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Taxation of Special Needs Trusts: A Brief Overview
By Amy C. O’Hara, Esq.
Suppose that a client asks a CPA to prepare income tax returns for a trustee of a special needs trust (SNT). In order to complete the income tax return and determine applicable tax rules, the CPA will first need to know whether the trust is a “first party” or “third party” SNT. All SNTs are created for the benefit of an individual with a disability. Assets transferred to SNTs are exempt and not counted as part of the beneficiary's resources when determining eligibility for government benefits, including Social Security’s Supplemental Security Income (SSI) and Medicaid.
First Party Special Needs Trust
A first party SNT—also referred to as a self-settled or (d)(4)(A) trust—is funded with assets or income that belong to an individual with a disability (the beneficiary). The trust must be irrevocable and must provide that Medicaid will be reimbursed upon the beneficiary's death or upon trust termination, whichever occurs first. The trust must be established by a parent, grandparent, legal guardian or the court, who are often referred to as the nominated grantor, because they are creating the trust on behalf of the beneficiary. For taxation purposes, the beneficiary is actually the grantor. A first party SNT is commonly funded with an inheritance, personal injury lawsuit or child support.
Generally, first party SNTs are considered grantor trusts under the Internal Revenue Code (IRC) section 671-679, allowing the trust income to be taxed to the beneficiary, while not being taxed at the standard federal rate for trusts (currently at a maximum tax rate of 35 percent for all income above $11,650). In first party SNTs, the grantor is the source of trust assets and the grantor) retains a beneficial interest in the trust income and principal. As a grantor trust, the first party SNT is ignored for income tax purposes and the grantor is treated as having received the income directly even though the trust receives the income. All income from the first party SNT will be taxed directly to the beneficiary. Grantor trusts only need to file an information fiduciary income tax return indicating that all items are reported on the grantor's personal income tax return. This is normally beneficial because the beneficiary will usually be in a much lower tax bracket and pay less tax than the trust would.
Third Party Special Needs Trust
A third party SNT (commonly referred to as a supplemental needs trust) is funded with assets belonging to a person other than the beneficiary. Common funding comes from the estates of parents or grandparents and life insurance policies naming the third party SNT beneficiary. Practically anyone other than the beneficiary can create a third party SNT. This trust has no provisions to pay back Medicaid upon the trust’s termination; rather, the person creating the trust decides how the trust remainder is distributed. A third party SNT can be testamentary (i.e., established under a Last Will & Testament) or inter-vivos (i.e., established during the lifetime of the person creating the trust). An inter-vivos third party SNT can be revocable or irrevocable.
If the trust is testamentary, it is possible for it to qualify as a qualified disability trust for income tax purposes. In 2001, Congress created IRC section 642(b)(2)(C), establishing a tax benefit for certain disabled individuals who are beneficiaries of SNTs. The qualified disability trust must satisfy certain statutory requirements under IRC section 1396p(c)(2)(B)(iv):
- The trust must be irrevocable.
- The trust must be for the sole benefit of the beneficiary who is disabled.
- The trust itself cannot be a grantor trust (i.e., it must be a taxpaying entity).
- The beneficiary must be under the age of 65 at the time the trust is established and must have a disability that is included in the definition of disabled under the Social Security Act (IRC section 1382c[a]).
A qualified disability trust is eligible for a deduction equal to the personal exemption in lieu of the $100 complex trust exemption. (The personal exemption is $3,800 for the 2012 tax year.) If the testamentary third party SNT cannot meet the requirements of a qualified disability trust, then it will be taxed as a complex trust and receive a significantly lower exemption.
If the third party inter-vivos SNT is revocable, all income is taxed to the grantor.
Certain irrevocable inter-vivos SNTs are grantor trusts for income tax purposes, but a careful assessment of the trust must be made to determine whether the trust qualifies as such. For example, if the grantor retains certain administrative powers, such as the power to reacquire trust assets by substituting other property of equivalent value or the power to borrow without adequate security, then the trust constitutes a grantor trust for income tax purposes. The grantor’s retention of a limited power of appointment also renders it a grantor trust for income tax purposes. Again, grantor trusts only need to file an information fiduciary income tax return indicating that all items are reported on the grantor's personal income tax return. Unlike in first party SNTs, the grantor is not the beneficiary in third party SNTs; rather, it is the person who created the trust (e.g., parent or grandparent).
It is also possible for an irrevocable inter-vivos third party SNT to be taxed as a qualified disability trust, provided that all of the requirements are satisfied. If the trust does not meet the requirements of a qualified disability trust or a grantor trust, then it will be taxed as a complex trust.
Taxation of SNTs is exceedingly complex. The language in SNTs can vary greatly from one to another, resulting in vastly different tax treatments. If clients are uncertain about how the SNT should be taxed, it is essential to have it reviewed by a legal professional experienced in special needs planning and taxation.
Amy C. O’Hara, Esq, is an attorney with Littman Krooks LLP, with offices in Manhattan and Westchester and Dutchess counties, specializing in estate planning and administration, trust administration, guardianships, special needs planning, elder law and veterans’ benefits. She is a member of the New York State Bar Association’s elder law and trusts and estates sections, Westchester County Bar Association, New Rochelle Bar Association, and Mamaroneck-Harrison-Larchmont Bar Association. She is also a member of the Special Needs Alliance. Ms. O’Hara received her JD from the University of Buffalo and her BS from Binghamton University. Ms. O’Hara can be reached by email at firstname.lastname@example.org.