When It Comes to Taxes, Special Needs Trusts Are Not All Equal

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.

Currently, a trust reaches the highest federal tax bracket of 39.6 percent at taxable income of $12,500, whereas a single individual with the same income would only be in the 15 percent tax bracket (the rate is 10 percent for married couples). In addition, the IRS allows for a certain amount of income to be earned tax-free by a taxpayer. For individuals, this is known as the “personal exemption” and is currently (2017) set at $4,050. The IRS is less generous with trusts, and it sets the exemption amount for most trusts at a mere $100. Further, individuals get a standard deduction (unless itemizing their deductions results in a larger amount) of $6,350. A trust gets no standard deduction.

Here’s a simple illustration of how large the tax difference could be depending on whether an individual or a trust is taxed: Assume a single father creates two trusts. One trust is revocable and was created with the father’s own assets (a grantor trust) and the other is irrevocable and was created with assets of others (a non-grantor trust). Each trust earns $13,000 of income in 2017. The grantor trust would have that $13,000 of income added to the father’s personal income tax return. If the father had other income of, say, $40,000, then his gross income would be $53,000. After reducing his gross income by the personal exemption of $4,050 and the standard deduction of $6,350, the father’s net taxable income of $42,600 would have a maximum tax rate of 25 percent. Meanwhile, the other trust, the non-grantor trust, gets no standard deduction and an exemption of only $100. Its net taxable income of $12,900 ($13,000 minus $100) would have a much higher maximum tax rate of 39.6 percent.

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.