A parent learns that their adult child has a severe disability and will require lifetime care. The child receives Supplemental Security Income and Medicaid benefits that pay for essential medical treatment and living expenses. The parent wants to leave an inheritance to help provide for the child’s future needs. However, the parent discovers that a direct inheritance could disqualify the child from these benefits, leaving the child worse off financially than before receiving the inheritance.
This dilemma confronts families across Texas every day. Government benefit programs like Supplemental Security Income and Medicaid provide essential support for individuals with disabilities. However, these programs impose strict asset and income limits. A modest inheritance or personal injury settlement that would seem like a blessing can become a curse by rendering the beneficiary ineligible for benefits worth far more than the inheritance itself.
The question becomes whether families can provide financial support for loved ones with disabilities without destroying their eligibility for government benefits. Texas law and federal regulations provide a solution through special needs trusts, also called supplemental needs trusts. These trusts allow families to set aside funds for a beneficiary’s supplemental needs while preserving eligibility for means-tested government benefits.
Understanding Government Benefit Programs and Their Limitations
Supplemental Security Income is a federal program that provides monthly cash payments to individuals who are aged, blind, or disabled and who have limited income and resources. The program is administered by the Social Security Administration. To qualify, an individual’s countable resources cannot exceed $2,000 for an individual or $3,000 for a couple. Monthly income also cannot exceed specified limits that vary based on living arrangements and other factors.
Medicaid is a joint federal and state program that provides health coverage to individuals with limited income and resources. In Texas, the program is administered by the Health and Human Services Commission. Medicaid eligibility rules are complex and vary depending on the category under which an individual qualifies. However, individuals receiving SSI automatically qualify for Medicaid in Texas.
Both programs impose resource limits that consider what assets the individual owns. If an individual receives an inheritance, personal injury settlement, or other windfall that causes their countable resources to exceed program limits, they lose eligibility for benefits. This creates a terrible choice for families. They can disinherit the family member with disabilities to preserve benefits, or they can leave an inheritance knowing it will disqualify the beneficiary from essential government support.
The harsh reality is that government benefits often provide far more value than modest inheritances. An individual receiving SSI might get several hundred dollars per month in cash assistance. Medicaid coverage can be worth tens of thousands of dollars annually depending on the beneficiary’s medical needs. Losing these benefits to receive a $50,000 inheritance leaves the beneficiary worse off once the inheritance is spent.
What Special Needs Trusts Accomplish
Special needs trusts provide a solution by holding assets for the benefit of an individual with disabilities without disqualifying that individual from means-tested government benefits. The trust owns the assets, not the beneficiary. Because the beneficiary does not own the assets, they are not counted as the beneficiary’s resources for purposes of SSI and Medicaid eligibility.
The trustee manages the trust assets and makes distributions for the beneficiary’s supplemental needs. The term “supplemental” is key. The trust supplements but does not replace government benefits. Distributions from the trust pay for goods and services that government benefits do not cover. This might include therapy not covered by Medicaid, entertainment and recreation, education, travel, personal care attendants beyond what Medicaid provides, and quality of life enhancements.
The trust cannot be used to provide food or shelter directly to the beneficiary without affecting SSI benefits. SSI rules treat food and shelter provided by the trust as “in-kind support and maintenance” that reduces the monthly SSI payment. However, the trustee can pay providers directly for these items in ways that minimize the impact on benefits, or the trustee can purchase other goods and services that improve the beneficiary’s quality of life without affecting benefit amounts.
Special needs trusts allow families to leave inheritances, structure personal injury settlements, and provide for loved ones with disabilities without destroying their eligibility for essential government programs. The beneficiary receives both government benefits and supplemental support from the trust, maximizing the resources available to meet their needs.
Types of Special Needs Trusts
Federal law and regulations recognize two main categories of special needs trusts: first-party trusts and third-party trusts. The distinction depends on whose assets fund the trust. First-party trusts hold assets that belong to the individual with disabilities. Third-party trusts hold assets that belong to someone else, typically a parent or other family member.
First-party special needs trusts are authorized by 42 U.S.C. § 1396p(d)(4)(A), which creates an exception to Medicaid’s transfer rules. These trusts are sometimes called self-settled trusts or (d)(4)(A) trusts after the authorizing statute. The beneficiary must be under age 65 when the trust is created. The trust must be established by the beneficiary’s parent, grandparent, legal guardian, or a court. The trust must provide that upon the beneficiary’s death, Medicaid will be reimbursed for benefits paid on the beneficiary’s behalf during their lifetime.
First-party trusts typically arise in three situations. A minor with disabilities receives a personal injury settlement or judgment. An adult with disabilities receives an inheritance before anyone realizes they need special planning. An individual becomes disabled later in life and has assets they need to protect while qualifying for benefits. In each case, the assets belong to the individual with disabilities, requiring a first-party trust to preserve benefit eligibility.
Third-party special needs trusts hold assets that never belonged to the beneficiary. Parents funding a trust with their own money for their child with disabilities create a third-party trust. A grandparent leaving a bequest in trust for a grandchild with disabilities creates a third-party trust. A sibling establishing a trust for a brother or sister with disabilities creates a third-party trust.
Third-party trusts have advantages over first-party trusts. They need not include a Medicaid payback provision. The beneficiary can be any age when the trust is established. The trust can be created by anyone, not just a parent, grandparent, guardian, or court. Upon the beneficiary’s death, remaining trust assets can pass to other family members or beneficiaries rather than reimbursing Medicaid.
A third category called pooled trusts exists under 42 U.S.C. § 1396p(d)(4)(C). These trusts are established and managed by nonprofit organizations. Each beneficiary has a separate sub-account, but the funds are pooled for investment and management purposes. Pooled trusts can hold either first-party or third-party assets. Unlike individual first-party trusts, pooled trusts can be established for beneficiaries over age 65. However, the trust must provide that upon the beneficiary’s death, either Medicaid is reimbursed or any remaining funds stay in the pool to benefit other beneficiaries with disabilities.
Creating a Third-Party Special Needs Trust
Creating a third-party special needs trust requires careful drafting to ensure the trust meets both Texas trust law requirements and federal benefit eligibility rules. The trust must be irrevocable. The beneficiary cannot have the power to revoke the trust or demand distributions. Such powers would cause the trust assets to be counted as available resources for benefit eligibility purposes.
The trust instrument should clearly state its purpose is to supplement and not replace government benefits. The trustee should be given absolute discretion over distributions. The beneficiary should have no right to demand distributions or compel the trustee to act. This discretionary structure prevents the trust assets from being considered available resources.
The trust should prohibit the trustee from making distributions that would disqualify the beneficiary from government benefits or reduce benefit amounts. The trustee should be directed to consider the impact of distributions on benefit eligibility. Many trust instruments include specific provisions about how to handle distributions for food and shelter given SSI rules about in-kind support and maintenance.
The trust should name a suitable trustee. This might be a family member, a professional trustee like a bank or trust company, or a combination through co-trustees. The trustee needs sufficient knowledge about government benefit rules to avoid distributions that jeopardize eligibility. Professional trustees bring expertise but charge fees that reduce funds available for the beneficiary. Family trustees serve without compensation but may lack knowledge about benefit rules and investment management.
The trust should address what happens to remaining assets when the beneficiary dies. Because third-party trusts need not reimburse Medicaid, the settlor can direct remaining assets to other family members, charities, or other beneficiaries. This flexibility makes third-party trusts attractive for estate planning purposes.
Creating a First-Party Special Needs Trust
First-party special needs trusts face additional requirements beyond those applicable to third-party trusts. The trust must be established by the beneficiary’s parent, grandparent, legal guardian, or a court. If none of these parties establish the trust, it will not qualify for the exemption from Medicaid transfer rules.
This requirement creates procedural complications. If the individual with disabilities is an adult and has capacity, they cannot establish the trust themselves even though the assets are theirs. A parent or grandparent must establish it. If no parent or grandparent is available or willing, a guardianship may be necessary so that a guardian can establish the trust. Alternatively, the individual might petition a court to establish the trust, though this requires court approval and associated costs.
The beneficiary must be under age 65 when the trust is established. This limitation reflects Medicaid program concerns about individuals improperly sheltering assets after they become eligible for benefits. If someone becomes disabled at age 70 and has assets they want to protect, a first-party special needs trust is not available. They might consider a pooled trust, which allows establishment for beneficiaries over 65, though contributions for beneficiaries over 65 trigger a transfer penalty period.
The trust must contain a Medicaid payback provision. Upon the beneficiary’s death, the trust must reimburse the state for all Medicaid benefits paid on the beneficiary’s behalf during their lifetime. Only after Medicaid is fully reimbursed can any remaining assets pass to other beneficiaries. This requirement significantly reduces the assets available to other family members.
The payback provision must comply with state law regarding which Medicaid claims must be reimbursed. In Texas, the payback applies to all Medicaid benefits paid, not just those paid after the trust was established. This can create unexpected liabilities if the beneficiary received Medicaid services before the trust was funded.
Despite these limitations, first-party special needs trusts serve an essential function. When an individual with disabilities receives a settlement, inheritance, or other assets, a first-party trust may be the only way to preserve benefit eligibility while protecting the funds for the beneficiary’s future needs.
Funding Special Needs Trusts
Third-party special needs trusts can be funded during the settlor’s lifetime or at death through a will or revocable trust. Lifetime funding allows the trustee to begin making distributions immediately and provides certainty that the trust is properly structured before the settlor dies. However, lifetime funding requires the settlor to part with assets they might need for their own care.
Testamentary funding through a will or revocable trust allows the settlor to retain control and use of assets during lifetime. The trust springs into existence at the settlor’s death when the beneficiary receives their inheritance. However, testamentary funding requires careful coordination. The will or revocable trust must create the special needs trust or direct assets to a previously established trust. Simply leaving assets outright to the beneficiary with disabilities destroys benefit eligibility.
Many estate plans include contingent special needs trusts that spring into existence only if needed. A parent might leave assets outright to a child but include a provision that if the child is receiving government benefits at the parent’s death, the inheritance passes to a special needs trust instead. This provides flexibility while protecting benefit eligibility.
First-party special needs trusts are funded with the beneficiary’s own assets. Personal injury settlements often fund first-party trusts. The settlement proceeds belong to the injured party. If that party has a disability and receives or will receive government benefits, the settlement should be structured to fund a first-party special needs trust rather than being paid directly to the injured party.
Courts must approve settlements for minors and incapacitated adults. When the settlement will fund a special needs trust, the settlement approval order should specifically authorize establishing and funding the trust. The court may need to approve the trust terms to ensure they comply with federal requirements. Coordinating settlement approval and trust establishment requires careful planning and proper court procedures.
Trustee Duties and Discretion
The trustee of a special needs trust bears significant responsibility. The trustee must manage trust assets prudently in accordance with the Texas Trust Code. The trustee owes fiduciary duties to the beneficiary including duties of loyalty, care, and impartiality. The trustee must invest trust assets properly, keep accurate records, provide accountings, and otherwise comply with trust administration requirements.
Beyond these general duties, the trustee of a special needs trust must understand government benefit rules. The trustee must know what distributions will affect benefit eligibility and how to structure distributions to minimize negative impacts. The trustee should consult with professionals knowledgeable about SSI and Medicaid rules when questions arise.
The trustee must exercise discretion in making distributions. The trust gives the trustee absolute discretion, but this discretion must be exercised reasonably and in good faith. The trustee should consider the beneficiary’s needs, desires, and quality of life while protecting benefit eligibility. The trustee should document the reasons for distributions and refusals to distribute to demonstrate proper exercise of discretion.
Common distribution requests include therapy and rehabilitation services not covered by Medicaid, medical equipment and supplies beyond what Medicaid provides, entertainment and recreation, education and training, clothing and personal items, electronic devices and computers, travel and vacations, and personal care services supplementing what government benefits provide. The trustee should develop familiarity with what Medicaid covers and what gaps the trust can fill.
The trustee should be cautious about distributions for food and shelter. As noted, SSI treats food and shelter provided by the trust as in-kind support and maintenance that reduces the monthly benefit amount. The reduction is capped at a specified amount (one-third of the federal benefit rate plus twenty dollars). The trustee might decide some distributions for housing or food are worthwhile despite the benefit reduction if the value exceeds the reduction amount.
The trustee can minimize SSI impact by paying providers directly rather than giving money to the beneficiary. Paying a landlord directly for rent counts as in-kind support and maintenance. However, paying for a vacation, entertainment, or therapy creates no SSI issue because these are not food or shelter. Careful structuring of distributions can maximize benefit to the beneficiary while protecting program eligibility.
Tax Considerations for Special Needs Trusts
Special needs trusts have important tax implications. Third-party trusts are typically treated as grantor trusts during the settlor’s lifetime if the settlor retains the power to direct trust distributions or change beneficiaries. This means trust income is taxed to the settlor rather than the trust. After the settlor dies, the trust becomes a separate taxpayer and must file its own income tax returns.
Trusts are taxed at compressed tax brackets that reach the highest marginal rate at much lower income levels than individuals face. Trust income above approximately $13,000 is taxed at the highest federal rate. This makes tax planning important for trusts expected to generate significant income. The trustee might consider making distributions to the beneficiary that carry out distributable net income, shifting the tax burden from the trust to the beneficiary who likely is in a lower tax bracket.
However, distributions to beneficiaries receiving SSI can affect benefit eligibility. Cash distributions count as income in the month received and as a resource in subsequent months if not spent. The trustee must balance tax efficiency against benefit eligibility concerns. Often, the benefit eligibility concerns predominate, requiring the trust to pay the higher tax rates to protect government benefits worth far more.
First-party special needs trusts are typically not grantor trusts because the beneficiary does not retain powers that would cause grantor trust treatment. The trust files its own returns and pays taxes on accumulated income. The trust might be structured as a qualified disability trust under Internal Revenue Code Section 642(b)(2)(C), which allows the trust to claim an exemption and use the same tax brackets as individuals rather than the compressed trust brackets.
Gift and estate tax issues also arise. Transfers to third-party trusts are completed gifts subject to gift tax rules. The settlor can use the annual exclusion (currently $17,000 per beneficiary per year) for transfers to the trust if structured properly. Transfers exceeding the annual exclusion count against the settlor’s lifetime exemption amount. Third-party trusts are not included in the beneficiary’s estate because the beneficiary never owned the assets and has no general power of appointment over them.
First-party trusts create more complex estate tax issues. Assets in first-party trusts are typically included in the beneficiary’s gross estate because the beneficiary transferred their own assets to the trust. However, this often has no practical effect because beneficiaries with disabilities rarely have estates large enough to trigger estate tax.
The Takeaway
Special needs trusts provide essential planning tools for families with members who have disabilities and receive means-tested government benefits. These trusts allow families to leave inheritances and provide financial support without disqualifying beneficiaries from Supplemental Security Income and Medicaid, which often provide far more value than the inheritance itself. Third-party trusts funded with a parent’s or other family member’s assets offer maximum flexibility, require no Medicaid payback, and can benefit other family members after the beneficiary with disabilities dies. First-party trusts funded with the beneficiary’s own assets require more restrictive terms, must include Medicaid payback provisions, and face age and establishment requirements, but serve a vital function when individuals with disabilities receive settlements or inheritances.
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