Contrary to what many people believe, you cannot necessarily shield your assets from tax liability simply by placing those assets into a trust. This principle applies to special needs trusts as much as it does to other types of trusts. There are tax issues, however, that can be exploited for the benefit of the beneficiary — and failing to take advantage of them might get the trustee into trouble.

Taxation of Third-Party Special Needs Trusts

A third-party special needs trust (SNT), established by someone other than the special needs beneficiary for the benefit of that beneficiary, is taxed on neither its assets not its distributions to the beneficiary. A third-party SNT itself is liable for income tax only on that portion of its annual income that is not distributed to beneficiaries. 

Trust income tax rates, however, are almost always higher than the ordinary income tax rates paid by beneficiaries on their trust distributions. For this reason, it generally makes sense to distribute all third-party SNT trust income to the trust beneficiaries every year, unless there is some good reason not to. In the case of a special needs trust.

One good reason for not distributing funds directly to a special needs beneficiary is that income to the beneficiary could render him ineligible for need-based government assistance programs. One way around this obstacle is to have the trust purchase  goods and services for the beneficiary, rather than provide the beneficiary directly with cash benefits.

Taxation of First-Party Special Needs Trusts

The case is different, however, for first-party SNTs. A first-party SNT is a trust established with the special needs beneficiary’s own assets, such as an inheritance or a personal injury settlement for the accident that caused his disability in the first place. 

Like a third-party SNT, a first-party SNT needn’t pay taxes on its assets. But its income is taxed at (lower) ordinary income tax rates, not trust income tax rates, regardless of whether or not the income is actually distributed. Of course, to the extent that the funds contributed come from an inheritance or a personal injury settlement, they are not taxable. But if these funds are subsequently invested, the investment income itself is taxable. 

Illustrative Example

Gary Grantor created a third-party irrevocable SNL for the benefit of his special needs son, Bill Beneficiary. He places $800,00 in assets into the trust in the form of a house, shares in a mutual fund and cash. The trust assets themselves are not taxable.

In 2019 the trust earns $114,000 in income from rent, stock price appreciation and interest, resulting in a trust asset balance of $914,000. Terry Trustee distributes only $100,000 to Bill because the terms of the trust instrument do not allow him to distribute more than $100,000 to Bill in any one year. 

Terry must file a tax return for the trust. He may deduct the $800,000 in principle as well as the $100,000 distribution from the trust’s taxable income. The trust must then pay trust income tax on $14,000 of trust income, while Bill must pay ordinary income tax rates on his $100,000 distribution. Since the tax rate paid by the trust is probably higher than what Bill pays on his distribution, it would save money to amend the trust to eliminate the $100,000 distribution limit.

Make It Happen With Lorenzo Law

If you have been named trustee of a special needs trust, or if you simply want to know how to manage a trust in the most tax-efficient manner, contact estate attorney Jose Lorenzo by calling (305) 999-5411, completing our online contact form or visiting one of our offices in Coral Gables and Ft. Lauderdale. We serve clients throughout the entire state of Florida.