Special needs trusts are an excellent way to provide additional financial support for a child with special needs without endangering eligibility for means-tested government benefits. However, these trusts do have potential tax implications, both for the trust itself and for the child who is the beneficiary of the trust.
First-Party or Self-Funded Special Needs Trusts
A first-party or self-funded special needs trust is funded with assets that belong to the child, usually from an inheritance or the proceeds of a personal injury settlement or damages award. Under federal tax law, this type of trust is known as a “grantor trust.” In this case, the income is never taxable at the trust level; it is taxable as if the trust didn’t exist at all, in that federal tax laws entirely disregard the trust as an entity. Any income earned on the funds invested in the first-party trust is always taxable to the beneficiary in the year it is earned, regardless of when or if it is distributed to the beneficiary. Therefore, the income earned by the invested funds in the trust is taxable at the individual’s tax rate, which is typically lower than the regular trust tax rate.
Third-Party Special Needs Trusts
In some cases, special needs trusts are third-party trusts, meaning that one or more third parties, who are usually parents, grandparents, or other relatives, have funded the trust for the child with their own assets. The trustee of these trusts must file a tax return each year showing any income that the trust has earned. The trust may deduct any distributions made for the benefit of the trust’s beneficiary, so the trust will not pay taxes on any income earned by the trust unless it has not distributed the income for the benefit of the beneficiary. Therefore, while the trustee should always take into account non-tax considerations as well as tax consequences, to the extent it is possible, the trust should distribute any income it earns for the benefit of the beneficiary each year, particularly since income tax rates for trusts tend to be higher than those for individuals.
However, any trust income distributed for the benefit of the beneficiary is not tax-free. The beneficiary will receive a tax form showing the taxable income received from the trust. The beneficiary then must pay tax on the income at the beneficiary’s tax rate. The trust can, of course pay that tax liability, but in doing so it will be considered a distribution on the tax return filed the following year.
There are some other strategies that you can use to minimize the tax that both the trust and the beneficiary pay on income from a third-party special needs trust. For instance, if the trust qualifies as a qualified disability trust under the Internal Revenue Code, then the trust is entitled to a $4,400 exemption for the tax year 2022. This means that the trust would not pay taxes on the first $4,400 of income.
Further , while the personal exemption is no longer available, the larger standard deduction of $12,950 in tax year 2022 is available to the beneficiary. Previously, the beneficiary could also claim a personal exemption if required to file an income tax return, thus doubling the income sheltered from taxes. However, the Tax Cuts and Jobs Act in 2017 eliminated the personal exemption (but not concerning qualified disability trusts), at least until 2026.
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