1. Advanced SNT Drafting Issues I: Tax Issues and Drafting to Hold IRAs Academy of Special Needs Planners Vincent J. Russo, J.D., LL.M., CELA Copyright March 2007 Westbury, Islandia, Woodbury and Lido Beach 1-800-680-1717 www.vjrussolaw.com

2. Overview ♦Special Needs Trusts ♦Pooled Trusts ♦IRAs ♦Supplemental Needs Trusts ♦Income Taxation of Person with Special Needs V incent J. Russo & Associates, P.C. ©2007

3. First Party Special Needs Trusts Requirements ♦Set up by parent, grandparent, legal guardian or a Court ♦To or for the sole benefit of a person who is disabled and under age 65 ♦Funded with the assets of the person who is disabled ♦Payback required to reimburse the State for Medicaid Paid ♦ 42 U.S.C. § 1396p (d)(4)(A) V incent J. Russo & Associates, P.C. ©2007

4. Tax Consequences First Party Special Needs Trusts ♦Gift Tax Treatment ♦On Funding ♦Income Tax Treatment ♦On Income Generation ♦Estate Tax Treatment ♦On demise of the beneficiary V incent J. Russo & Associates, P.C. ©2007

5. Gift Tax Consequences First Party Special Needs Trust ♦Johnny, age 6 ♦Receives a $4,000,000 medical malpractice settlement ♦If funding the SNT is taxable... ♦Federal gift tax is $920,690 ♦Calculated: $1,266,490 less unified credit - $345,800 ♦If funding the SNT is not taxable... ♦Federal gift tax is $0 ♦Estate Tax Consequences V incent J. Russo & Associates, P.C. ©2007

6. Gift Tax Consequences First Party Special Needs Trust ♦Gift Guidelines: ♦$1,000,000 and under ♦no federal consequences ♦Over $1,000,000 ♦Gift tax rates from 41% to 45% ♦Unified credit amount is $345,800 ♦ (shelters the first $1,000,000 of taxable gifts) ♦State gift tax laws - NC, LA, TN and Puerto Rico ♦CT (as of 2005) no longer impose gift tax ♦NY (as of 2000) no longer impose gift tax V incent J. Russo & Associates, P.C. ©2007

7. Gift Tax Consequences First Party Special Needs Trust ♦Example #1: ♦Donor transfers property to trust ♦Trustee to pay income to the donor or accumulate it in the discretion of the trustee ♦Donor retains a testamentary power to appoint the remainder among his descendants ♦No portion of the transfer is a completed gift V incent J. Russo & Associates, P.C. ©2007

8. Gift Tax Consequences First Party Special Needs Trust ♦Example #2: If the donor had not retained the testamentary power of appointment ♦Trust provides remainder to X or his heirs ♦The entire transfer would be a completed gift. ♦Example #3: ♦If the exercise of the trustee’s power for the grantor is limited by a fixed or ascertainable standard ♦Gift is incomplete to the extent of the ascertainable value of any rights retained by the grantor. V incent J. Russo & Associates, P.C. ©2007

9. Income Tax Consequences Who is Taxed on the Trust Income First Party Special Needs Trust ♦Trust ♦Complex Trust ♦Someone other than the grantor ♦Complex or Simple Trust ♦Grantor treated as the owner ♦Overrides Complex or Simple Trust Rules ♦Grantor Trust Rules - IRC Sections 671 -678 ♦Ignore IRC §676 - Power to Revoke V incent J. Russo & Associates, P.C. ©2007

10. Who is the Grantor - Income Tax Special Needs Trust - Definition of Grantor - PLR 9437034 ♦Facts: ♦The lawsuit arose from an accident in which the plaintiff was seriously injured. ♦The settlement proceeds compensated the decedent for his personal injuries. ♦Plaintiff was the transferor of the funds V incent J. Russo & Associates, P.C. ©2007

11. Who Pays the Income Tax First Party Special Needs Trust ♦General Rule ♦Grantor should pay the tax ♦Trust should never pay the tax ♦Exception: ♦ Qualified Disability Trust ♦Guideline: Less than $3,400 of income ♦Example: $68,000 invested at 5% yields $3,400 V incent J. Russo & Associates, P.C. ©2007

12. Who Pays the Income Tax First Party Special Needs Trust ♦Exception: Have some trust income taxable to trust and to beneficiary ♦Must be a Complex Trust ♦Can not be a Grantor Trust ♦One of the following: ♦Trust is required to accumulate income annually, or ♦Trust actually makes principal distributions, or ♦Trust may pay or permanently set aside or use Trust principal for charitable purposes V incent J. Russo & Associates, P.C. ©2007

13. Income Tax Consequences First Party Special Needs Trust ♦Trust is taxed on income ♦Rates - 35% over $10,450 ♦Exemption Amount - $100 complex/$300 simple ♦Qualified Disability Trust ♦Exemption Amount - same as standard deduction for a single person ($3,400 in 2007) ♦Grantor is taxed on income ♦Rates - individual rates apply - 35% over $349,700 Exemption Amount -$3,400 (single) ♦Beneficiary is taxed on income ♦Rates - individual rates apply - 35% over $349,700 ♦Exemption Amount - $3,400 V incent J. Russo & Associates, P.C. ©2007

14. Income Tax Consequences First Party Special Needs Trust ♦Trust is funded with $3,000,000 ♦Annual Income - $180,000 ♦Who Pays the Income Tax... ♦If Trust Pays - federal income tax - $62K ♦If Johnny Pays - federal income tax - $45K (54K if subject to Kiddie Tax) ♦If Johnny’s Parents Pay - federal income tax -$54K ♦Assuming Johnny’s parents other taxable income is $100,000 and married filing jointly V incent J. Russo & Associates, P.C. ©2007

15. Grantor/Beneficiary Pays the Income Tax Special Needs Trust - Trust Provisions ♦How does the Grantor make it happen: ♦Grantor may Exchange Property of Equivalent Value in non-fiduciary capacity ♦IRC §675 ♦Power to remove Trustee and replace with a non- adverse party who is related to or subservient to Grantor. In such case Trustees powers are attributed to Grantor and Trust is a Grantor Trust ♦IRC §672, IRC §674 V incent J. Russo & Associates, P.C. ©2007

16. Grantor/Beneficiary Pays the Income Tax Special Needs Trust - Trust Provisions ♦How does the Grantor make it happen: ♦Income payable by nonadverse party to the grantor ♦IRC § 677 ♦Adverse Party - any person who has a substantial beneficial interest in the trust which would be adversely affected ♦IRC §672 ♦Use Trust income to pay premiums of insurance on life of Grantor or grantor’s spouse ♦IRC §677 V incent J. Russo & Associates, P.C. ©2007

17. Grantor/Beneficiary Pays the Income Tax Special Needs Trust - Trust Provisions ♦How does the Grantor make it happen: ♦Reversionary Interest--at least 5% of property ♦IRC §673 ♦Testamentary GPOA-causes Grantor Trust as a reversionary interest ♦IRC §673 ♦Testamentary LPOAs generally do not create grantor trusts for income tax purposes ♦Exception: Capital Gains on principal - grantor taxed on the capital gain V incent J. Russo & Associates, P.C. ©2007

18. Income Tax Consequences Special Needs Trust - Grantor Trust ♦Tax Identification Numbers ♦Option 1- no TIN number obtained ♦Trustee providers Grantor (unless Grantor is Trustee) with a statement ♦Option 2 - New TIN for Trust ♦Trust Income Tax Return (IRS Form 1041) ♦Check the box for Grantor Trust in entity type ♦Generates a Grantor Statement (analogous to a ♦ Schedule K- 1) V incent J. Russo & Associates, P.C. ©2007

19. Estate Tax Consequences Special Needs Trust - Arrington Matter ♦Valuation: Arrington v. United States ♦Facts: ♦Parents file medical malpractice claim against doctor and hospital for injuries caused to their son. ♦Case was settled and an annuity was set up for the benefit of the son. In addition, a trust for the benefit of the son was set up to hold a lump sum certain. The son was the only beneficiary of the trust and the annuity. V incent J. Russo & Associates, P.C. ©2007

20. Estate Tax Consequences Special Needs Trust - Arrington Decision ♦Lump sum and the annuity was included in son's estate under IRC §2031 and §2033 ♦Since the trust and the annuity were "beneficially owned" by the decedent-son at his death. ♦Beneficial ownership under the IRC §2033 and IRC Regs 20.2033-1 is determined by State Law. V incent J. Russo & Associates, P.C. ©2007

21. Estate Tax Consequences First Party Special Needs Trust ♦Included in Estate for Estate Taxes Purposes ♦Decedent had a income interest and a vested remainder in the corpus of the trust and a present income interest and vested remainder in all of the annuity payments. ♦Decedent had a beneficial interest in the annuity and the trust under Texas law ♦The date of death value of the trust and the annuity payments were included in decedent's estate under IRC §2033 V incent J. Russo & Associates, P.C. ©2007

22. Estate Tax Consequences First Party Special Needs Trust ♦Debt of the Estate - Pay Back Amount ♦Deduction Against Gross Estate ♦IRC §2053(a)(2) ♦PLR 200240018 V incent J. Russo & Associates, P.C. ©2007

23. Estate Tax Consequences Special Needs Trust - TAM 9506004 ♦Facts: ♦Decedent's parents reached a settlement for medical malpractice which resulted in the establishment of two irrevocable trusts. ♦One trust was funded with settlement payments payable over ten years. ♦The second trust was funded with an annuity for A's lifetime. V incent J. Russo & Associates, P.C. ©2007

24. Estate Tax Consequences Special Needs Trust - TAM 9506004 ♦A had a testamentary limited power of appointment of the assets of both trusts. ♦In default of appointment, upon A's death, ♦The assets of the first trust were to pass to his intestate beneficiaries ♦The assets of trust 2 were to be held in trust for A's parents and their issue. V incent J. Russo & Associates, P.C. ©2007

25. Estate Tax Consequences Special Needs Trust - TAM 9506004 ♦The transfer by the parent (as guardian of A) did not constitute a gift ♦A retained the right to change the beneficiaries of the trust until his death ♦This rendered the gift to the trust incomplete. ♦The periodic payments were awarded by the hospital and the doctors in respect of A's injuries. ♦The payments were A's property. V incent J. Russo & Associates, P.C. ©2007

26. Estate Tax Consequences First Party Special Needs Trust ♦A retained the right to change beneficial enjoyment of the trust for his lifetime ♦The trust assets were included in his estate under §2036(1) and §2038 of the IRC ♦Valuation of Future Periodic Payments on Structured Settlements V incent J. Russo & Associates, P.C. ©2007

27. Pooled Trusts under (D)(4)(c) Tax Consequences ♦No Definitive Authority ♦Generally taxed as Complex Trusts ♦Treas. Reg. §1.642(c)-5 ♦Receive deduction for DNI distributed to participants ♦Participants receive Schedule K-1 V incent J. Russo & Associates, P.C. ©2007

28. IRAs and SNTs The Medicaid Rules ♦IRAs ♦Available versus Not Available ♦Permanent Pay Status ♦Required Minimum Distributions ♦Annuities ♦SNTs ♦Trust Assets not available - Medicaid V incent J. Russo & Associates, P.C. ©2007

29. IRAs and SNTs IRA Tax Rules - Trust as Designated Beneficiary ♦IRC Reg. §1.401(a)(9)-4, A-5) ♦Trust must be valid under state law ♦Trust must be irrevocable or will, by its terms, become irrevocable upon death of the participant ♦The beneficiaries must be “identifiable... from the trust instrument” ♦Certain documentation must be provided to “the plan administrator” by 10/31 of the year following the year of participant’s death ♦All trust beneficiaries must be individuals V incent J. Russo & Associates, P.C. ©2007

30. Designating SNT as IRA Beneficiary Case Study ♦Bob’s only child, Krista, is 35 years old and has CP. ♦Option #1 ♦Bob creates a Living Third Party SNT for Krista with nominal funding ♦Bob designates SNT as beneficiary of the IRA ♦Option #2 ♦Bob’s Revocable Trust with SNT for Krista ♦Bob’s Will with SNT for Krista ♦Bob designates as his IRA beneficiary the SNT for Krista under Revocable Trust, with the SNT under the Will as contingent beneficiary. V incent J. Russo & Associates, P.C. ©2007

31. IRAs and SNTs Private Letter Ruling - 200620025 ♦Taxpayer A, age 69 died ♦Four sons surviving; Child B is disabled ♦Sons are named beneficiaries of the IRA V incent J. Russo & Associates, P.C. ©2007

32. IRAs and SNTs Private Letter Ruling - 200620025 ♦Strategy ♦Separate Sub-IRAs established for each child ♦Annual RMDs are made ♦Court authorizes establishment of SNT ♦Mother - Guardian of Child B - disclaims interest in the SNT V incent J. Russo & Associates, P.C. ©2007

33. IRAs and SNTs Private Letter Ruling - 200620025 ♦Ruling ♦SNT is a Grantor Trust ♦IRC §671 ♦If grantor is owner - income attributed to grantor ♦IRC §677(a) ♦Trustee (non adverse party) may distribute income to grantor, accumulated for future distributions or applied to the payment of life insurance premiums on the life of the grantor ♦Transfer of B’s share of the IRA to SNT is not a taxable event V incent J. Russo & Associates, P.C. ©2007

34. IRAs and SNTs Private Letter Ruling - 200620025 ♦Letter Ruling Request ♦Transfer of IRA X to SNT will be disregarded for federal income tax purposes ♦The Trustee of SNT may calculate the annual distributions using Child B’s life expectancy ♦Ruling ♦SNT is a Grantor Trust ♦Transfer of B’s share of the IRA to SNT is not a taxable event ♦Trustee may calculate the annual RMDs based on life expectancy of Taxpayer B V incent J. Russo & Associates, P.C. ©2007

35. SNTs - Gift and Estate Taxes Private Letter Ruling - 9437034 V incent J. Russo & Associates, P.C. ©2007 ♦Decedent created an Irrevocable Trust ♦Funded with structured settlement proceeds with a guaranteed payment ♦Special Needs Trust created to be the recipient of the settlement proceeds ♦SNT Provisions ♦For sole benefit of Decedent ♦Testamentary Special Power of Appointment

36. SNTs - Gift and Estate Taxes Private Letter Ruling - 9437034 V incent J. Russo & Associates, P.C. ©2007 ♦Ruling: ♦Included in Estate for Estate Tax Purposes ♦IRC §2038(a)(1) ♦Decedent has the right at death to alter disposition of trust assets ♦Incomplete Gift ♦IRC Reg. §25.2511-2 ♦Donor retained special power to change the enjoyment of the trust assets

37. Third Party Supplemental Needs Trusts Essential Provisions ♦Set up by a third party for another person’s benefit ♦Funded with the third party’s assets ♦No pay back required to Medicaid ♦Can be Inter Vivos Trust or a Trust under a Will ♦Medicaid Transfer Penalty Rules V incent J. Russo & Associates, P.C. ©2007

38. Tax Consequences Third Party Supplemental Needs Trusts ♦Gift ♦Complete versus Incomplete ♦Control by drafting trust provisions ♦Income ♦Grantor ♦Simple Trust ♦Complex Trust ♦Conversion from Grantor Trust V incent J. Russo & Associates, P.C. ©2007

39. Estate Tax Consequences Third Party Supplemental Needs Trusts ♦Included in Estate of Grantor ♦Strings Attached ♦Maintain Control or Beneficial Enjoyment ♦Excluded from Estate of Grantor ♦No Strings Attached ♦No Control or Beneficial Enjoyment Retained V incent J. Russo & Associates, P.C. ©2007

40. WOW Make a Difference Have A Great Day! V incent J. R usso & A ssociates, P.C. ©2007 Special Needs Planning