by Vincent J. Russo, Esq.
Jack is the Trustee of a Special Needs Trust (SNT) for his niece, Jamie, who is seven years old. The SNT was funded with five hundred thousand dollars from a medical malpractice settlement.
The medical malpractice attorney was very supportive to the family during the lawsuit, but once the matter was settled, her job was done. A SNT was established in order to maintain government benefits for Jamie and to supplement her quality of life with the trust income and assets.
But no one mentioned to Jack and Jamie’s parents how important it was to understand the tax consequences of the SNT.
What is a Special Needs Trust?
One type of “Special Needs Trust” is a trust established by a parent, grandparent, legal guardian or court with the assets of the beneficiary who is under the age of 65 and disabled. The SNT must be for the sole benefit of the beneficiary while maximizing available government benefits. The SNT is treated as an Exempt Trust under the Medicaid and Supplemental Security Income (SSI) rules. Upon the beneficiary’s demise, the Trustee must first pay back the State for any and all Medicaid paid on behalf of the beneficiary during her lifetime. Any remaining trust assets can pass to the beneficiary’s estate or as designated in the trust instrument. This type of SNT is sometimes referred to as a “Pay Back Trust”, “D4A Trust” or a “First Party Special Needs Trust”.
Income Taxation of SNTs
For income tax purposes, a SNT is generally treated as a “Grantor Trust.” This means that the income generated by the trust assets would be taxable to Jamie. She is treated as the creator of the trust because her assets were used the fund the SNT. The Trustee of the SNT is required to file federal and state (if applicable) income tax returns for the trust but no taxes would be due. These income tax returns are informational and they let the government know that Jamie will have to report the income on her personal income tax returns. This is the case even if the income was retained by the Trust.
The Trustee of the SNT would obtain a separate taxpayer identification number (“TIN”) for the Trust. In the alternative, if the Trustee uses Jamie’s social security number as the TIN, there would be no need to file the informational trust income tax return. All of the income would be reported directly by Jamie on her personal income tax return. Some financial institutions and banks may not be willing to open the trust account using Jamie’s social security number so a TIN for the SNT would need to be obtained.
Jack as Trustee and the parents of Jamie needs to know that (1) Jamie has to report the trust income on her personal income tax return. Jamie’s income tax returns, along with any taxes that are due would have to be filed by April 15th of the year following the tax year, (2) Jamie must pay income tax based on her parent’s tax rates because of the Kiddie Tax which is applicable to children under age 18 with “passive income” and (3) Jamie may have to pay estimated tax payments for the income generated by the SNT (even if the SNT does not pay the income directly to her) and if she fails to do so she could be subject to estimated tax penalties.
Gift and Estate Taxation of SNTs
The funding of the SNT should be treated as an incomplete gift and hence, no federal and state (if applicable) gift tax returns have to be filed. The trust assets will be included in Jamie’s estate for federal and state (if applicable) estate tax purposes.
Complicated stuff! Without having proper tax counsel, costly mistakes can be made by the Trustees and the Family.
Vincent J Russo, J.D., LL.M., CELA is a nationally recognized special needs planning and tax attorney and is the Founder of Vincent J. Russo & Associates, PC with offices located in Westbury, Islandia, Lido Beach and Manhattan, New York. He is also the Co-Founder of the Theresa Foundation, the Academy of Special Needs Planners and the National Academy of Elder Law Attorneys.
This article is merely informational and not legal advice. One should seek legal counsel before implementing special needs and tax planning. For a free Special Needs Planning Guide,
call 1-800-680-1717 or go to www.vjrussolaw.com.IRS Circular 230 Disclosure: In order to ensure compliance with IRS Circular 230, we must inform you that any U.S. tax advice contained in this writing and any attachments hereto is not intended or written to be used and may not be used by any person for the purpose of (i) avoiding any penalty that may be imposed by the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein.