A special-needs trust is an entity created to benefit a disabled individual. Like all trusts, the special-needs trust has a trustee who manages the assets, a grantor who creates the trust and a beneficiary who receives the trust funds according to the trust document. Internal Revenue Service rules on taxation of a special-needs trust depend on several variable factors.
Types of Trusts
The two broad categories of special-needs trusts are first-party and third-party trusts. In a first-party trust, the assets with which the trust is funded actually belong to the disabled beneficiary (often as the result of a lawsuit or personal injury settlement). In a third-party or "supplemental" needs trust, the assets belong to someone else -- often a parent or relative. The IRS also makes an important distinction between "grantor" trusts, which are not separate entities for tax purposes, and "non-grantor" trusts, which are separate.
Taxation of First-Party Trusts
In a first-party trust, the grantor and the beneficiary are the same. The IRS considers this type of trust simply a holding account for the grantor's assets. The earnings are considered ordinary income earned by the grantor/beneficiary, who pays taxes on the income at his individual rate, whatever that may be. This represents a big tax savings over the federal tax rate on trusts, which reaches the maximum 39.6 percent bracket on any and all income over $11,950 (as of 2013), as opposed to the max rate on income over $400,000 for individual taxpayers.
Third-Party Trusts and Grantor Status
For third-party trusts, it's important to remember the difference between grantor and non-grantor trusts. The IRS considers a trust to be grantor under certain conditions: if the grantor keeps the authority to manage the assets or income, if the grantor has the authority to borrow from the trust or if the grantor may revoke the trust and take personal title to the assets. A grantor trust pays taxes at the individual rate, so "grantor" status is desirable if the trust does not pay all of its earnings to the beneficiary. Because the IRS allows trusts to deduct these payments, however, non-grantor status may be advantageous if the trust pays out all of its income. This allows the trust to deduct the payments to the beneficiary and owe little in the way of taxes.
Qualified Disability Trusts and Deductions
An ordinary trust can claim a maximum deduction of $300 on income as of 2013. But in 2001, the IRS raised the deduction to match the full personal exemption amount for individual taxpayers ($3,900 in 2013) for "qualified disability trusts." The trust must be irrevocable, meaning the grantor may not change its terms; it must also be created for the sole benefit of the disabled beneficiary, who must be younger than 65 when the trust originates. In addition, the beneficiary must meet Social Security's definition of disability. If the trust is revocable, then the grantor is liable for taxes on all of the income it generates, with only the standard, very small deduction amount.
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