Special needs trusts can be an invaluable tool for families that have a child with special needs. One often overlooked aspect of a special needs trust (SNT), however, is how the trust is taxed. This consideration is important because the tax savings can be substantial depending on how the trust is structured.
In the world of SNTs there are two types of trusts: first-party trusts (also called self-settled trusts), which are funded with assets of the special needs child (such as a personal injury settlement); and third-party trusts, which are funded with assets of someone other than the child with special needs (such as the assets of the child’s parent or grandparent).
With a first-party trust, the trust beneficiary (the special needs child) is generally considered the creator or “grantor” of the trust even if he was not the actual creator of the trust agreement. Only the person whose assets are being contributed to the trust can be considered the grantor. The IRS usually considers first-party trusts as “grantor trusts,” and the grantor trust status in turn allows the reporting of all trust income, deductions and credits to pass onto the beneficiary’s own individual tax return.
Third-party trusts are often trickier because they can be more expansive than a first-party trust. Third-party trusts can be revocable or irrevocable, and they can be funded by one individual or from many different sources. These differences bear on how the trust will ultimately be taxed. For example, a revocable trust created by a father for his daughter is usually considered a grantor trust of the father. Because the father’s assets are used to fund the trust, and because it is revocable, the IRS considers the father to have sufficient control over the trust that it will allow the father to report all the income from the trust on his own individual income tax return.
On the other hand, if a father creates an irrevocable trust for his daughter’s benefit and the trust is funded by the assets of others, such as family members and friends making various donations, then the IRS will see this third-party trust as a separate taxable entity from the grantor – in other words, a non-grantor trust. The trust would be required to file its own income tax return and pay its own income taxes instead of reporting the income on either the beneficiary’s or the grantor’s individual tax returns.
Why All This Is Important
So, what does it matter that the trust is a grantor or a non-grantor trust? That is, what’s the difference if the grantor reports the income on his personal tax return or the trust pays the taxes? For starters, in the case of a non-grantor trust where the trust pays the tax, a second full income tax return must be prepared. Families often do not feel comfortable preparing trust income tax returns themselves, so this tax filing usually comes at the price of a CPA to prepare it. But more importantly, a trust is taxed at a far higher income tax rate with a lower exemption and fewer deductions than is an individual. This results in more taxes being paid by a non-grantor trust than a grantor trust on the same income earned by the trust.
For 2023, trusts reach the highest federal tax bracket of 37% at taxable income of $14,451 (except for capital gains, which are taxable at a lower rate). By comparison, the tax rate for single taxpayers on taxable income between $11,000 and $44,725 is only 12%. A trust whose governing instrument requires that all income be distributed currently is allowed a $300 exemption (2023), even if it distributed amounts other than income during the tax year. A qualified special needs trust is allowed a $4,700 exemption.
The tax differences between a grantor and a non-grantor trust can be considerable. And because of these differences, there can be significant tax savings in structuring a special needs trust to qualify for grantor trust status. It is very important that this complex aspect of a SNT not be overlooked and that families discuss all of the various tax issues with their special needs planners during the trust’s planning and drafting stages.