What are the taxable implications of setting up a Special Needs Trust?

by J. Patrick Collins, Jr., CFP®, EA

Often times there are tremendous legal and financial benefits for setting up a Special Needs Trust for an individual with a disability. Planning for the tax implications of such a transaction should be considered carefully. For the purpose of this article we are going to look at two different types of Special Needs Trusts: third party funded and self-settled. A third party trust is funded by anyone other
than the individual with the disability. A self-settled trust is funded by the individual with the disability (often from a settlement or inheritance). Here are the steps that need to be followed in order to plan for the taxation of the trust:

1. Obtain an Employer Identification Number (EIN): fill out form SS-4 with the IRS. Just as the IRS identifies US citizens by their social security numbers, the IRS will use this number to identify this Special Needs Trust.

2. Identify the “Grantor” of the Trust: this can be tricky since it will depend on the type of trust you are establishing. For the purposes of filing with the IRS, the grantor of a self-settled trust is typically the individual with the disability. The grantor of the third-party trust is typically the individual establishing and funding the trust (often a parent or guardian).

3. Use the trust’s EIN: for trust bank and brokerage accounts, the grantor’s social security number should never be used. Instead, the trustee should always use the trust’s assigned EIN to establish banking/brokerage accounts.

Here are the two different trusts discussed above and their typical tax treatment:

1. Self-Settled Trusts: most self-settled trusts allow income and deductions that are generated from the trust to “pass-through” to the beneficiary and be taxed at his/her personal tax rates, even if the income is not distributed from the trust. This is a favorable situation since personal tax rates are typically much lower than trust tax rates. In 2005, the federal tax rate on a trust reached a maximum of 35% once income exceeded $9,750. Conversely, the federal rate on an individual did not reach 35% until his/her income exceeded $326,450. This trust should file an annual taxreturn (Form 1041), but it is for “Information Only” since all income and deductions are passed through to the beneficiary.

2. Third Party Trusts: a typically third party trust is considered a separate entity for tax purposes. The trust pays tax (at trust tax rates) on any undistributed income while the beneficiary pays tax on any distributed income from the trust (at his/her personal tax rate). This is often an unfavorable situation if the majority of income is undistributed, since trust tax rates accelerate quickly. With a third party trust, the management of the assets is extremely important to minimize the tax consequences (i.e. taxfree interest, controlling capital gains, etc.).

This short article is not meant to be a comprehensive look at the tax consequences of establishing a special needs trust. This is a very complicated area of special needs planning and should be discussed with your personal financial or tax advisor before any decisions are made.

The information in this article is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, and does not purport to be complete and is not intended as the primary basis for financial planning or investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.