A special needs trust is created to help with the care of a person with disabilities. Taxation of a special needs trust depends on exactly how it's set up, and the way it's set up can have consequences for government assistance such as Medicaid. It's often a good idea to contact a lawyer or expert financial planner when setting up any trust.
IRS and Grantor Trust Taxes
As with any trust, a special needs trust is a legal structure set up by somebody called a grantor, administered by someone known as a trustee on behalf of a person known as a beneficiary. The trustee is required to follow the rules established in the trust documents in the best interest of the beneficiary.
Some special needs trusts are set up with assets that the person with disabilities already owns such as an inheritance or a legal settlement. Those are called self-settled trusts. Others are third-party trusts, set up with assets someone else, such as a parent or grandparent, already owns.
Special needs trusts are also generally divided into support trusts, which cover the day-to-day expenses of the beneficiary, and supplemental needs trusts, which cover expenses beyond what's covered by other sources like government programs. These are usually set up specifically not to count as funds that can limit access to means-tested programs and generally need to be carefully designed for that purpose.
Supplemental needs trust taxation law says that these trusts are often considered "grantor trusts" for tax purposes even if someone else other than the grantor sets up the trust. In most other circumstances, grantor trusts are by definition trusts run by the person who sets them up while that person is alive – such as trust set up and administered by a parent for his children. Special needs trust capital gains and income taxes for trusts considered grantor trusts are handled through the grantor's own tax return, meaning, in this case, the tax return of the disabled person is taxed at her normal tax rate.
If the special needs trust is not considered a grantor trust and other exceptions don't apply, the trust must file its own tax return using IRS Form 1041 for every year in which it has more than $600 in income or if the beneficiary is legally a nonresident alien. Trusts are taxed at different rates than individuals. They can often deduct income distributed to beneficiaries, which is then taxed on the beneficiary's return instead.
2018 Tax Law Changes
The new tax rules for 2018 mean lower tax brackets for trusts and individuals alike. This can mean that regardless of how a special needs trust is arranged, less tax will be paid on its income for 2018 and subsequent tax years.
2017 Tax Law
For the 2017 tax year, tax rates are generally higher for both individuals and trusts filing their own tax returns, so a special needs trust with Form 1041 filing requirements or a grantor trust filing through an individual return could both see higher taxes in 2017 than 2018.
- Margolis & Bloom: Supplemental Needs Trusts: Do They Need a Separate Tax ID?
- Nolo: How Special Needs Trusts Work
- American Bar Association: Special Needs Trusts Basics
- IRS: Abusive Trust Tax Evasion Schemes - Questions and Answers
- Investopedia: Grantor Trust Rules
- The Tax Adviser: Income Taxation of Trusts and Estates After Tax Reform
- Forbes: New: IRS Announces 2018 Tax Rates, Standard Deductions, Exemption Amounts And More
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