Knowing a Little About How Special Needs Trusts Are Taxed Can Be Helpful

Having a little working knowledge about how Trusts are taxed can help you with planning for your special needs person. It will also help you to work more effectively with your accountant, lawyer and trustees.

First, it is important to realize that most trusts are separate entities and can be subject to both State and Federal income tax. This applies to trusts set up by family members and trusts holding a disabled person’s own assets. The rules can be very different for each one.


The IRS gives taxable trusts a $600 deduction. If a trust fund is small enough, I often advise clients to keep the interest income less than $600 per year in order to avoid having to file a trust tax return. The beneficiary may still have to file his own return. The trust tax return is called a “pass through” return by the IRS as most of the income, taxes, and deductions are “passed through” to the beneficiary. The return is filed with the IRS on Form 1041. Trusts are taxed on a calendar year which ends on December 31st.


Trusts generally get an income tax deduction for all of the money which they distribute to a beneficiary or pay for the beneficiary’s treatment, support or needs. Frankly, this is how good trustees should be using the money of a special needs person. The trust deducts the portion of its income which it pays out. Principal which is spent or paid out is usually not taxable to the trust or the beneficiary.

Looking at a simple example is often helpful. If a trust has $100,000 worth of principal and it simply deposits the money in a bank account and does not generate interest or income the trust does not have to pay any income tax or file a return. If the trustees distribute a portion of that account, by way of example $30,000 for the medical needs of the beneficiary, the distribution of principal is not taxable income to the beneficiary.


Income received by a trust from investing in a tax-free source keeps its “character” and is tax-free to the beneficiary when it is spent for their needs. Knowing this, we often advise clients to put some or all of the beneficiary’s funds in tax-free municipal bonds.


The second big general rule is that many but not all of the deductions that are available to individuals may also be available to Trusts. However, the trust tax rate on income that a Trust earns but does not pay out to a beneficiary is much higher than the individual tax rate that your special person will pay. To avoid this his it often makes sense to plan ahead and spend down all trust income by December 31st each year. Currently, Trusts pay about a 38% federal tax on income that the trust accumulates and does not spend on behalf of a beneficiary. Your state income tax can increase this burden.


Knowing that the trust income that is spent for a beneficiary that is likely to be taxable on the beneficiary’s personal return is important. The trust can make estimated income tax deposits on Form ES1040 and transfer the benefit of those income tax prepayments to your beneficiary. This can cover any tax liability that your beneficiary might owe due to trust income. It can help relieve worries, properly prepay tax liability and the payment of taxes caused by trust income is almost always a legitimate trust expense.


Congress did add a special provision to the tax code for qualified disability trusts. It is found in section 642 and can be helpful to a D4a trust provided the trust is not a “grantor” trust. It effectively doubles the personal deduction of $3,300 by giving the trust the benefit of a personal deduction and allowing the beneficiary to keep a similar personal deduction. In practice this is difficult to accomplish for most larger trusts but is worth exploring. You should ask your accountant if it can work for your family.


A trust may pay employees on behalf of your special needs beneficiary. Don’t forget workman’s compensation insurance is required. FUTA withholding is required if an employee is paid more than $1,000 in a quarter. Social Security must be withheld and paid if an employee is paid more than $1,500 in a calendar year. Filing a 1099 is generally required when a trust makes payments to vendors in excess of $600.00.

This article just shares a little insight into some of the general trust tax rules. There are places where you can begin to look for tax breaks if you work with your accountant, trustees and lawyers. Keep in mind that trusts are subject to the alternative minimum tax, estimated withholding, capital gains taxes, depreciation and the loss carry-forward and carry-back regulations. It is important that your professionals always check the actual code sections as they apply to your family’s specific situation. Of course, you also have to double check your state’s tax specific regulations.

Source by Joseph M. Hoffmann, Esq

Diana McCalpin is an accountant who manages a Certified Public Accounting Practice in Laurel, Maryland which performs audit, accounting and tax services to customers. She loves to share information with clients to help them grow their businesses and be profitable.

Share this

Leave a Reply