People who care for loved ones with special needs or disabilities often create and fund special needs trusts. It can provide peace of mind to improve a family member’s future quality of life without jeopardizing their eligibility for government benefits. However, families must also consider the tax implications associated with a special needs trust before implementing the legal documents.

Tax Form 1041

A disability attorney or special needs planning attorney may often collaborate with a CPA, tax attorney, or other financial professionals to help their client understand how special needs trust taxation works. Typically, beneficiaries of a trust pay taxes on income distributions they receive from the trust’s principal. When a trust makes a distribution, there is a deduction of the income distributed from the trust’s tax return. Tax Form 1041 is the form used to document taxable income distributed to a beneficiary.

Schedule K-1

The beneficiary then receives a Schedule K-1, indicating how much of the distribution received is interest income versus principal. The distinction between the trust’s interest income and the principal determines the taxable income to claim on the beneficiary’s tax return.

• Distribution from the principal balance of the trust has no tax consequences. The IRS assumes these funds were taxed before being placed into the trust.
• Income earned distributed from the principal funding carries a tax liability.

Overall, tax rules on special needs trusts can be pretty straightforward. However, the income tax rules become more complex depending on the type of special needs trust.

First and Third-party Trusts

A first-party or grantor trust’s funding comes from the beneficiary, typically from an inheritance, the proceeds of a personal injury settlement, retirement plan, divorce settlement, or life insurance policy. It is usually required to have a payback provision for repayment to the state upon the beneficiary’s death. The repayment covers Medicaid benefits the beneficiary receives during their lifetime. This trust is mainly funded by a donor-beneficiary under 65 years of age.

Because transferring assets into a first-party special needs trust permits an individual to qualify for government benefits such as Medicaid and SSI, most states don’t protect the trust’s assets from creditor claims to the beneficiary. Because all trust assets can satisfy the beneficiary’s debts and provide benefits, the IRS treats taxation as if there were no trust. So if the trust receives investment income, the taxes are assessed as income directly received by the beneficiary, even if the income is not yet distributed and remains in the trust.

A third-party trust receives funding from someone other than the trust’s beneficiary. This funding can be via life insurance policies, personal wealth, or other financial resources. However, third-party trust funding often occurs upon a family member’s death and is known as a testamentary trust. Assets transferring to a third-party trust during the funder’s lifetime, rather than death, may include trust language permitting the trust income to be taxable to the donor rather than the beneficiary or the trust. Sometimes referred to as an “intentionally defective grantor trust,” it can create advantageous situations, such as lowering the beneficiary’s tax bracket.

Complicated Interest, Dividends and Capital Gains

A typical third-party special needs testamentary trust is responsible for paying the income tax directly from the trust. Income tax brackets for trusts are subject to generally high rates, but the trust may deduct what it pays out to its beneficiary. However, the income to the beneficiary is taxable through issuing a K-1 showing taxable income to the IRS. The situation becomes more complex when treating interest and dividends as taxable income. Yet, capital gains distributions via mutual funds may not be treated as income, remaining trapped in the trust and taxable.

Before finalizing plans for a loved one’s special needs trust, it is critical to assess how the trust and its beneficiary will be taxed in the future. Understanding the tax laws regarding special needs trusts requires disability planning and tax law expertise. Collaboration with special needs and disability lawyers, including tax specialists, can help you craft a special needs trust and estate plan that will provide the best advantage for the future of your disabled loved one.

We hope you found this article helpful. Contact our office at (740) 947-7277 and schedule a free consultation to discuss your legal matters. We look forward to the opportunity to work with you.