§ 3.3 Special Needs

Letter of Intent, Taxation and Life Insurance

Three questions arise once the trust itself is drafted: how will the trustee know what to do, how will the trust be taxed, and where will the money come from. The first has no legal answer at all, and it is the one that matters most.

The letter of intent

A letter of intent — also called a letter of instruction — is not a legal document and creates no obligations. It is a written account of the beneficiary as a person, prepared by the people who know them best, for the use of whoever takes over when those people are gone.

The need is easy to underestimate. A trust document says the trustee may make distributions for the beneficiary's health, support and welfare. It does not say that she cannot tolerate fluorescent light, that the second Tuesday appointment must be in the morning, that a particular aide has worked with the family for eleven years, or that music is the only thing that reliably calms a bad afternoon. A parent knows a thousand such things. A successor trustee, a guardian or a residential provider knows none of them.

A useful letter covers, at minimum:

• Daily life: routines, sleep, food preferences and aversions, what a good day looks like and what a bad one looks like.
• Functional abilities: what the person does independently, what they need help with, what they are working toward. Written to describe rather than diminish.
• Communication: how they express pain, distress, refusal and pleasure — particularly where speech is limited.
• Medical: diagnoses, medications, allergies, the history that a new physician would take an hour to reconstruct, and the practitioners who already know them.
• Services and benefits: what programmes they receive, which agencies administer them, where the paperwork lives, and which waiver interest lists they are on.
• People: family, friends, staff — who matters, who should be told, who has been reliable.
• Preferences and hopes: what they enjoy, what they fear, what the family hopes for them, and what living arrangement they would want if the current one ends.

Write it plainly, date it, keep it with the trust documents, tell the named trustee where it is, and revise it every year or two. An eleven-year-old letter describing a person who has since changed considerably can mislead as easily as help.

How these trusts are taxed

Taxation depends on the trust's structure, and the differences are consequential.

A third-party trust is normally a non-grantor trust with its own taxpayer identification number and its own return. Income distributed to or applied for the beneficiary is generally taxable to the beneficiary, who is often in a very low bracket; income retained is taxed to the trust at compressed rates that reach the top federal bracket at a very low threshold. That compression is a strong argument for distributing income rather than accumulating it — subject always to the benefits consequences of doing so.

A self-settled trust is usually a grantor trust as to the beneficiary, so income is reported on the beneficiary's own return at their individual rates. This is generally favourable and it means the beneficiary must file where income is sufficient.

A qualified disability trust is a category available to certain trusts for beneficiaries who are disabled, allowing a larger exemption than an ordinary complex trust receives. Whether a given trust qualifies is a technical question worth putting to the preparer explicitly rather than assuming.

Because a poorly structured trust can lose a substantial portion of its income to tax over decades, the tax treatment should be considered when the trust is drafted rather than discovered by the first accountant to file for it. It is worth restating the original point made on this subject: a special needs trust that is not created carefully can be taxed heavily enough to lose most of its resources.

Life insurance as the funding answer

Most families face the same arithmetic problem. Adequate lifetime support for a person with significant disabilities may require a substantial sum, and the parents' assets are needed for their own retirement. The estate will not be large enough to do both.

Life insurance resolves this more often than any other tool, because it converts affordable periodic premiums into a lump sum available exactly when the parents' support ends. The usual structure names the third-party special needs trust as beneficiary of the policy — never the disabled individual directly, which would end their benefits, and never a sibling on the understanding that they will "look after" the money, which exposes the funds to the sibling's creditors, divorce and mortality, and is unenforceable.

Second-to-die policies covering both parents and paying on the second death are frequently used, since that is when the need actually arises and the premium is lower. Where a family wishes to divide an estate equally in dollar terms while still funding the trust adequately, insurance is the usual way to square that circle.

Whether the trust or an individual should own the policy is a separate question with estate tax and control implications, and it should be settled with advice rather than by default.

How much is enough

The honest answer is that nobody can calculate it precisely, but the estimate is worth attempting: current annual costs not met by benefits, projected forward across a life expectancy, adjusted for inflation, less what public programmes are likely to provide, plus a contingency for the loss of a programme or a change in living arrangements. The number is usually large and often unreachable in full.

That is not a reason to do nothing. A partially funded trust is enormously better than none, and the letter of intent — which costs nothing — may do more good than any amount of money. The instruments themselves are compared on the trust types page, and the benefits they protect are set out on the overview page.