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Special Needs Trusts and Taxes: What You Need to Know

Special Needs Trusts and Taxes: What You Need to Know

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Special Needs Trusts (SNTs) can play an important role in the financial wellbeing of people with disabilities, helping them protect their assets while still taking advantage of public benefits like Medicaid and Supplemental Security Income. But if you’re the trustee of an SNT or helping to manage a beneficiary’s finances, there are a number of tax considerations you need to be aware of. We recommend consulting a CPA or other tax professional for help with your specific situation, but here’s a rundown of what you’ll want to discuss. 

1. Different types of trusts have different taxation schemes

​​In the world of SNTs there are two types of trusts: first-party trusts, which are funded from assets of the individual living with a disability (e.g. through a personal injury settlement); and third-party trusts, which are funded with assets of someone other than the person with special needs (such as the assets of a parent or grandparent).

The IRS usually considers first-party trusts to be “grantor trusts” – a classification that allows the reporting of all trust income, deductions, and credits to pass onto the beneficiary’s personal tax returns. On the other hand, a third-party SNT established by a friend or relative for a person with special needs may generate taxable income for the grantor of the trust, the beneficiary of the trust, the trust itself, or all three at once, depending on the circumstances. 

This is important because trust income is taxed at a far steeper rate than personal income. For 2023, personal income only reaches the highest tax rate (37%) when it exceeds $539,900, whereas trust income is taxed at the highest tax rate (also 37%) when the trust income exceeds just $14,450. Because of their different tax structures, the income tax owed can vary considerably between first-party and third-party trusts even if they accrue the same amount of income. And while the trust type can’t be changed once an SNT has been established, trustees can work with an accountant and/or financial advisor to understand how different investment decisions or disbursement plans could impact the tax liability of the trust and the beneficiary. 

2. Additional tax forms are often required

In certain situations, trustees have to file income tax returns for the special needs trust itself, and other, more complicated forms pertaining to distributed income may have to be prepared for the beneficiary. Regardless of the type of SNT, most trustees will need to submit IRS Form 1041 – the U.S. Income Tax Return for Estates and Trusts. In the case of first-party trusts, this form is fairly simple to complete, but will be more complex for a non-grantor third-party trust. Non-grantor trusts will also require a Schedule K-1, a federal tax document used to report income distributions from trusts and estates to beneficiaries. 

In states where trusts are also subject to a separate state income tax, there is typically a state form on which estate or trust income needs to be reported. These forms differ from state to state, so it’s a good idea to consult with an elder law attorney or accountant who is familiar with trust taxation.

3. You may be able to deduct eligible expenses 

Depending on how taxes are filed, there are a number of expenses that could be deducted from the trust’s income or an individual’s income. These include: 

  • Medical expenses like co-pays, prescriptions, and insurance premiums;
  • Mobility aids like wheelchairs or motorized scooters; 
  • Tuition for some schools that provide special education services;
  • Home or vehicle upgrades to accommodate a disability; and
  • Reasonable fees for lawyers, trustees, financial advisors, etc. 

Note that if you’re providing care and support for a loved one living with a disability, there are additional factors you’ll want to consider for your personal taxes before sending everything off to the IRS. Learn more in this article on Family Caregivers & Tax Season.

4. The SNT may be able to pay trust and personal taxes

If the SNT’s income is reported by the beneficiary on his own personal return, the trust document may allow the beneficiary’s income tax liability to be paid using the trust’s assets. This is because beneficiaries may not have their own assets to pay their income tax liability. In the case of third-party trusts where the SNT income is reportable at the trust level, the trustee is responsible for paying any income tax liability out of the trust’s assets.

5. When a refund is considered “income” 

Sometimes, individuals with disabilities are hesitant to claim certain tax credits or maximize their personal tax refund for fear of resource limits attached to public benefit programs. Fortunately, an individual has 12 months to spend down their tax refund before these funds risk impacting their benefits eligibility. 

6. ABLE Accounts can be helpful for SNT beneficiaries 

Someone with a disability who has an SNT can also open an ABLE Account as a way to save money, make purchases, and stay below the resource limits for public benefits. Unlike a trust, where income such as interest, dividends, or capital gains may be subject to taxation, investments can grow tax free in an ABLE account and will remain so when withdrawn as long as funds are spent on Qualified Disability Expenses (QDEs)

Anyone helping a beneficiary manage their finances should have a baseline understanding of the tax implications, deductions, and reporting requirements associated with an SNT. Proper planning and compliance with disbursements can help optimize the financial benefits of the trust for the individual with special needs while preserving their eligibility for essential government benefits. For help navigating your personal tax situation, we recommend consulting a CPA or other tax professional.

This article is not intended to provide investment, tax, or legal advice. Before making decisions involving investing, legal, tax or accounting concerns, you should consult appropriate professionals regarding your specific situation. You can also find a wealth of information from the IRS for adults living with disabilities and their caregivers.

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