What You Need to Know About Using a Special Needs Trust & Its Tax Benefits

In most states, owning more than $2,000 of assets can prevent those with special needs from qualifying for Medicaid or other government assistance.
 
Family members who want to transfer property to loved ones may inadvertently disqualify them from important government programs such as Supplemental Security Income. A special needs trust, or supplemental needs trust (SNT), is one way to transfer assets to those in need without affecting their eligibility for government benefits.

Here we examine the various types of SNTs, as well as important tax considerations when establishing an SNT.

First-Party SNTs

There are two main types of SNTs: first-party and third-party. If the trust is funded by the person with special needs (often with funds from an inheritance or court settlement), the trust is considered a first-party SNT. First-party SNTs are irrevocable, and they must be administered for the sole benefit of the beneficiary.

The beneficiary of a first-party SNT must be under age 65 when the trust is created and funded. The trust also must provide that Medicaid will be reimbursed upon the beneficiary’s death or upon termination of the trust, whichever occurs first.
 
Any income, deductions, and credits generated by a first-party SNT are included in the beneficiary’s Form 1040, U.S. Individual Income Tax Return. However, the trustee is required to file Form 1041, U.S. Income Tax Return for Estates and Trusts, as a grantor trust if the trust has a separate tax identification number.

Third-Party SNTs

The most common type of SNT is a third-party trust, funded by assets belonging to a person other than the beneficiary. These trusts are generally funded by parents, grandparents, siblings, or any other third party. Third-party SNTs can have multiple beneficiaries, and not all must have special needs. Whether or not a third-party SNT is required to file its own tax return depends on who owns or controls the trust’s assets.

Unlike first-party SNTs, upon the beneficiary’s death, a third-party SNT is not required to reimburse Medicaid benefits received by the beneficiary during his or her lifetime. The person creating the trust determines how the remainder of the trust is distributed when the beneficiary dies.

Grantor SNTs

If the person who created the SNT, i.e., the grantor, is the current owner of the trust’s assets, any income, deductions, and credits generated by the trust are reported on the grantor’s Form 1040, or on a separate Form 1041 if the trust has its own tax identification number.

Nongrantor SNTs

If the grantor has no control of the SNT’s assets, the trust will be treated as a separate taxable entity, and it must file its own Form 1041. These trusts are considered irrevocable nongrantor trusts.

Nongrantor SNTs pay taxes on income that is not distributed to its beneficiaries. The SNT will issue a Schedule K-1 for any distributions of income to be reported on the beneficiary’s Form 1040. Since trusts are taxed more aggressively than individuals, it is usually advised that these trusts distribute most, if not all, of their income each year for tax purposes.

One benefit of nongrantor SNTs is that they may qualify as qualified disability trusts (QDT). QDTs are given an annual exemption of $4,450 (2022). To meet the requirements for a QDT, all the SNT’s beneficiaries must be considered disabled as defined by the Social Security Act.

Medical Expense Deductions

Expenses that are deductible as medical expenses on an individual’s Schedule A (Form 1040), Itemized Deductions, often do not provide much, if any, tax benefit to the beneficiary. This is because the IRS only allows individuals to deduct unreimbursed medical expenses that exceed 7.5% of the individual’s adjusted gross income. A benefit of SNTs is that this 7.5% threshold does not apply to medical payments made by the SNT, potentially resulting in greater tax savings.

Gift & Estate Taxes

If contributions are made to a revocable or grantor SNT, the transfer is considered an incomplete gift and is not subject to gift tax until the property is distributed to the beneficiary. Once the gift is complete, the grantor may be required to pay gift taxes.

Contributions to an inter-vivos SNT, i.e., an SNT created during the grantor’s lifetime, are considered taxable gifts. Because these gifts are of future interests, they are generally not eligible for the annual gift tax exclusion.

If the SNT is testamentary, or established under a will, the assets are included in the decedent’s estate and not subject to gift taxes. Another benefit of testamentary SNTs is that the trust’s assets can qualify for a step-up in basis, reducing future capital gain taxes (see “Tax Basis Planning After the TCJA”).

Summary

Determining what type of SNT is appropriate for your loved one can feel overwhelming. When considering an SNT, it is important to identify who will fund the trust, who will own or control the trust’s assets, and where the trust’s income will be reported, i.e., on the trust’s tax return, the beneficiary’s tax return, or grantor’s tax return. It also is worth considering whether the assets will be subject to gift or estate taxes, and if the trust will be required to pay back any Medicaid received on the beneficiary’s behalf.
 
Becoming knowledgeable about the various tax implications can help ensure you make the most informed decisions for your loved ones.

If you or someone you know would like more information on SNTs, reach out to one of our professionals or submit the Contact Us form below.