Special Needs Trust: A critical distinction between first and third party

By: Bridget O’Brien Swartz, Esq., Vice President and Sr. Trust Officer, Camelback, Ariz. branch, First International Bank & Trust

Last month, we defined a special needs trust (SNT) and who can benefit from one.  Read that blog post.

We discussed the various terms of art in referring to such a trust, such as  special needs trust, special treatment trust (in AZ), discretionary supplemental care trust, or supplemental trust.  What a trust is called does not tell you its purpose, and how it is administered or managed.   So, it is very important to read beyond the name of the trust.  A trustee must read and understand a trust’s terms to best administer or manage it; when it comes to SNTs, the source of funding of the SNT should be identified.

What do we mean by “source of funding?”

What we’re trying to get to the bottom of is who funded the trust; in other words, whose assets went into the trust.  It’s often mistakenly assumed, that the grantor or settlor who established the trust  is also the individual who funded the trust.  That is not always the case, and in the case of SNTs (as well as for tax reasons), this is a critical distinction.

First party Special Needs Trust

If a beneficiary’s own assets funded the SNT, then it is a first party or self-settled SNT, regardless of who or how it was established.  In fact, federal law does not permit a beneficiary to establish his or her own SNT.  The law requires that a SNT funded with the assets of an individual who is disabled be established by a parent, grandparent, guardian, or court of law.  If the SNT is funded with the assets of an individual who is disabled and also the beneficiary, then certain requirements must be met under federal law, and in many jurisdictions, also state law, Arizona being one such state.

The requirements within the federal law fall under 42 U.S.C. § 1396p(d)(4)(A) and are as follows:  (1) The beneficiary must be under the age of 65 at the time the trust is established; (2) the beneficiary must be disabled; (3) the trust must be established by a parent, grandparent, guardian or court of law; and (4) the trust must state that at the time the trust is terminated, Medicaid will be reimbursed up to the cost of medical services provided to the beneficiary.  As mentioned above, additional requirements may apply under state law.  In Arizona, the law and regulations set forth what disbursements from the trust are allowable, and which are prohibited.

Special Needs Trust

Third party Special Needs Trust

A third party trust is one that is funded with the assets of someone other than the beneficiary.  This type of trust can be established and funded by anyone.   It’s often established by a parent for the benefit of a child who is disabled, and funded when the parents pass away with assets from their estate.  But the trust can be established by any relative or a friend, and does not need to be primarily funded with the assets of the same individual who established it.  Some states require nominal funding by the individual who established the trust in order to consider it viable.

Third party SNTs are not a creature of federal or state law; although some jurisdictions do have statutes that impose requirements regarding third party SNTs.  Arizona is not one of those states.  Much more flexibility exists in how a third party SNT is drafted and administered than is the case with respect to a first party SNT.  Most importantly, a third party SNT is not required to contain a provision that provides for reimbursement to Medicaid on termination of the trust, which is typically at the time of the beneficiary’s death.  If assets remain at that time, the grantor or settlor can direct to whom those remaining assets are to be distributed.

So, now we’ve covered what is a special needs trust, who needs a SNT or can benefit from it, and the critical distinction between first and third party SNTs.  What else are you interested in hearing about? Leave a comment, please.

Bridget O’Brien SwartzBridget is originally from Duluth, Minnesota, earned her undergraduate degree from Notre Dame, then and her law degree as well as a Masters in Public Administration from ASU.  She has been a specialist in Estate & Trust Law certified by the State Bar of Arizona and a Certified Elder Law Attorney certified by the National Elder Law Foundation.  She remains actively involved in national attorney organizations such as National Academy of Elder Law Attorneys and the Special Needs Alliance.