the trust must be Delaware for purposes of determining the trust’s validity, construction and administration.

• The trust must appoint at least one Delaware trustee.

• The assets must be custodied by the Delaware trustee in Delaware.

• The Delaware trustee must maintain records for the trust.

• Fiduciary Income Tax Returns. The Delaware trustee must prepare or arrange for the preparation of fiduciary income tax returns.

• Trust Administration. The Delaware trustee must materially participate in the administration of the trust.^[2]

• Resident Trustee. The trustee must either be an individual who resides in Delaware or a corporation that is authorized to conduct trust business in Delaware and is regulated by the Delaware banking commissioner or a federal agency.^[3]

• Any action to enforce a claim against a Delaware DAPT must be brought in the Delaware Court of Chancery. The Act also bars original actions and actions to enforce judgments, including judgments entered elsewhere.^[4]

The grantor of a Delaware trust may retain the power to:^[5]

• Consent to or direct investment changes;
• Veto distributions; and
• Replace trustees or advisors.

The grantor of a Delaware DAPT may have the following:

• Income and Principal. The ability to receive income and principal pursuant to a broad discretion or a standard determined by the Delaware trustees.

• Current Income. The right to receive current income distributions.

• Power of Appointment. A Special Limited Testamentary Power of Appointment.

• Payments on Death. The ability to provide for the payment of debts, expenses, and taxes on death.

The grantor of the Delaware DAPT may not serve as Trustee.^[6] While individuals other than the grantor may serve as co-trustee even if they are not Delaware residents, the downside is that this may increase the ability of creditors to serve process in other states, and the possibility that a court may find that Delaware law does not control.

There are certain super creditors established under federal law, which trump state law. Super creditors include, but are not limited to:

• The Internal Revenue Service (IRS)

• The Securities and Exchange Commission (SEC)

• The Federal Trade Commission (FTC)

• Children seeking child support

• Alimony/Equitable Distribution. Only a spouse married to the grantor before the trust was created may invoke this exception.

If a Delaware DAPT is established as an irrevocable non-grantor trust without a Delaware beneficiary, the income accumulated and capital gains incurred for the non-resident will not be subject to Delaware income tax.[7]

With respect to situs, the Delaware Supreme Court declared in 1947 that, “In determining the situs of a trust for the purpose of deciding what law is applicable to determine its validity, the most important facts to be considered are the intention of the creator of the trust, the domicile of the trustee, and the place in which the trust is administered.”[8] In New Jersey, which has adopted the Federal Grantor-Trust Rules, the tax can be avoided by having the grantor agree to limit distributions to himself subject to approval of an adverse party. To avoid this income or capital gains tax, a Pennsylvania resident must use a type of Delaware DAPT known as a Delaware Incomplete Non-Grantor Trust (DING Trust). This is because Pennsylvania has not adopted the Federal Grantor-Trust Rules.

OFF-SHORE TRUSTS

While arguments can be made that off-shore trust provide advantages unavailable under a DAPT, there are also risks attendant in an off-shore trust. When establishing an off-shore trust, assets must be moved to that jurisdiction, such as the Cook Islands or the Cayman Islands, to insulate them from creditors. This is expensive and involves many logistical hurdles. Law of the foreign jurisdiction controls, which gives the advantage that the Full Faith and Credit Clause of the United States does not apply. Laws of those jurisdictions are specifically designed so that a creditor must file suit in the foreign jurisdiction under those laws and laws in these jurisdictions make it very difficult for a creditor to obtain a judgment. Trustee powers are very broad, which makes it difficult for a creditor to collect from trust assets. The problem is that trustee are often non-compliant, and there are instances where grantors of these trusts have been incarcerated for failure of the foreign trustee to comply with orders of U.S. courts.

[1] Del. Code Ann. tit. 12, §§3570(11)(a) , (b) & (c).

[2] Del. Code Ann. tit. 12, §3570 (8)(b).

[3] Del. Code Ann. tit. 12, §3570(8)(a).

[4] Del. Code Ann. tit. 12, §3572(a).

[5] Del. Code Ann. tit. 12, §3570(8)(d); Del. Code Ann. tit. 12, §3570(11)(b).

[6] Del. Code Ann. tit. 12, §§3570(8)(c), 3571.

[7] Del. Code Ann. tit. 30, §§1636, 1636(b).

[8] Louis v. Hanson, 36 Del. Ch. 235, 128A.2d 819, aff’d 357 U.S. 235.