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George F. Bearup, J.D. Senior Legal Trust Advisor

16-Feb-21

Decanting a Special Needs Trust- Proceed with Caution

Take-Away: A self-settled special needs trust which preserves the beneficiary’s eligibility for Supplemental Security Income (SSI) generally cannot be terminated ‘early’ without jeopardizing the beneficiary’s SSI benefits and triggering a repayment of the previously received Medicaid benefits. A decanting of that special needs trust is viewed by the Social Security Administration (SSA) as a termination of the trust. Accordingly, care needs to be taken if a special needs trust is decanted, or even modified, which the SSA may treat as a ‘termination.’

Background: A self-settled special needs trust is a trust that is created with the disabled individual’s own assets. For such a trust to not be ‘counted’ as an available resource of the beneficiary, in order to maintain their eligibility to receive SSI and Medicaid benefits, the special needs trust must adhere to numerous statutory rules and requirements. [42 U.S.C. 1396p(d)(4)(A.] The common name given to this type of trust is a (d)(4) trust.

  • Third-Party Special Needs Trust: A trust created for the benefit of a disabled person by a third-party, e.g. parent or grandparent, is not subject to these rules or restrictions. These trusts are not addressed below.
  • Reimbursement or Pay-Back Obligation: A (d)(4) trust permits the disabled beneficiary to continue to receive SSI and Medicaid benefits, and also receive discretionary distributions from the trust, with the caveat that on the beneficiary’s death, the trust must reimburse the government for all Medicaid benefits paid to the beneficiary while alive, i.e. a pay-back trust. One of the major rules or restrictions is that a (d)(4) has limitations on when it can be terminated and to whom the trust assets can be distributed.
  • Early Termination of a (d)(4) Trust: This limitation is intended to address the practice of creating a self-settled (d)(4) trust with clauses that allow the termination of the trust prior to the death of the disabled beneficiary if the beneficiary’s disability ended or the beneficiary otherwise became ineligible for benefits. The SSA’s ‘early termination’ policy was developed to address the practice of drafting a (d)(4) trust with clauses that allowed termination prior to the beneficiary’s death if either the beneficiary’s disability ended or the beneficiary otherwise became ineligible for benefits. These clauses would otherwise allow a (d)(4) trust to escape the obligation to reimburse the states that had provided Medicaid services to the disabled beneficiary during his or her lifetime. Therefore, the SSA’s informal ‘early termination’ policy provided that a trust with an early termination clause will be treated as a countable resource unless upon termination, all states that provided Medicaid services are reimbursed from trust assets before any other disbursements (excluding taxes and some administration expenses) and all remaining trust funds are returned to the disabled beneficiary. [POMS SI 01120.199.]
  • IRS Silent on Trust Decanting: The trustee’s exercise of distribution discretion to distribute trust assets to another trust, i.e. a decanting, has been on the IRS’s ‘no-ruling’ list for several years now, and it continues to be on that ‘no ruling’ list. [Revenue Procedure 2020-3, I.R.B. 131, Section 5.01(8), (13-14).] The IRS’s refusal to comment on the tax consequences of a trustee’s decanting of trust assets creates a cloud on whether a trustee should exercise a decanting power of not due to a fear of triggering some income or transfer tax. To a large degree, the SSA has followed the IRS.
  • SAA’s View of Trust Decanting: For several years the Social Security Administration has also refused to take a formal position on the implications of a trustee decanting the assets of a (d)(4) trust. [POMS PS 01825.026.].Informally, the SSA has asserted that a total decanting of trust assets was a form of ‘early termination’ of the trust. Consequently, decanting a (d)(4) trust interferes with the  SSA’s general rule that prohibits an ‘early termination’ of a (d)(4) trust. That changed in October, 2020, when the SSA released its national policy on decanting of (d)(4) trusts.

SSA’s New National Policy on Trust Decanting: In October, 2020 the SSA released a national policy on trust decanting. The SSA’s national policy broadly defines decanting as “the distribution or transfer of trust property from one trust to one or more other trusts.” [POM SI 01120.199.] The policy goes on to state that decanting may involve early termination of the first trust or “the effect of decanting may be materially the same as the effect of an early termination.” The SSA will thus evaluate a trust’s decanting provision under its ‘early termination’ prohibition. As a result, under this new SSA policy, a transfer from one (d)(4) trust to another (d)(4) trust for the same disabled beneficiary might be permitted without having to comply with the SSA’s ‘early termination’ rule, which requires an immediate payback of all Medicaid benefits previously received by the disabled trust beneficiary.

New Policy-Specific Limiting Language: In short, the new national policy is a limited exception to the old SSA informal policy that treated decanting provisions a violation of the ‘early termination’ prohibition. A (d)(4) trust may include a decanting clause without a Medicaid reimbursement clause or otherwise satisfy the ‘early termination’ requirements if the trust allows solely for the transfer of the beneficiary’s assets to a (d)(4) trust for the same beneficiary. However, to qualify for this exception, the decanting clause must also contain ‘specific limiting language’ that precludes disbursements other than to another self-settled (d)(4) trust for the same beneficiary, or to pay certain administrative expenses. Disbursements is not qualified in any way in the national policy. While the exception suggests that a (d)(4) trust with a decanting clause will not automatically trigger the SSA’s ‘early termination’ prohibition as it did before, it is still not necessarily a ‘safe harbor.’ Similarly, it may be that the ‘early termination’ prohibition might still be triggered if there is only a partial decanting of a (d)(4) trust’s assets as opposed to a totally decanted (d)(4) trust.

Practical Implications of the SSA’s New Policy: When considering the decanting of a (d)(4) trust, it is important to remember that if the SSA disagrees with the scope of the decanting clause, the beneficiary will be denied SSI benefits. Similarly, if Medicaid benefits must be repaid as a result of a decanting, then a large portion of the (d)(4) trust could be depleted immediately after the decanting, making decanting of a (d)(4) trust a risky proposition. That would then entail a long and costly appellate process to restore the lost SSI benefits or recovery of the pay-back Medicaid amount.

In particular, there is still legal ambiguity whether a trust decanting, which is an extension of the trustee’s distribution power. Does a trust decanting either continues the existing trust or does it terminate the existing trust, the latter of which might have a bearing on the SSA’s ‘early termination’ prohibition? Accordingly, some practical considerations follow if a (d)(4) trust may later be decanted:

  • Age: The disabled beneficiary must be age 65 at the time of the transfer of assets to the second trust. By federal law, SSI beneficiaries age 65 or older may not establish a (d)(4) trust. [42 U.S.C. 1396p(d)(4)(A)(C).]
  • Trust Modification: Due to the confusion if a decanting is a continuation or termination of the first trust, every action should be taken consistent with the decanting of the (d)(4) trust as a modification of the existing trust and not present the decanting as a distribution (or resulting termination) of the (d)(4) trust.
  • Identification Number: Consistent with treating the decanting of the trust as a modification of the trust and not a distribution/termination, the (d)(4) trust should retain its original taxpayer identification number after the decanting.
  • Restatement: To be consistent with a trust modification, the product of the decanting should be either the first trust as amended or even a complete restatement of the first trust, using the same name so that the trust’s assets need not be retitled. The restatement of the existing or first trust could be executed by the decanting trustee or another person acting as the nominal settlor.
  • Name: If a change of name is desired for the decanted (d)(4) trust, the report of the change of name should be on the next filed Form 1041. Note, although self-settled (d)(4) trusts are grantor trusts, reporting income directly on a Form 1040 is not always done, most often to avoid SSA confusing taxable income with SSI income concepts.
  • Think Twice About Including a Decanting Clause: Decanting clauses are often drafted in trust instruments, even in jurisdictions like Michigan which have specific decanting statutes, usually in the belief that they can only help and not hurt. However, decanting clauses in a (d)(4) trust will invite close scrutiny by the SSA that could jeopardize the beneficiary’s SSI eligibility. The SSA’s policy is to evaluate all decanting clauses in (d)(4) trusts to ensure that they do not violate it ‘early termination’ rule. [POMS SI 01120.199, section 7.]
  • Follow the Narrow SSA National Policy: If the trust instrument is going to contain a decanting provision, it should strictly adhere to the exception under the SSA’s national policy to allow only a transfer from one (d)(4) trust to another (d)(4) established solely for the disabled beneficiary. Otherwise, a more broadly phrased decanting power might jeopardize the beneficiary’s SSI eligibility. Because Michigan already has two decanting statutes, it probably makes little sense to include a decanting authorization in a (d)(4) trust, especially when under the Michigan Trust Code, the trust’s express provisions control and override provisions of the enabling decanting statute.  Restated, the Michigan Trust Code’s decanting power is a default power that can be relied upon when the trust instrument is silent yet still exists to give the trustee the power to decant the (d)(4) trust’s assets if that is required.
  • Consider Alternatives: Because the presence of a decanting power in a (d)(4) trust invites considerable SSA scrutiny, which could lead to troubles with the SSA and loss of both SSI eligibility and loss of trust assets, perhaps a change in situs provision in the trust (moving the trust to a state with a more favorable decanting statute) or giving a trust director the power to amend the trust in order to add the desired flexibility that the decanting would otherwise have achieved, is an acceptable alternative to including an express decanting provision in a (d)(4) trust.

Conclusion: The good news is that the SSA’s new national policy suggests that a (d)(4) trust with a decanting provision will not automatically disqualify the trust as a violation of the prohibition of its ‘early termination’ rule. Unfortunately, the new policy narrowly written with regard to its exception when it uses words like solely to another (d)(4) trust, and it prohibits even disbursements  to the disabled beneficiary as a part of the decanting process. As such, the existence of the national policy could lull many into a false sense of security of a ‘safe harbor’ by including a decanting authority in a (d)(4) trust instrument. If the (d)(4) trust is to include a decanting authorization, the more every step of the decanting is consistent with a trust modification, the more likely it is that the SSA will view decanting as a modification of the existing (d)(4) trust and not apply its ‘early termination’ rule. An even better approach is for the trust instrument to remain silent, and rely upon Michigan’s default decanting statutes that will apply to the trust which is silent on the existence of a decanting power held by the trustee.