Qualified Disability Trusts Can Offer Tax Savings

As tax season comes to a close, donors and trustees should be aware that in certain circumstances, a third-party special needs trust may be treated as a "qualified disability trust" for purposes of income taxation. Why should you care? Because a qualified disability trust is allowed to take a much higher personal exemption than a regular trust, resulting in lower income taxes for the trust. Many people, including inexperienced attorneys, are not necessarily familiar with how a special needs trust becomes a "qualified disability trust." Here are the basics.

A standard irrevocable trust that is not considered a "grantor trust" (meaning that the income is not included as a part of the donor's personal income) must file an income tax return every year. Unfortunately, income tax treatment of trusts is very severe -- most irrevocable trusts have only a $100 personal exemption (the amount of income exempt from taxation in a given year) and income in non-grantor trusts is taxed at the maximum 39.6 percent rate as soon as a trust has $12,150 in income. An individual taxpayer, on the other hand, has a personal exemption of $3,950 and her income is not taxed at the highest rate until she reaches several hundred thousand dollars in yearly income. Because the tax treatment of trusts often results in very high income tax penalties, the government allows certain trusts established for people with special needs to use the $3,950 personal exemption instead of the typical $100 trust exemption.

In order to qualify as a "qualified disability trust," a trust must meet several important requirements. First, the trust cannot be a grantor trust, because grantor trusts, by their very nature, pass income along to individual taxpayers who can claim the full $3,950 personal exemption. Since so-called "first-party supplemental needs trusts" are almost always grantor trusts, a qualified disability trust will typically be "third-party trusts," which are created and funded with funds that are not owned by a person with special needs.

Second, a qualified disability trust must be established for the sole benefit of a person under age 65 who meets the Social Security Administration's definition of "disabled." This means that the beneficiary of the trust is almost always going to be receiving either Supplemental Security Income (SSI) or Social Security Disability Insurance (SSDI). Of course, the devil is in the details when it comes to this second requirement because not all special needs trusts are for the sole benefit of a person with disabilities -- sometimes there are multiple beneficiaries. Also, there are some cases where family members create so-called special needs trusts for people over age 65 that may allow that person to qualify for benefits like Medicaid but do not allow someone to obtain SSI.

What is the actual net result if a trust qualifies as a proper qualified disability trust? For trusts that have more than $12,150 in income (after taking the full $3,650 qualified disability exemption), the trust can save approximately $1,340 in taxes per year. Especially for smaller trusts with limited resources, this is a substantial savings.

Not all special needs trusts will qualify as qualified disability trusts for a variety of reasons. In fact, given a donor's individual tax bracket, the amount being placed into trust, and the needs of the beneficiary, some planners will not create qualified disability trusts at all because the benefits of having a grantor trust outweigh the advantages of a qualified disability designation. To help you and your family make the choice that is right for you, contact your attorney with expertise in special needs planning.

Article Last Modified: 04/12/2010


Planners near Providence

  • Providence Special Needs Attorney James Mullen
    James Mullen
    Bristol, RI

  • Providence Special Needs Attorney Elizabeth Phillips
    Elizabeth Phillips
    Warwick, RI

  • Providence Special Needs Attorney Macrina Hjerpe
    Macrina Hjerpe
    Providence, RI