The Voice: Is a Qualified Disability Trust Appropriate?
Lovingood McGuffey, P.C. is a member of the Special Needs Alliance. We are privileged to reprint the latest issue of the SNA’s official newsletter, The Voice. This installment was written by Special Needs Alliance member Elizabeth L. Gray, of the Fairfax, Virginia law firm of Cossa, Gray and O’Reilly, PLC, where she focuses her practice on special needs planning, elder law and general estate planning and administration. Elizabeth writes and lectures frequently on issues affecting seniors, individuals with disabilities and their families. She has been recognized as one of the best attorneys in Washingtonian Magazine and Northern Virginia Magazine and has been selected as a Super Lawyer for Washington D.C. and Virginia.
We all worry about taxes, including taxes for our children with special needs. As part of the process of preparing a special needs trust, the attorney drafting the trust instrument must consider what to do about the taxes that may be owed on income generated by the trust assets and discuss this issue with his or her clients, typically the parents of the child with special needs. This may seem like a strange consideration, since, in most cases, the trust will be funded with just a token amount at the time it is set up. That is, it is more likely than not that the trust will hold few, if any, assets during the lifetime of the clients and will sit nearly empty until the death of the surviving parent or until another family member, like a grandparent, leaves something to the trust. Nevertheless, considering that the trust will eventually be funded and generate taxable income, clearly the clients need more information in order to be fully informed.
Special needs trust taxation is a complex subject that requires some important choices be made when the attorney prepares the trust document. The following example illustrates the differences in the tax treatment applicable to supplemental needs trusts and can help parents become more informed about the choices.
Suppose the child’s grandparents leave $500,000 to an irrevocable special needs trust that the parents have established for the benefit of their child. Assume that the trust generates $25,000 in annual trust income. Further consider that the trustee spends $10,000 during the year on expenses for the child’s benefit. Who pays the income tax bill?
During the parents’ lifetime, there are several possibilities:
- It is possible to write the trust’s tax provisions so that the parents are responsible for paying the income taxes on all of the trust’s income even though they did not actually receive any of it. This is called a “grantor” trust for income tax purposes. The taxes will end up being paid at the parents’ marginal income tax rates. If the parents’ marginal rate is 33%, the trust income of $25,000 will result in approximately $8,333 of additional federal income tax due per year, plus any state and local income taxes. Some clients may like this technique because the value of the trust will not be diminished by income tax payments.
- If the parents do not want to be responsible for the income taxes on trust income, or if the parents have died, trust income tax law causes trust income spent for the child’s benefit to be taxed to the child. Therefore, that $10,000 will be taxed as the child’s income. This is usually tax efficient, since the child is likely to have his or her income taxed at the lowest tax rate.
- That still leaves $15,000 of trust income to be taxed to the trust. And therein lies the problem. Irrevocable, non-grantor trusts have compressed income tax brackets, reaching the maximum tax bracket of 35% at only $11,650 of taxable income (in 2012). Not only is the tax rate high, the personal or dependency exemption is normally very low for irrevocable trusts. Is there any way around this problem?
Yes! Until relatively recently, unless written as grantor trusts, special needs trusts were typically treated as “complex” trusts for income tax purposes. This means that they were entitled to claim only a $100 personal or dependency exemption (in contrast with the $3,800 tax exemption for individuals in 2012). In 2003, Congress added a section to the Internal Revenue Code allowing disability trusts to qualify for a special personal exemption. Trusts that meet the requirements of this law are called qualified disability trusts.
Trusts considered to be qualified disability trusts are entitled to the same personal exemption allowed to all individual taxpayers when filing a tax return. The personal exemption in 2012 is $3,800. Thus, if the trust has qualified disability trust status, no income tax will be due on the first $3,800 of income the trust generates. Better yet, if the trust is a qualified disability trust and the beneficiary has to file an individual tax return because his income from all sources (work, trust distributions, etc.) requires him to do so, both the beneficiary and the trust can take the personal exemption, thereby excluding up to $7,600 of income from tax ($3,800 x 2). It is a win/win situation, particularly when one considers that if the special needs trust does not qualify as a qualified disability trust, more likely than not it will be considered a complex trust for income tax purposes and be allowed to claim only a $100 personal exemption. Any income generated by the trust exceeding this exemption amount that is not distributed to or for the benefit of the beneficiary would be subject to income tax at the accelerated trust income tax rates.
How does a trust become eligible for qualified disability trust treatment? There are several required criteria:
- The trust must be irrevocable;
- The trust must be established for the sole benefit of the disabled beneficiary;
- The disabled beneficiary must be under the age of 65 at the time the trust is established; and
- The beneficiary must have a disability that is included in the definition of disabled pursuant to the Social Security Act.
In addition, the trust must be a “third-party trust,” which means that all of its funding must come from someone other than the disabled beneficiary, typically a parent or grandparent, other relative or friend. It is important to note that if the person funding the trust during his or her lifetime is also serving as the trustee, qualified disability trust status may not be attainable.
In order to qualify for qualified disability trust status, the trust cannot be funded at any time by the disabled beneficiary or with his or her own money. This excludes from qualified disability trust treatment the so called (d)(4)(a) or (d)(4)(c) payback trusts or pooled trusts that have been written about in previous issues of The Voice.
As noted, the trust must be for the “sole benefit” of the disabled beneficiary. This means that no other person or entity can benefit from the trust during the lifetime of the disabled beneficiary. However, after the death of the disabled beneficiary, the trust assets can pass to other designated beneficiaries who need not be disabled.
Finally, the trust must be established and funded before the disabled individual turns 65, and the beneficiary must be considered to be disabled pursuant to the criteria set forth by the Social Security Act, or receiving Supplemental Security Income or Social Security Disability Insurance benefits.
Since most special needs trusts will be funded with the parents’ own assets, including perhaps life insurance proceeds and gifts from other family members, they can be established and treated as qualified disability trusts. This unique treatment makes the special needs trust an even more valuable planning tool for the family and their child with a disability.
About this Newsletter: We hope you find this newsletter useful and informative, but it is not the same as legal counsel. A free newsletter is ultimately worth everything it costs you; you rely on it at your own risk. Good legal advice includes a review of all of the facts of your situation, including many that may at first blush seem to you not to matter. The plan it generates is sensitive to your goals and wishes while taking into account a whole panoply of laws, rules and practices, many not published. That is what The Special Needs Alliance is all about. Contact information for a member in your state may be obtained by calling toll-free (877) 572-8472, or by visiting the Special Needs Alliance online.