Taxes on Special Needs Trusts

by Jennifer F. Bender ; Updated July 27, 2017

Individuals create special needs trusts to protect individuals who suffer from disabilities. These trusts allow people with disabilities to have an unlimited amount of money put aside for their benefit. This money is to be used in addition to government aid. Every trust has its own Employer Identification Number (EIN) that is used by the Internal Revenue Service. There can be tax implications for special needs trusts depending on how the trust is established.

Grantor Trust

A grantor trust is a special needs trust funded with the beneficiary's own money that was received as an inheritance or from a lawsuit. These trusts are taxed as if no trust exists. The beneficiaries can still apply for and receive government benefits for their care. If there is investment income, this will be taxed as if the beneficiary were receiving direct income even though the money remains in the trust.

Third-Party Trust

Third-party trusts are special needs trusts created by an individual other than the individual with the disability. The most common example is when a parent dies and leaves money in a trust for a disabled individual. These trusts pay income tax themselves at a typically high rate. As of 2011, the tax rate is 35 percent when income reaches $11,200. The trust can deduct what it pays to the beneficiary. This income is shown on a K-1 form to the beneficiary, and then the beneficiary must pay tax on this money.

Qualified Disability Trust

A qualified disability trust is a trust established by someone other than the beneficiary and before the beneficiary reaches age 65. The beneficiary must be receiving Social Security or Social Security disability benefits before the end of the trust's first tax year for the trust to qualify. These trusts are eligible for a higher personal exemption if the trust has to pay taxes on income from dividends or capital gains.

Reporting Issues

All special needs trust distributions carry out income and will need to be reported to the IRS by the beneficiary. However, these distributions are not necessarily income as defined by the government. Sometimes government agencies send out tracers to obtain income information on beneficiaries. These agencies might send out notices threatening to cancel benefits because of alleged income received by beneficiaries. The trustee should then respond with a letter confirming that these distributions were not income as defined by the government agency.