By Joel Krooks, Esq., JD

Certified public accountants are often among the first advisors to learn that a client’s family member has a disability, has received a personal injury settlement, or is about to inherit assets. In each of those situations, tax planning and benefits planning intersect. A well-intentioned gift or inheritance can unintentionally jeopardize Supplemental Security Income, Medicaid, housing assistance, or other means-tested benefits. A properly structured special needs trust, also known in New York practice as a supplemental needs trust, can help preserve eligibility for benefits while allowing assets to be used to improve the beneficiary’s quality of life.

For CPAs, the central point is that special needs planning is not only a legal issue; it also affects income tax reporting, fiduciary administration, estate tax analysis, and practical client counseling. Understanding the basic trust structures can help CPAs identify issues early and coordinate effectively with counsel.

What Is a Supplemental Needs Trust?

A supplemental needs trust is a trust established for an individual with a disability. Its purpose is to supplement, rather than replace, government benefits. Assets held in a properly drafted and administered supplemental needs trust are generally not treated as available resources of the beneficiary for purposes of certain means-tested public benefits.

This distinction is critical. Means-tested benefits include Supplemental Security Income, Medicaid, Section 8 housing assistance, and Supplemental Nutrition Assistance Program benefits. Non-means-tested benefits, such as Social Security Disability Insurance and Medicare, generally are not affected by the beneficiary’s resource level in the same way. In New York, practitioners must also be attentive to services administered through agencies such as the Office for People With Developmental Disabilities (OPWDD) and the Office of Mental Health.

The correct planning tool depends on whose assets are funding the trust, the beneficiary’s age and benefit status, the amount involved, the available fiduciaries, and the family’s estate planning goals.

Third-Party Special Needs Trusts

A third-party special needs trust is funded with assets that never belonged to the beneficiary. Parents, grandparents, siblings, or other relatives may create and fund such a trust during lifetime or at death. For example, parents of an adult child with developmental disabilities who receives SSI and Medicaid may leave that child’s inheritance to a third-party special needs trust instead of outright to the child.

Third-party trusts offer considerable flexibility. There is no federal statute that creates the trust in the same way that federal Medicaid law governs certain first-party trusts, although state law and benefit program rules remain highly relevant. There is no age restriction and no Medicaid payback requirement. On the beneficiary’s death, the remaining trust assets can pass to other family members, charities, or other named remainder beneficiaries.

The trust should be fully discretionary and drafted to avoid mandatory support language. It should not give the beneficiary withdrawal rights, Crummey powers, or a general power of appointment. Those powers may create tax or estate planning benefits in other contexts, but they can be dangerous in special needs planning because they may be treated as available resources or otherwise interfere with public benefits.

For estate and gift tax purposes, a third-party special needs trust can often use many of the same planning concepts as other irrevocable trusts but with modifications. The disabled beneficiary should not be given powers or rights that are inconsistent with preserving benefits. This is a recurring area where CPAs and estate planning counsel should coordinate before gifts are made or trust provisions are finalized.

Tax Treatment of Third-Party Trusts

A third-party special needs trust is commonly structured as a non-grantor complex trust. In that case, fiduciary income tax rules apply. Income retained by the trust is taxed at trust rates, while income distributed or required to be distributed may carry out distributable net income and be taxed to the beneficiary. Because trust tax brackets compress quickly, distributions that carry out income may produce a lower overall tax result when the beneficiary has little or no other taxable income. However, distributions must be evaluated not only for tax efficiency, but also for their effect on benefits.

Some third-party special needs trusts may qualify as Qualified Disability Trusts. In general terms, a qualified disability trust must be irrevocable, established for the sole benefit of an individual who is disabled within the meaning of applicable federal disability standards, and treated as a non-grantor trust. A qualified disability trust may be entitled to a personal exemption under the Internal Revenue Code, subject to current law. CPAs preparing fiduciary returns should determine whether the trust satisfies the requirements rather than assume the classification applies.

An inter vivos third-party special needs trust can also be drafted as a grantor trust. That structure may be appropriate when the grantor is expected to pay the income tax attributable to the trust, allowing trust assets to grow for the beneficiary’s supplemental needs. The grantor trust decision should be integrated with the family’s broader income, gift, and estate tax planning.

First-Party Special Needs Trusts

A first-party special needs trust is funded with the beneficiary’s own assets. Common funding sources include a personal injury settlement, an outright inheritance received by the beneficiary, accumulated assets, or child support payable for the benefit of a person with disabilities.

The classic first-party special needs trust is authorized under 42 U.S.C. § 1396p(d)(4)(A). It must be established for an individual with a disability who is under age 65 when the trust is created and funded. It may be established by the individual, a parent, grandparent, legal guardian, or court. Although someone else may create the trust instrument, the beneficiary is treated as the settlor because the trust is funded with the beneficiary’s own property.

A properly structured first-party special needs trust can allow the beneficiary to maintain eligibility for SSI and Medicaid, with the trust assets treated as exempt. The trust must be irrevocable, and distributions must be discretionary. The beneficiary must be disabled under Social Security standards; a medical diagnosis or family opinion alone is not sufficient.

The key trade-off is the Medicaid payback requirement. On the beneficiary’s death, or upon certain early terminations, the state Medicaid agency must be reimbursed from remaining trust assets for Medicaid benefits paid on behalf of the beneficiary, before other remainder beneficiaries receive assets.

Tax Treatment of First-Party Trusts

First-party special needs trusts are almost always grantor trusts for income tax purposes under the grantor trust rules, including Internal Revenue Code Sections 671, 673, and 677. As a result, the trust’s income, deductions, and credits are generally reported on the beneficiary’s individual Form 1040.

Even when the trust is a grantor trust, there may be reasons to file Form 1041 for reporting clarity, trustee records, or tax administration. CPAs should review the trust instrument and the applicable grantor trust provisions. In many cases, grantor trust treatment is beneficial because individual tax rates may be lower than compressed trust rates, particularly for beneficiaries with little or no earned income.

A first-party special needs trust generally does not qualify as a qualified disability trust because it is typically treated as a grantor trust. This is an important distinction from some third-party non-grantor trusts.

For estate tax purposes, a first-party special needs trust is generally includable in the beneficiary’s gross estate because the trust is funded with the beneficiary’s assets and the beneficiary has retained interests within the meaning of Internal Revenue Code section 2036. Estate tax may not be due, but inclusion can have important consequences. Trust assets may receive a step-up in basis at death, and the Medicaid payback may be deductible as a claim against the estate. Any remaining trust assets may also be subject to creditor claims depending on the trust terms and applicable law.

Administration: Tax Planning Must Follow Benefits Planning

Trust administration is as important as trust drafting. A special needs trust should be fully discretionary, and distributions should be for the benefit of the individual with disabilities. Trustees should keep detailed records and avoid distributing cash directly to the beneficiary.

Certain payments can reduce SSI. Payments for food or shelter may result in a reduction of SSI benefits, often up to one-third under applicable rules. This does not mean shelter payments should never be made. In some cases, preserving housing or paying rent is necessary and appropriate even if SSI is reduced. The trustee, counsel, and tax advisor should understand the tradeoff and document the decision. A room and board agreement may be appropriate in some circumstances.

In first-party trusts, additional oversight may apply. Annual accountings may be required, and the Department of Social Services may need to be notified when disbursements exceed specified percentages of trust value. Bond may also be required. These fiduciary requirements should be built into the trustee’s administrative calendar.

Investment decisions should reflect the beneficiary’s needs, the trust’s anticipated duration, liquidity requirements, and the trustee’s fiduciary duties. Many special needs trusts are intended to provide lifelong supplemental support, making conservative and well-documented investment management especially important.

Support Trusts

A support trust may be appropriate when the individual does not receive, and is unlikely to need, means-tested government benefits, but still requires financial oversight. For example, a person may receive SSDI and Medicare rather than SSI and Medicaid, or may have sufficient private resources but be vulnerable to undue influence or poor financial decision-making. In that case, a traditional support trust may provide structure and protection without the restrictions required for a special needs trust.

Conclusion

Special needs trusts require careful coordination among attorneys, CPAs, trustees, families, and benefits professionals. The wrong transfer can cause a loss of essential benefits, while the right trust can preserve eligibility, improve quality of life, and integrate with the family’s tax and estate plan.

For CPAs, the most important questions are practical: Whose assets are funding the trust? Is the beneficiary receiving means-tested benefits? Is the trust first-party or third-party? Is it a grantor or non-grantor trust? Are distributions being made in a way that affects SSI or Medicaid? Has the trustee maintained records sufficient for tax reporting and fiduciary accountability?

By spotting these issues early, CPAs can help families avoid costly mistakes and ensure that tax planning supports, rather than undermines, the broader goal of protecting a person with disabilities.

Joel Krooks, Esq., JD, is an attorney admitted to practice in the State of New York, focusing his practice on elder Law, special needs planning, trusts and estates, and estate administration. He regularly advises individuals and families on long-term care planning, Medicaid asset protection, fiduciary matters, and complex estate and trust issues. Mr. Krooks is a frequent speaker at professional and community speaking engagements, presenting on topics including elder law, special needs planning, Medicaid planning, trust & estates and estate administration. He is actively involved in thought leadership within the field and is the Co-Chair of the New York State Bar Association’s Publications Committee for the Elder Law and Special Needs section. He also serves as a co-author of the Special Needs Trust Handbook, a comprehensive treatise published by Wolters Kluwer, which serves as a critical guide for legal practitioners nationwide. His professional accomplishments have been recognized by multiple organizations. Mr. Krooks has been named a Best Lawyer, a Super Lawyers Rising Star in 2025, and a Top Lawyer in the Hudson Valley. He is also a member of the Special Needs Alliance.