Disabled and Chronically Ill Beneficiaries Update

Take-Away: Leaving retirement benefits to a disabled or chronically ill designated beneficiary can exploit stretch required minimum distributions. The challenge will be to meet the statutory definitions of disabled or chronically ill. Fortunately the SECURE Act gives us new tool to use, the Applicable Multi-Beneficiary Trust to direct retirement benefits to separate trust shares created for disabled or chronically ill trust beneficiaries.

Background: Under the 2019 SECURE Act, disabled and chronically ill beneficiaries who inherit retirement accounts will be able to continue to stretch distributions from the inherited retirement account over their life expectancies. These beneficiaries are placed in a new category of beneficiary called an eligible designated beneficiary, or EDB. [EDB’s also include the retirement account owner’s surviving spouse and minor children, until the child attains the age of majority, i.e. 21, and designated beneficiaries who are less than 10 years younger than the deceased account owner.] While a disabled or chronically ill individual could fall within the EDB classification, not all disabled or chronically ill beneficiaries will meet the narrow statutory definitions and IRS guidelines to be treated as an EDB. The ‘test to stretch’ is not tied to the individual’s ability to collect on a work-related disability income policy or to receive a disability pension but to other code sections.

Disabled Beneficiary: It is a challenge to meet the SECURE Act’s definition of a disabled eligible designated beneficiary, since the definition is so limited.  For a disabled individual to qualify as a eligible designated beneficiary, he/she must meet the following definition [IRC 401(a)(9)(E)(ii)(lll).]:

For purposes of this section, an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be long-continued an indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require. [IRC 72(m)(7).]

Thus, an individual who may collect on a disability insurance policy or receive benefits under a disability pension, who also has a part-time job or their own occupation, will not qualify as being disabled under the SECURE Act. While Social Security disability income is based on a 12-moth inability to work standard, the SECURE Act requires that the individual’s disability must be long-term, which might be more than 12 months in duration.

Chronically Ill Beneficiary: The definition of being chronically ill to thus qualify as an eligible designated beneficiary is also narrow, but not perhaps as big a hurdle to meet as is the definition of being disabled. [IRC 401(a)(9)(E)(ii)(IV).]

A chronically ill individual is someone who qualifies under the tax rules for defining long term care (LTC) services in LTC insurance policies. From Tax Code Section 7702(B)(c) and under the SECURE Act, to qualify as a chronically ill person would have to be certified by a licensed health care practitioner to the unable to perform at least two activities of daily living for at least 90 days or require ‘substantial supervision’ due to severe cognitive impairment.

Therefore, the chronically ill eligible designated beneficiary must be unable to perform  two (2) of five (5) activities of daily living of the six (6) listed in the Tax Code, or have a disability similar to that or may have a cognitive impairment such that they need substantial supervision for their health and safety.

Snapshot Determination Date: Under the current Proposed Regulations, the beneficiary’s status as either being disabled or chronically ill is determined on the date of the retirement account owner’s death. If a designated beneficiary later becomes either disabled or chronically ill  as defined by the SECURE Act, that determination will be too late. The beneficiary must either be disabled, or chronically ill as defined by the Act, on the account owner’s date-of-death, not later.  Equally confusing and what remains open is who makes the determination of a disability. This is not a problem for a chronically ill beneficiary as health care providers are identified in the Regulations who may make such a determination and provide a certification. Yet another question that the Proposed Regulations seem to address (still a bit unclear, though) is when the determination-certification must be completed, which appears to be no later than October 31 following the year of the retirement  account owner’s death, because that will be the same time to deliver a see-through trust instrument to the IRA sponsor or qualified plan administrator.

Applicable Multi-Beneficiary Trust: The SECURE Act recognizes the important role that special needs trusts play in planning for a disabled or chronically ill individual. Accordingly, a retirement plan left to a special needs trust can be distributed over the lifetime of a beneficiary with either a disability or who is chronically ill. [IRC 401(a)(9)(H)(iv).] What is different about the SECURE Act, as it was passed, is that it creates a new category of trust that is available for those beneficiaries who require special needs trusts. These are third-party special needs trusts that would qualify the beneficiary potentially for Medicaid and other governmental benefits and applicable multi- beneficiary trusts.

Individual Beneficiaries: Under an equable multi-beneficiary trust, typically there are multiple trust beneficiaries, one of whom is either disabled or chronically ill. All of the trust beneficiaries, however,  must be individuals. The rule can also apply to a ‘standalone’ third-party trust established for the eligible designated beneficiary, but no one can have an interest in the special needs trust except the disabled or chronically ill beneficiary during his/her lifetime.

Immediate Division into Shares: The division into separate shares must happen immediately after the retirement account owner’s death. While not formally described, that probably means no later than December 31 of the year that follows the death of the retirement account owner, which is when separate accounts have to be established under the Regulations for beneficiaries of inherited IRAs.

No ‘Diversion’ Provisions: What this means is that with other trusts which are drafted with a ‘poison pill’ provision so that if the trust beneficiary no longer qualifies for governmental benefits, such as Medicaid, that it’s assets will go to alternate beneficiaries, that type of provision will not work under the SECURE Act’s applicable multi-beneficiary trust. Similarly, if there is a trust provision that directs if there is excess income, it can be distributed to the descendants of the settlor, or to other trust beneficiaries, that alternate distribution provision will also not work under the SECURE Act’s applicable multi-beneficiary trust.

Summary: Consequently, it is very important to draft the trust carefully and closely follow the disabled and chronically ill requirements under the Tax Code. This is similar to Qualified Disability Trusts, as described in IRC 642. What is key is that the trust shares created for those other trust beneficiaries who are neither disabled nor chronically ill will be allowed to be divided under the trust instrument, but they will follow the 10-year distribution rule that is required for those individuals who are designated beneficiaries.

Death: When the disabled or chronically ill beneficiary dies, the 10-year distribution rule will then kick- in for the remainder beneficiaries of the disabled or chronically ill beneficiary’s share. All other beneficiaries under the trust will take following the 10-year distribution rule. Whether the other beneficiaries take in an accumulation or conduit trust format is a question that the Proposed Regulations will hopefully address, but they all take under the 10-year distribution rule.

Pick-and-Choose Assets: This arrangement with an applicable multi-beneficiary trust then provides some flexibility to the trustee. The trustee will be able to pick-and-choose what assets that can be allocated among the different trust beneficiaries. Often the retirement assets would be more valuable to the special needs trust beneficiary since those distributions can last over the disabled or chronically ill eligible designated beneficiary’s lifetime.

Proposed Regulations: The Proposed Regulations issued earlier this year provide numerous examples with respect to trusts with multiple beneficiaries. They also provide that an individual who has not attained the age of 18 id deemed disabled if, as of the date of the account owner’s death, the individual has a medically determinable physical or mental impairment that results in marked and severe functional limitations that can be expected to result in death or to be of a long-continued and indefinite duration.

Planning: If there are disabled or chronically ill beneficiaries, consider the following:

1. Use a statement of intent (material purpose?) provision in the trust instrument that clearly states the settlor’s intent to “create an Applicable Multi-Beneficiary Trust under the SECURE Act.”
2. Provide authority to an agent acting under any Durable Power of Attorney  that the agent possesses  broad powers to execute beneficiary designations that might change allocations among beneficiaries as the beneficiary’s needs change.
3. Make sure that no charities are named as remainder beneficiaries of the trust (directly or contingent.).
4. Since a disabled or chronically ill individual may be receiving some form of governmental benefits, naming such person directly as the inheritor of a retirement account could jeopardize their governmental means-tested benefits. Thus, it is probably best to name a  special needs trust as the designated beneficiary of the retirement account.
5. A Roth IRA or Roth 401(k) account would be a better retirement account to leave to a disabled or chronically ill beneficiary, since the tax-free nature of the distributions from the Roth account will not cause problems with the receipt of governmental benefits.
6. If possible, due to potential time constraints, disability or chronically ill determinations and certifications should be obtained while the retirement account owner is still alive.

Conclusion: Dealing with disabled and chronically ill beneficiaries is always a challenge, especially if the goal is to enable them to take stretch RMD distributions over their lifetime. The determination and certification requirements are problematic- not impossible, just a lot of pressure to obtain in a relatively short period of time (e.g. exhausting appeals with regard to a Social Security disability determinations.) The is some help, though, with the applicable multi-beneficiary trust rule, that enables the account owner to not have to create two trusts, one for designated beneficiaries, and another for eligible designated beneficiaries.