Taxation of Special Needs Trusts
Written by Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a New Jersey Special Needs Trust Attorney
Taxes, taxes, taxes. Everything is taxed. A Special Needs Trust is no different. It is subject to taxation. Let me give you an overview.
A. Characterization and Taxation of Income.
The characterization of income for trusts is the same as the characterization of income for individual taxpayers. Thus, income from interest, rents, and royalties is taxed as ordinary income. Although trusts are taxed on this income in the same manner as individuals, trusts have an accelerated rate schedule, which means that a trust reaches its maximum marginal tax rate at a much lower net income than does an individual. For 2009, a trust reaches its maximum marginal tax rate of 35% at only $10,700 of taxable income, while a single individual taxpayer would have to earn over $347,700 to be taxed at the same marginal tax rate.
Under current law, income in the form of qualified dividends paid to individual taxpayers is taxed at capital gain rates. As with individual taxpayers, trusts pay capital gain rates on qualified dividends
B. Difference Between Income for Tax Purposes and Income for Purposes of Determining Eligibility for Government Assistance
The Internal Revenue Code defines “gross income” as: all income from whatever source derived, including (but not limited to) the following items:
(1) compensation for services, including fees, commissions, fringe benefits, and similar items; (2) gross income derived from business; (3) gains derived from dealings in property; (4) interest; (5) rents; (6) royalties; (7) dividends; (8) alimony and separate maintenance agreements; (9) annuities (10) income from life insurance and endowment contracts; (11) pensions; (12) income from discharge of indebtedness; (13) distributive share of partnership gross income; (14) income in respect of a decedent; and (15) income from an interest in an estate or trust.
This contrasts with the definition of income for purposes of SSI purposes. 42 U.S.C. § 1382(a) provides:
(a) For purposes of this subchapter, income means both earned income and unearned income; and —
(1) earned income means only — (A) wages…; (B) net earnings from self-employment…; (C) remuneration received for services performed in a sheltered workshop or work activities center; and (D) any royalty earned by an individual in connection with any publication of the work of the individual, and that portion of any honorarium which is received for services rendered; and
(2) unearned income means all other income, including — (A) support and maintenance furnished in cash or kind…; (B) any payments received as an annuity, pension, retirement, or disability benefit, including veterans’ compensation and pensions, workmen’s compensation payments, old-age, survivors, and disability insurance benefits, railroad retirement annuities and pensions, and unemployment insurance benefits; (C) prizes and awards; (D) payments to the individual occasioned by the death of another person, to the extent that the total of such payments exceeds the amount expended by such individual for purposes of the deceased person’s last illness and burial; (E) support and alimony payments…; (F) rents, dividends, interest, and royalties…; and (G) any earnings of, and additions to, the corpus of a trust established by an individual…, of which the individual is a beneficiary, to which § 1382b(e) of this title applies, and, in the case of an irrevocable trust, with respect to which circumstances exist under which a payment from the earnings or additions could be made to or for the benefit of the individual.
Taxation of a Special Needs Trust
II. Taxation of Trusts
A. Grantor Trusts vs. Non-Grantor Trusts
A Non-Grantor Trust is a separate taxpayer from its creator. Not so for a grantor trust. Congress and the Internal Revenue Service brought about the grantor trust rules. A violation of these rules by the grantor or other designated individuals caused the trust to be disregarded for income tax purposes, and the income taxed to the grantor at his or her individual income tax rate. These rules were quite effective in eliminating many of the strategies that the IRS viewed as abusive.
Many years later, creative estate planners began to take advantage of the grantor trust rules by purposefully violating them in the creation of an “Intentionally Defective Grantor Trust” or IDGT. The IDGT is an irrevocable trust that is established during the lifetime of the grantor and is used to remove assets from the estate of the grantor. If the proper rules are violated, the trust assets will not be included in the grantor’s estate at death, but the income from the trust will be taxed to the grantor. In addition, because the grantor is legally liable to pay the income tax for the trust from his or her personal funds, the income and principal of the trust are preserved to compound on a tax-free basis. This is very desirable since it reduces the size of the grantor’s taxable estate while allowing assets outside the taxable estate to grow at a faster rate.
B. Income Taxation of First Party Versus Third Party SNT’s
A Special Needs Trust may be taxed as either a grantor trust or a non-grantor trust, depending upon the circumstances surrounding its creation.
A First Party SNT is a Special Needs Trust that is created by the disabled beneficiary. It typically holds the proceeds from the settlement of the lawsuit resulting from the actions that created the beneficiary’s disability or an outright inheritance from a third party. This type of trust is authorized under 42 U.S.C. § 1396p(d)(4)(A). It is commonly referred to as a Litigation SNT or a (d)(4)(A) Trust.
First Party SNT’s are generally characterized as grantor trusts for income tax purposes because the grantor is the source of the trust assets and the grantor retains a beneficial interest in the trust income and principal, even if that beneficial interest is restricted by the fact that distributions are at the full discretion of the trustee and can generally be made only for purposes that are supplemental to any benefits that the disabled beneficiary would receive from whatever government assistance programs for which he or she has qualified for.
A Third Party SNT is a Special Needs Trust created by someone other than the disabled beneficiary. Third Party SNT’s are often created by the parents or grandparents of a special needs person. The Third Party SNT can be created during the lifetime of the grantor. In this case the trust is generally drafted as a stand-alone document. The trust is usually irrevocable, but is sometimes drafted as a revocable trust.
If created during lifetime, the Third Party SNT can be drafted as either a grantor trust or a non-grantor trust. If drafted as a grantor trust, the income from the SNT would be taxable to the third party creator. This is usually advantageous because this allows the SNT assets to grow at a faster rate (since they are not being depleted by taxes) and because the creator is usually being taxed at a lower tax rate than would be applicable if the Third Party SNT was being taxed as a non-grantor trust. If drafted as a grantor trust, the grantor trust status would terminate upon the death of the creator(s) and the trust would thereafter be taxed as a non-grantor trust.
If drafted as a non-grantor trust, the lifetime Third Party SNT would report its income on its own income tax return and pay the taxes on its income from income trust or principal. The non-grantor Third Party SNT would be subject to the compressed tax rates for trusts, so it would generally pay a greater tax on accumulated income than a Third Party SNT drafted as a grantor trust.
Call our office today.
Ask for Mr. Niemann to personally discuss taxation questions about your New Jersey Special Needs Trust.
You can call him toll-free at (855) 376-5291 or e-mail him at firstname.lastname@example.org.
He looks forward to meeting with you.