Trusts created for individuals with special needs generally fall into two broad categories: those created with the beneficiary’s own funds, often from the proceeds of a personal injury settlement, and those funded by third parties, often by parents and grandparents. The tax treatment of the two trusts is somewhat different.
Trusts funded by the person with special needs himself are often referred to as “first-party”, “(D)(4)(A)” or “pay-back” trusts. Because the funds come from the beneficiary and he’s the only beneficiary during his life, for tax purposes, they are “grantor” trusts. As a result, for tax purposes, all the trust income flows through to the beneficiary, whether or not it is actually distributed to him or spent on his behalf.
Here’s how that works practically: The trust must obtain its own tax identification number and file its own 1041 tax return. While reporting its income, it also reports a 100% deduction for the pass through to the beneficiary. As part of its return, it issues a k-1 form to the beneficiary, reporting the pass-through income that the beneficiary must report on his own tax return. Often, beneficiaries have so little income that they, in fact, pay no income tax.
A complicating factor can occur when the beneficiary applies for public benefits or has his eligibility reviewed. The agency may question the income reported on his tax return. Then someone—whether the beneficiary, the trustee, or a special needs planning attorney—must explain that while the beneficiary must report the trust income, he actually received no money himself. The meaning of “income” for tax purposes is different from its meaning for purposes of eligibility for public benefits, but often this difference has to be explained.
Trusts created and funded by someone other than the beneficiary are often referred to as “third-party” trusts. These are non-grantor trusts for tax purposes. In contrast with first-party trusts, only income actually distributed to or used on behalf of the beneficiary is taxed to the beneficiary. Income retained by the trust will be taxed to the trust. Practically, with most smaller trusts, there’s no real difference in the tax treatment of the two types of trusts, since they use all their annual income for the benefit of the individual with special needs. But the difference can be significant with respect to larger trusts.
By way of example, let’s assume a third-party special needs trust earns $20,000 in a year and uses $10,000 in distributions to or on behalf of the beneficiary. It will file a 1041 return, reporting the $20,000 of income and deducting the $10,000 of distributions, and issue a k-1 to the beneficiary, which she will have to report on her tax return. The trust will pay taxes on the remaining $10,000 of income (assuming, for these purposes, no deductions for trustee fees and other trust expenses). This will result in a tax of about $2,000.
This may seem high for just $10,000 of taxable income. After all, the standard deduction for individuals is $12,400, higher than the $10,000 of income. But trusts have no standard deduction and they have an accelerated tax schedule—reaching the 35% bracket at $9,450 of income. As a result, it can get expensive for third-party trusts to accumulate too much income. Of course, this must be balanced with the consequences of distributing all the income to the beneficiary.
While all special needs trusts must file annual income tax returns, only larger third-party trusts that earn more than they distribute each year actually pay any taxes. The others pass through their income to the beneficiary with special needs.