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By their very nature, special needs trusts (Special Needs Trusts) are usually designed to terminate, or at least radically change, when the trust’s primary beneficiary dies. But terminating a special needs trust is not as simple as merely writing a check to the remainder beneficiaries and calling it a day. There are several key considerations and requirements to keep in mind.
Where does the money go?
The trustee is responsible for dissolving the trust and fulfilling the instructions laid out in the trust document. These include filing the trust’s final tax return and paying any income taxes due. (For more on paying taxes when a special needs trust is terminated**.) There may be other expenses, too, such as funeral and burial costs.
If the trust is a first-party trust – a trust funded with the person with special needs’ own assets — it will owe money to the state if the person with special needs received Medicaid benefits during his or her lifetime. In what is known as a pay-back provision, the first-party trust must reimburse the state, dollar-for-dollar, for all Medicaid expenses incurred throughout the beneficiary’s life on the death of the beneficiary.
Federal or state estate tax may be due from first-party Special Needs Trust assets. In 2020, each individual has a federal exemption amount that equals $11.58 million, meaning that if the amount remaining in the beneficiary’s estate is less than this amount, no federal estate tax is due. This estate tax exemption will grow each year due to inflation, but unless Congress acts before then, this law is scheduled to sunset in 2025 and the federal exemption amount will fall to $5 million. The tax rate ranges from 18 percent up to 40 percent, depending on the amount over the exemption amount that is being taxed.
What happens to any assets left over, after Medicaid is paid back?
If the trust has designated secondary, or remainder, beneficiaries, the assets would pass to them once taxes and expenses have been paid, according to the language of the trust. Although many trusts specifically name the remainder beneficiaries (i.e., “25 percent of the trust shall go to Jane, 75 percent to Mary”), in other cases the trust names only a class of beneficiaries (“the donor’s grandchildren will share the remainder of the trust funds equally”). It is up to the trustee to determine the identities of any unnamed remainder beneficiaries, contact all the beneficiaries, and make arrangements to distribute the trust funds to them. If any of the remainder beneficiaries are young or have special needs of their own, the trust may allow the trustee to retain the trust funds for the benefit of those particular beneficiaries under terms that may be quite similar to those found in the original trust.
Is it possible to change secondary beneficiaries?
This depends on the wording and terms of the trust. The trust may have an “amendment provision,” which gives the trustee some flexibility to make changes to the trust. This could include changing the remainder beneficiaries through a provision known as “power of appointment.” If the trustee (or perhaps even the beneficiary himself, depending on the trust language) has power of appointment, he can create a document to change who will receive the assets in the special needs trust on the death of the primary beneficiary. A variation is the limited power of appointment, which, though more restricted, would still allow the trustee or beneficiary to make changes.
What if secondary beneficiaries are not fit to inherit the trust’s assets?
The secondary beneficiary may be a minor, a person with disabilities, or struggling with gambling, drug, or alcohol addiction. Depending on the terms of the trust, the trustee may have some authority to change the distribution of funds to such remainder beneficiaries. The trustee may, for example, hold the assets in a special account, under a rule known as a “flexible distribution provision.” In this way, the trustee has discretion to act in the interests of the secondary beneficiary while safeguarding the assets within the trust itself.
Special needs trusts are designed to provide funds over a long period of time, to care for the primary beneficiary for the entirety of his or her life. Many things can change over this period, so it is vitally important that the trust is carefully constructed to take all this into account. Likewise, the trustee must understand the terms and provisions of the trust thoroughly, during the beneficiary’s lifetime and afterward.
For more detailed information pertaining to your circumstances, contact Attorney Patricia Bloom-McDonald , an experienced special needs planner.
**What Taxes Are Due When the Beneficiary of a Special Needs Trust Dies?
Trusts are important vehicles in special needs planning. They not only set aside funds to pay for the care of the person with special needs while maintaining eligibility for programs like Medicaid, but they provide ways to preserve these funds through the person’s lifetime. What happens, though, when the primary beneficiary of the Special Needs Trust dies and there are assets left in the trust? How are taxes calculated and paid?
At the beneficiary’s death, in most cases the Special Needs Trust will be terminated. The trustee is responsible for dissolving the trust and fulfilling the instructions laid out in the trust document. These include filing the trust’s final tax return and paying any income taxes due. There may be other expenses, such as funeral and burial costs.
If the Special Needs Trust is a third-party trust, it is funded perhaps by a relative or parent, and the pay-back provision to the State does not apply. Even if the special needs beneficiary used Medicaid services, the state cannot claim reimbursement once a third-party trust is terminated. Any funds left over will be distributed to the remainder beneficiaries named in the Special Needs Trust or transferred to the deceased person’s estate as specified in the trust document. There is often an income tax associated on the transfer of assets. The distributions to the remainder beneficiaries are reported on the recipients’ income tax returns, and taxes may be due. No estate tax is due, however, because the assets in the third-party Special Needs Trust are not counted as part of the beneficiary’s estate for estate tax purposes.
In addition, certain states have a separate estate tax that may be owed by the trust. These states include Connecticut, the District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington. The exemption amounts range from $1 million up to $5.682 million. In addition, certain states have an inheritance tax that is paid by the recipients of the money. These states include: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
Among the emotional challenges in special needs planning is making provisions for the death of your loved one with disabilities. But it’s important to understand all aspects relating to government benefits, taxation, and inheritance as you engage in the process. Consult your special needs planner to develop the best strategy for your family and your financial situation.