This material contains references to concepts that have legal, accounting and tax implications. It is not intended as legal, accounting or tax advice. Consult your own attorney and/or accountant for advice regarding your particular situation. Accordingly, any information in this document cannot be used by any taxpayer for purposes of avoiding penalties under the Internal Revenue Code. Information provided by The Prudential Life Insurance Company. I am not affiliated with Prudential or its affiliates in any way.
Obviously, in order for a trust to accomplish its purpose, it must be funded. How the trust is funded will depend upon whether the trust is a revocable trust, an irrevocable trust, or a testamentary trust.
Revocable Trust
A revocable trust can be funded as soon as it is created, and additional money or assets can be placed in it at any time by anyone. If the parents choose to establish a revocable trust as the special needs trust and serve as the trustees, they maintain control of it in all respects. That control, however, comes at a price. During the life of the grantor, the trust is not a separate taxpayer. All of the income, dividends, and capital gains generated by the trust assets are taxed to the grantor, not the trust. If the grantor’s estate is large enough to be subject to estate taxation, the trust assets are also subject to that tax. The assets in a revocable trust are also subject to the grantor’s creditors.
The good news is that the parents may place assets into the trust without limitation as to amount or type. Others may also make gifts to the trust. Those gifts may or may not be subject to gift tax, depending on the size of the gift. Often, it is a grandparent who desires to put assets into the revocable trust established by the parents. This causes at least two problems. The gift from the grandparents is now in the parents’ revocable trust, and any assets placed in that trust are included in the parents’ estates for estate tax purposes, as well as being subject to the claims that any creditors might have against the parents. Secondly, a distribution from the trust will be considered a gift to the child, thus potentially doubling the gift tax transaction.
The trust can also be the recipient of inheritances from friends and family and can be the owner and beneficiary of a life insurance policy. Since the trust is revocable, the parents (assuming that they are the grantors) can withdraw assets from it from time to time for themselves, the child, or other family members.
Irrevocable Trust
An irrevocable trust is also established during the parents’ lifetimes. Because the trust is irrevocable, the parents lose a measure of control, but there are reasons that they might be willing to do so. This type of trust pays its own income tax so items of income are not included on the parents’ income tax return. Only the creditors of the trust can reach its assets; the trust is not subject to the claims of the parents’ creditors. However, the most common reason for using an irrevocable trust is as an owner and beneficiary of life insurance in order to avoid the inclusion of the insurance proceeds (as well as other trust assets) in the parent’s estate for estate tax purposes.
A disadvantage of the irrevocable trust is the difficulty in funding it during the lifetimes of the grantors. Because it has a separate existence from the parents, any money that they or anyone else place into it is a gift. Because the child cannot withdraw assets from the trust at the time of the gift, the gift likely will not qualify for the annual per donee gift tax exclusion. That means that there may be gift tax consequences involved in funding an irrevocable trust. The receipt of the insurance proceeds by the trust at the death of the insured generally is subject to neither gift nor estate taxation, and life insurance death benefits are generally received income tax-free under IRC § 101(a). Thus an irrevocable trust coupled with life insurance is one of the ways to help provide significant funding for the future of the child. This strategy does not take into account the time value of money and may not be appropriate in all cases.
Testamentary Trust
Because the terms of a testamentary trust are contained in a will, this type of trust cannot come into existence until the death of the maker of the will (testator). The disadvantage of using a testamentary trust is that it cannot be funded as long as the testator is alive. It can be funded only after death, for example, by life insurance proceeds, an inheritance, or as the result of receiving assets as a beneficiary of an IRA.
Funding the Trust
As noted, each of these trusts has its own funding advantages and disadvantages; however, regardless of which type of trust is used, the amount of money or other assets that most families have available to place in trust for the child, either during life or at death, is limited. Unless there are substantial assets available from the family, it is very difficult to sufficiently fund the trust to provide care for the lifetime of the child.
It is important to carefully consider all options that are available and ensure that they are used wisely. Lifetime planning with a legal advisor who specializes in special needs planning is critical. The family must know what public assistance is available and understand that changes in those programs may occur, and that those changes may negatively impact the availability of funds even after the parents’ deaths. Events within the family such as retirement, disability or the deaths of those providing the funding will likely disrupt the lifestyle of the child. Unfortunately, the parents’ ability to provide funding later in life is generally reduced.
In many cases, the parents are able to address the child’s needs while they are alive. However, a parent’s untimely death could cause considerable financial hardship not only for the child but also for other family members. And this is where a licensed financial professional can be of assistance.
Life Insurance
Life insurance can be a cost effective and efficient method for providing funding to help achieve family goals. It immediately places assets in the trust at the deaths of the parents or other insureds.
The value of life insurance for special needs families goes beyond simply providing for the child. An untimely death of the breadwinner in the family could significantly impact the financial situation of all of the family members, not just that of the child with special needs. Therefore, it is important to consider not only providing funding for the child but also the surviving spouse and other family members. Working with your tax and legal advisors can help put in place the funding to help ensure the financial future of your family.
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