Presented on September 2, 2003

THOMAS J. MURPHY is the sole shareholder in Murphy Law Firm, Inc., located in the Ahwatukee area of Phoenix. His practice emphasizes estate planning, elder law (to include nursing home issues), all probate matters (to include contested matters) and tax controversies.

He was the 1999-2000 President of the Estate Planning, Probate and Trust Section of the Maricopa County Bar Association. He was selected by the National Academy of Elder Law Attorneys to serve on its prestigious Steering Committee to plan NAELA’s annual 2002 Advanced Elder Law Institute. He serves on the Advisory Board of the Phoenix Tax Workshop and the Editorial Board of the Maricopa Lawyer.

He has been published in many national, state and local professional journals writing on a wide variety of legal and tax matters. His written materials on the new Section 529 college savings plans have already garnered national recognition. His articles explaining recent IRS regulations for required minimum distributions from retirement plans have been widely published and were the featured articles in the August 2, 2002 and April 6, 2001 editions of Tax Practice, the nation’s leading weekly tax journal. His articles on beneficiary deeds and financial powers of attorney were prominently featured, respectively, in the June 2002 and December 1998 issues of Arizona Attorney. Both articles have been widely praised and are considered to be the definitive source of authority in Arizona on the topics. He has been cited as a leading authority on estate planning law in the March 2002 edition of SmartMoney magazine, published by the Wall Street Journal. He has been invited to speak before such groups as the National Academy of Elder Law Attorneys, the State Bar of Arizona, the Arizona Society of Certified Public Accountants, the Arizona Federal Tax Institute, the Maricopa County Bar Association, the West Maricopa County Bar Association, the Mohave County Bar Association, the Coconino County Bar Association, the College of Estate Planning Attorneys, the Phoenix Tax Workshop, the Estate Planning Tax Study Group, the Prescott Estate Planning Council, Prudential Financial, Mesa Community College and Phoenix College. He is a member of the National Academy of Elder Law Attorneys, the Tax Law, Probate & Trust Law and Mental Health & Elder Law Sections of the State Bar of Arizona and the Arizona Medicaid Planning Council. He has served on numerous state and county bar association committees and was selected to be the State Bar representative to the Arizona Supreme Court’s Committee on Reform of Lower Jurisdiction Courts. He is also one of the most experienced trial attorneys in the Southwest, having been the sole or lead counsel in over 100 jury trials. He has successfully litigated cases in the United States Tax Court, the Arizona Tax Court and the Arizona Board of Tax Appeals. He has represented clients before all levels of the Internal Revenue Service and Arizona Department of Revenue.

He was born and raised in Attleboro, Massachusetts, a suburb of Boston. He is an honors graduate of Tufts University with a double major in economics and history. He received his law degree from Suffolk University Law School with a concentration in taxation. He is a former officer in the United States Air Force with assignments to the 314^th Combat Support Group, Little Rock Air Force Base, Arkansas and the 401^st Tactical Fighter Wing, Torrejon Air Base, Spain. He is married to the former Ana Maria Orrantia, a native Arizonan who is a Professor of Nursing at Mesa Community College. They have four children.

THE PROBLEM: Medicaid costs are exploding while state budgets are in the red as never before. In 2002, there were 51 million people enrolled in Medicaid spending $216 billion. Of the 51 million enrollees, 9 per cent were elderly and 16 percent were disabled. Of the $216B spent, 27 percent was spent on behalf of the elderly and 43 percent spent on the disabled. In 2003, the Kaiser Foundation estimates that Medicaid costs will increase by $11B with 77 percent of that attributable to the elderly and disabled. Finally, in 2004, state budget deficits are expected to exceed $70B.

What all this says to me is that there will be significant cutbacks in those eligible for Medicaid (ie, AHCCCS in Arizona) and cutbacks in the services provided to those who are eligible.

THE OBJECTIVE: To provide a disabled or elderly person with funds to pay for their care without losing eligibility for AHCCCS and other governmental benefits that the person is already receiving or about to receive.

THE SOLUTION: A "special needs trust"

But first, a bit of history…..

Up until about 10 years ago, I would occasionally encounter a situation that did not have an easy solution. Typically, it involved parents of s disabled child who wanted to make a will or trust. The disabled child was their foremost concern and they wanted to make sure that the child was provided for. Thus far, the child was doing well with the government programs that he/she was enrolled in. But the parents were concerned that, if the disabled child was left a large bequest, then the child would lose eligibility for those programs.

About the best we could do was to disinherit the child and leave what would have been that child’s share with another of the parents’ children. Yet I was never entirely comfortable with this. First, there was probably no way for us to require the child to provide for the disabled child. We simply had to hope that the child would do the right thing. Second, it we could go to court to enforce this understanding, the disabled child would become ineligible for the benefits he/she had been receiving. This is what the parents were trying to avoid in the first place. Third, the child might encounter creditor problems whereby the creditors might be able to reach and seize the assets that are now held in the non-disabled child’s name. Or the child might just simply blow the money – drugs, big cars, riotous living, etc. And fourth, there was always the possibility of a bad marriage. My clients would tell me that they trust their daughter. I would ask "do you trust your son-in-law?"

For all of these reasons, this arrangement definitely left something to be desired.

#2. The person is disabled or blind, as defined under 42 USC 1382c(a) – inability to engage in any substantial gainful activity for at Another possible solution was to create a "support" trust with the disabled child as the beneficiary. In such a trust, the trustee has unlimited discretion to provide for the beneficiary’s support in whatever manner the trustee deemed fit. It was thought that, since the beneficiary could not compel distributions from the trust, then neither could anyone else, such as the local Medicaid agency. However, in some states, the Medicaid agency was successful in requiring the trustee to pay for the services that Medicaid was providing and by rendering the disabled child ineligible for further benefits until the trust was exhausted. See, for instance, the hotly divided Ohio Supreme Court in Young v. State Dept of Human Services, 668 NE2d 908 (Ohio, 1996).

Then, in the early 1990’s, there were two big developments. First, Congress passed the Omnibus Budget Reconciliation Act of 1993 (aka OBRA ’93). Then, in November 1994, the Health Care Financing Administration (now known as the Center for Medicare and Medicaid Services) issued Transmittal #64. These two developments reshaped and clarified many of the issues confronting families and their advisors in this area. Among these issues was the authority to create special needs trust.

A PRIMER ON SPECIAL NEEDS TRUSTS

Special needs trusts (SNTs) come in two varieties – those created by the disabled person and those created by a third party (typically a parent or family member) for the benefit of the disabled person. They are governed by federal statutes and regulations, primarily 42 USC 1396p, 20 CFR 1103 et seq and Social Security POMS SI01120, as well as state statutes, such as ARS 36-2934.01 and the AHCCCS Policy and Procedures Manual.

The starting point for any SNT is 42 USC 1396p(d)(4)(A), which sets out the criteria that, if met, will not disqualify the disabled person from public benefits. These are commonly known as D4A trusts. The criteria are:

#1. The disabled person is under 65 years of age

#2. Disability as defined by statute, 42 USC 1382c(a) – unable to engage in substantial gainful activity for at least twelve months or visual acuity of less than 20/200.

#3. The trust is created by a parent, grandparent, legal guardian or a court

#4. The disabled person is the sole beneficiary while the person is alive

#5. The trust must be irrevocable and the disabled person cannot demand access to the trust funds.

#6. The trust should not distribute cash to the disabled person – only "in-kind" distributions should be made. Otherwise, a disqualification period will be imposed.

#7. The trust must contain a payback provision whereby, upon the death of the disabled person or termination of the trust, the State gets paid for the services rendered to the disabled person.

The other key factor is determining the public benefits to which the disabled person is entitled. Supplemental Security Income (SSI) and AHCCCS/ALTCS are means-tested programs. In other words, an eligible person can only have minimal assets and income. Social Security Disability Insurance (SSDI) is not means-tested and is based on a person’s wage history. The person’s assets and income do not otherwise come into play in determining eligibility for SSDI benefits.

THIRD PARTY SNTs

The two most common examples of third party SNTs are those created by a parent for a disabled child and those created by an elderly spouse for a spouse that is in a nursing home.

For third party SNTs, some of the D4A rules are relaxed or eliminated. Among the more important of these are:

#1. A trust can be created for someone over age 65.

#2. There is no requirement of a payback provision to the State.

#3. If a trust is created via a will, none of the D4A requirements apply.

Yet, care must still be taken in drafting these trusts. First, the trust must make it clear that there is no duty of support (ie, not a minor child) owed by the person creating the trust to the disabled or elderly person. Second, it must be made clear that the trust is only meant to supplement and not replace the existing benefits that the person is receiving. Third, the rules regarding in-kind distributions, discussed below, must be strictly adhered to or disqualification could result.

SELF-SETTLED TRUSTS

In such a situation, a D4A trust can be established that will hold and invest the lawsuit proceeds.

There is another form of trust that will also work – a D4C trust, also called a "pooled" trust. This is a trust where a non-profit organization is the trustee for trusts established for many disabled persons. Currently, there is no such program in Arizona but several of my colleagues in Tucson are working with charities to establish one.

DISTRIBUTION OF TRUST FUNDS – BE CAREFUL!!

Once you have established an SNT, the next question is how do you distribute the trust assets in a manner that will not disqualify the disabled person.

One simple rule – don’t ever distribute cash to the disabled person. This will result in a dollar-for-dollar decrease in monthly benefits and, if the cash distribution is large, it could result in a period of ineligibility. See 20 CFR 416.1121.

Instead, always have the trustee purchase good and services directly from the provider. These are called "in-kind" distributions or "ISM". The federal regulations specifically allow a trust to purchase the following items that will be used for the disabled person:

Medical care and services not otherwise provided

Social services, including vocational rehabilitation or education

Proceeds from an insurance policy or a loan

Home improvement

20 CFR 416.1103

A trustee (and even the disabled person themselves) can also purchase certain items that are exempt from any adverse eligibility issues, such as:

Purchase a home if none owned

Pay down mortgage

Do repair work or modify and improve home

New roof, paint, carpeting or A/C

Add garage or enclose carport

Build a pool

Purchase burial insurance

Policy is irrevocably assigned to mortuary

Purchase the parcel of land next-door

Must be contiguous

Purchase automobile

Unlimited value if necessary for medical treatment

Travel to doctor’s office should be "necessary"

Otherwise, FMV cannot exceed $4,500.00

Only one car per couple

Purchase burial plan

Create burial fund up to $1,500.00

Use for payment of flowers, transportation for family, embalming, cost of church service

Must be in separate account designated as such

Purchase new household goods

New furniture or appliances

Useful to buy items for "homier" nursing home

Travel or take a vacation

But watch out for money used to purchase food, shelter or clothing. Such purchases will cause a decrease in monthly SSI benefits and could result in disqualification. Shelter includes room, rent, mortgage payments, property taxes, heating fuel, utilities and garbage collection services. 20 CFR 416.1130(b).

Other items that a disabled person cannot receive are: annuities, pensions, alimony, inheritances, gifts and death benefits payable from life insurance policies on the life of another person. 20 CFR 416.1121