How Are Special Needs Trusts Taxed?

First-Party and Third-Party Trusts

When speaking of special needs trusts (SNT), there are basically two types:

  • A “self-settled” or “first-party” trust; and
  • A “third-party” or “third-party supplemental needs” trust.

A “first-party” trust is typically funded (in most states) when the donor-beneficiary is under 65 and with the beneficiary’s own funds. Such funds are usually out of proceeds of a personal injury settlement, or an inheritance. It requires a “payback” provision, which provides repayment to the state at time of the beneficiary’s death for Medicaid benefits received during the beneficiary’s lifetime.

On the other hand, a “third-party” trust is funded with the funds of someone other than the beneficiary of the trust and typically, by a family member (parent, friend, or family member for the benefit of a person with special needs), but not necessarily at the family member’s death. It does not require a “payback” provision unless the family member applies for Medicaid for his or her own long-term care needs. Additionally, a third party special needs trust provides for the discretionary payment of income and/or principal for the benefit of the beneficiary while not replacing or diminishing any government benefits such as Medicaid or Supplemental Security Income (SSI) benefits.

Taxation of a Third-Party Special Needs Trust

The creator of a third-party SNT will not be taxed. Rather, the income is taxed to the beneficiary of the trust. However, if the income is not distributed in a calendar year, the trust will be responsible for the tax at the trust income tax rate, which is higher, approximately triple the amount than individual tax payer income tax rates. Therefore, for tax-saving purposes, distribution should be a consideration.

There are, however, a few additional selections to consider in order to take advantage of the best tax-saving alternatives. For example, the trust can further be classified as either:

  • A grantor trust; or
  • A non-grantor-trust.

If the SNT is established during the then the trust can be classified as either a grantor trust or a non-grantor trust, depending upon the trust provisions.

If classified as a grantor trust, the SNT must have been established during the lifetime of its creator (i.e. parent/grandparent) and trust income and expenses are taxable to the grantor (parent or a grandparent) on their personal income tax return and not by the trust or the trust beneficiaries.

If classified as a non-grantor-trust, the SNT must have been established during the lifetime of its creator (i.e. parent/grand-parent) and if the trust income is intended to be used for the benefit of the beneficiary with special needs who is receiving government benefits, then the income will be attributed to the beneficiary who would likely be in a lower income tax bracket than the grantor or the trust.

Third-Party Special Needs Trust Gift Taxation

If the SNT is established under a will, then there are no gift tax consequences. If the trust is created by the settler while he or she is alive (called an inter vivos trust), then there may or may not be gift tax consequences, depending upon the provisions of the trust, such as whether the trust is revocable or irrevocable, grantor or non-grantor.

Third-Party Special Needs Trust Estate Taxation

One thing to note about a Special Needs Trust is that if the SNT is established and funded under a will, trust assets will be included in the estate of the decedent.

Another thing to consider is If the SNT was established during the lifetime of the grantor, then the trust may or may not be included in the grantor’s estate, depending upon the trust provisions.

One main perk of the SNT is to gain a step up basis under IRC estate tax code. This step up will reduce or even eliminate capital gains taxes on the later sale of the trust assets.

Taxation of a First-Party Special Needs Trust

Generally, for income tax purposes, a first-party trust will be taxed to the beneficiary during his or her lifetime. All income, deductions, and/or credits earned by the assets of the SNT will be reported on the beneficiary’s individual tax return.

First-Party Special Needs Trust Gift Taxation

There are no gift tax consequences with a SNT, because the assets of the person with special needs are used to fund the SNT and the person with special needs is the sole beneficiary during his or her lifetime.

First-Party Special Needs Trust Estate Taxation

Most beneficiaries will not have taxable estates. However, if estate tax is applicable, the SNT will be includable in the gross estate of the individual for estate tax purposes even if no estate tax is actually owed.

Who Is Responsible for Paying Taxes on a Special Needs Trust?

It is the responsibility of the trustee to make sure that the beneficiary files all necessary tax returns so that the trust can use some of the trust funds to pay the taxes for the beneficiary for such any portion that is required due to the trust. It is also the trustee’s duty to have all the tax returns prepared and to pay the taxes owed by the trust, from the trust. Have additional questions about how special needs trusts are taxed? Reach out to a skilled Orange County trust attorney at Evolution Tax and Legal today.

August 16, 2022

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