Special Needs Trusts can be essential to certain individuals who need to remain eligible for government assistance, while maintaining their quality of life and ability to pay for supplemental daily expenses. SNTs that generate income are required to file taxes, but the manner of filing varies, depending on the type of SNT and on how much money it carries. Here are a few important aspects to consider.
Do I Have to Pay Taxes on a Special Needs Trust?
The short answer is, ‘yes.’ There are variations on how this plays out, depending on whether you have a grantor trust or a non-grantor trust. The IRS classifies first-party SNTs as grantor trusts (because they are funded with the beneficiary’s own assets), and in some cases, the IRS may see a third-party trust as a non-grantor trust. The biggest difference is who files the tax return and at what rate he or she is taxed. Depending on your specific situation, either the beneficiary may need to report the income on his or her personal tax return, or the trust itself will need to file a tax return.
How Are Third-Party Special Needs Trusts Taxed?
Third-party SNTs are funded with the assets of others—parents or relatives that donate to the trust to benefit their disabled loved one. Because third-party SNTs can be revocable or irrevocable, the IRS can classify them differently when it is time to file a tax return. Generally speaking, a revocable SNT funded by a third-party (such as a parent) is considered a grantor trust because the donor still carries some control over the assets placed in the trust. The IRS allows the grantor of a third-party revocable SNT to report trust income on their personal tax return.
If the SNT is irrevocable, the donor or donors effectively give up ownership of the assets placed in the trust. The IRS does not consider an irrevocable SNT to be a grantor trust for that reason. Therefore, the trust would be required to file its own taxes and cannot be part of the grantor’s or beneficiary’s personal tax returns. This is important because trusts are often taxed at higher rates than personal taxes, so proper planning is paramount to avoid unnecessarily high taxation.
How Are First-Party Special Needs Trusts Taxed?
Because first-party SNTs are funded by the beneficiary’s own assets, the IRS considers them to be a grantor trust. As we have seen above, grantor trusts do not require a separate tax return, and any income is taxed at an individual level rather than being subject to trust-level taxation. This means that the trust can pass on to the beneficiary’s tax return any deductions, credits, and income reports.
Notice that both types of trusts result in some form of tax reporting. This is also true for distributions received by an SNT beneficiary, which may count as taxable income for the IRS. This is often a cause of concern for many families who fear their loved one may lose eligibility for government benefits, but, in most cases, taxable income does not automatically become countable income for Medicaid purposes.
There are many other considerations regarding special needs trusts and their tax requirements. It is strongly suggested you seek the advice of an estate planning attorney or a tax professional to fully understand how SNTs work, and how they are taxed. The team at Oren Ross & Associates has assisted many families with their special needs trust questions and is ready to assist you, too. Contact us at (404) 436-1752 to schedule an appointment.