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, 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.
Taxation of Special Needs Trust
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.
Taxation of Non-Grantor Trusts
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. A qualified disability trust can claim an exemption of up to $4,150, which is not subject to phaseouts.
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.
For tax year 2018:
- If taxable income is $2,550 or less, the trust tax is 15 percent of taxable income.
- For income greater than $2,550 up to $6,000, the trust tax is $382.50 plus 25 percent of the amount that exceeds $2,550.
- For income greater than $6,000 up to $9,150, the trust tax is $1,245 plus 28 percent of the amount that exceeds $6,000.
- For income greater than $9,150 up to $12,500, the trust tax is $2,127 plus 33 percent of the amount that exceeds $9,150.
- And for income greater than $12,500, the trust tax is $3,232.50 plus 36.9 percent of the amount that exceeds $12,500.
Completing Form 1041
Form 1041 begins with Box A, in which you designate the type of trust, including grantor and qualified disability trusts. The rest of the form walks you through the sections of income, deductions and tax and payments. The attached Schedules A, B and G help you figure amounts that you transfer to certain lines of Form 1041 in the overall computation of your tax liability.
- Margolis & Bloom: Supplemental Needs Trusts: Do They Need a Separate Tax ID?
- Nolo: How Special Needs Trusts Work
- IRS: Abusive Trust Tax Evasion Schemes - Questions and Answers
- How a Grantor Trust Works - SmartAsset
- The Tax Adviser: Income Taxation of Trusts and Estates After Tax Reform
- Eide Bailly: Tax Reform - Trust and Estate Key Rate Changes
- IRS: 2018 Form 1041
- IRS: 2018 Instructions for Form 1041
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.