TEN THINGS TO KNOW ABOUT TAXATION OF SPECIAL NEEDS TRUSTS

1. Tax Rates.  Tax rates for trusts are generally higher than tax rates for individuals.  The federal tax for a trust or an individual is 37%.  However, trusts hit this maximum tax rate at a significantly lower income threshold.  For example, a trust hits the maximum bracket at a mere $16,000 of taxable income in 2026.  By contrast, the tax on an individual earning $16,000 is $1,600.  For a single individual filer, the threshold for the 37% bracket is $640,600 in 2026.  These rates are adjusted annually.
2. Third Party Special Needs Trust (TPSNT).  A TPSNT is funded by someone other than the trust beneficiary.  
3. Qualified Disability Trust (QDT).  There is a separate type of TPSNT known as a QDT.  QDTs are granted a generous federal tax exemption equivalent to the standard deduction for an individual.  To qualify as a QDT, the trust must meet specific criteria:
   1. Age.  The trust beneficiary must be 65 years of age or younger when the trust is established.
   1. Disability. The trust beneficiary must be officially determined to be disabled by the Social Security Administration.
   1. Irrevocable.  The trust must be irrevocable.
   1. No Grantor Status.  The trust must operate as a tax paying entity, not the person who established it.
4. Grantor Trust.  A Grantor Trust is a trust where the person who establishes and funds it is the Grantor.  The Grantor must retain significant control or ownership over the assets of the trust, so that the Grantor is considered by the IRS as the owner of the trust for federal income tax purposes.  A Grantor Trust does not pay its own income taxes or file its own income tax return.  All income is taxable to the Grantor.  To qualify as a Grantor Trust, one or more common powers must be retained by the Grantor:
   1. Power of revoke or terminate the trust.
   1. Right to use trust income or principal for themselves or their spouse.
   1. Power to reacquire trust assets by substituting other property of equal value.
   1. The ability to borrow from the trust without providing adequate security.
5. Non-Grantor Trust.  Any trust that does not qualify as a Grantor Trust is a non-Grantor Trust.
6. Self-Settled Special Needs Trust (SSSNT).  An SSSNT is a trust funded with the assets of the individual.  Typically, the funds come from a personal injury settlement or an inheritance.  However, the funds can come from other sources.  An SSSNT is considered a Grantor Trust for federal tax purposes.  All income and deductions pass directly to the trust beneficiary and are taxed at the beneficiary’s individual rate.

The trustee of an SSSNT is not required to file income tax returns because the SSSNT is a Grantor Trust and taxes must be paid by the trust beneficiary.

• Taxation of a TPSNT.  If the trust is irrevocable, it is a Complex Trust.  Any income retained by the trust is taxable to the trust.  Any income paid out to or for the benefit of the beneficiary is taxable to the beneficiary.

A revocable TPSNT is a non-Grantor Trust.  If income reaches or exceeds $600 per month, it must pay tax on any income retained by the trust.  Since it is a Complex Trust, income received by the trust beneficiary is considered income of the beneficiary and must be reported on the beneficiary’s tax return.

• IRS and Medicaid/SSI.  The rules set forth in this paper apply to the Internal Revenue Service, not to Medicaid, particularly SSI.  While the IRS may not tax a distribution from a SNT, Medicaid may still count the distribution as income that may reduce SSI or Medicaid benefits.
• Distributions.  Distributions from a Special Needs Trust (SNT) may be considered by the IRS as income or not.  The decision depends on what the funds are used for.
  • Qualified Disability Expenses (QDEs).  Distributions for QDEs are exempt.  These include:
    • Medical treatments
    • Therapies
    • Adaptive equipment
    • Certain educational costs
  • Taxable.  Distributions for non-qualified expenses may be considered taxable income to the beneficiary.  These include:
    • Personal vacations
    • Food
    • Shelter
• Tax Avoidance.  By careful planning, the tax on an SNT may be totally eliminated.