The Sole Benefit Rule: A Requirement for First-Party Special Needs Trusts

First-party special needs trusts are irrevocable trusts funded with assets belonging to the individual receiving government benefits. However, transfers to irrevocable trusts normally result in a lookback penalty because the transfer is considered to be for less than fair market value.[1] So how does one fund a first-party trust without triggering the lookback penalty? The answer is by following the sole benefit rule.

If a trust benefits only the individual receiving benefits, then the that individual receives fair market value for any transfer made to that trust. Thus, transfers to trusts that are “established solely for the benefit of an individual under 65 years of age who is disabled” will not trigger a lookback penalty.[2] A trust is for the sole benefit of an individual “if the trust benefits no one but that individual, whether at the time the trust is established or at any time for the remainder of the individual's life.”[3] Therefore, both the corpus and income of the trust must only benefit the individual receiving benefits during their life.[4]

The sole benefit rule requires a written instrument that binds parties to a course of action.[5] In this case, the written instrument will be the trust document. Ideally, the trust should clearly state that the trust exists for the “sole benefit” of the disabled individual. In addition, the trust must provide that (1) “no individual or entity except . . . the disabled individual under age 65 can benefit from the assets or income transferred in any way either at the time of the transfer or at any time in the future” and (2) “the spending of the funds involved for the benefit of the individual is actuarially sound based on the life expectancy of the individual involved; that is, the individual must be able to receive fair compensation or return of the benefit of the transferred asset during his lifetime.”[6] Further, the trust should not allow the trustee to transfer any assets to third parties except when those transfers are primarily for the benefit of the disabled individual.[7] Finally, the trust should not be able to be terminated for the benefit of a third party.[8]

However, as I explain in a different post, spendthrift clauses are not effective in first-party special needs trusts. This raises a potential problem for first-party special needs trusts: if the assets cannot be protected from creditors, then will paying those creditors violate the sole benefit rule? The simplest solution to this potential problem is to pay any preexisting debts of the disabled individual before the first-party trust is formed, perhaps as part of a spend down plan. However, if this is not feasible or if the beneficiary of the trust incurs new debts after the trust is formed, then the trustee almost certainly can pay the beneficiary’s creditors without violating the sole benefit rule. The POMS allows payments to be made to third parties “for the benefit” of the disabled individual.[9] Thus, the trustee may pay creditors without violation of the sole benefit rule, as long as those transfers are for the benefit of the disabled individual. Furthermore, payments to the beneficiary’s creditors by a trust are specifically contemplated by the POMS[10] and the ESS Manual.[11] However, if the loan from the creditor was used for the beneficiary’s support or maintenance, then payment of the loan will be counted as income for the disabled individual.[12]

A trustee should be chosen that understands the limitations of first-party special needs trusts and is familiar with the POMS, which provides detailed guidance to trustees about what transactions will and will not violate the sole benefit rule.[13] Providing reasonable compensation to this trustee does not violate the sole benefit rule.[14] In addition, the drafter of the trust should be clear about what exactly the sole benefit rule accomplishes.[15] Following the sole benefit rule ensures that a transfer to a trust will not trigger a lookback penalty. However, the sole benefit rule does not by itself ensure that a first-party trust is not counted as a resource for the individual receiving government benefits; this is only accomplished by following the rules established in 42 U.S.C. § 1396p(d)(4). Thus, the sole benefit rule must be followed in addition to the rules in 42 U.S.C. § 1396p(d)(4), not as an alternative to those rules.

[1] ESS Public Assistance Policy Manual § 1640.0576.04.

[2] 42 U.S.C. § 1396p(c)(2)(B)(iv) (emphasis added).

[3] SSA POMS SI 01120.201.F.1; see also HCFA Transmittal No. 64 § 3257.B.6.

[4] SSA POMS SI 01120.201.F.2.

[5] HCFA Transmittal No. 64, § 3258.10.B.1; ESS Public Assistance Policy Manual § 1640.0609.07.

[6] ESS Public Assistance Policy Manual § 1640.0609.07.

[7] SSA POMS SI 01120.201.F.2-3.

[8] SSA POMS SI 01120.203.B.6. However, a pooled trust can retain a certain amount of funds in the pooled trust after the death of the disabled individual. HCFA Transmittal No. 64 § 3257.B.6.

[9] SSA POMS SI 01120.201.F.2.

[10] SSA POMS SI 01120.201.I.1.d.

[11] ESS Public Assistance Policy Manual § 1640.0560.01

[12] SSA POMS SI 01120.201.I.1.d, 01120.201.I.1.b.

[13] Specifically, the trustee should be familiar with SSA POMS SI 01120.201.F.

[14] SSA POMS SI 01120.201.F.4; HCFA Transmittal No. 64 § 3257.B.6.

[15] 42 U.S.C. § 1396p(c)(2)(B)(iv).