How Do Special Needs Trusts Work?

Parents with disabled children worry about how their offspring will manage when parents are no longer able to care for them. Leaving money directly to a child receiving means-tested government benefits, like Social Security Supplemental Income or Medicaid, could make them ineligible for these programs, explains an article from Kiplinger titled “Estate Planning: A Special Trust for a Special Need.” In most states, beneficiaries of either program are only allowed to have a few thousand dollars in assets, with the specific amount varying by state. However, the financial support from government programs only goes so far. Many families opt to have their own family member with special needs live at home, since the benefit amount is rarely enough.

The solution is a Special Needs Trust, which provides financial support for a disabled individual. The SNT owns the assets, not the individual. Therefore, the assets are excluded from asset limit tests. The funds in the trust can be used to enhance quality of life, such as a cell phone, a vacation or a private room in a group living facility. The SNT is a means of making sure that a vulnerable family member receives the money and other relatives, such as a sibling, don’t have a financial burden.

SNTs can only be created for those who are younger than age 65 and are meant for individuals with a mental or physical disability so severe they cannot work and require ongoing support from government agencies. A disabled person who can and does work isn’t eligible to receive government support and isn’t eligible for an SNT, although an estate planning attorney will be able to create a trust for this scenario also.

Each state has its own guidelines for SNTs, with some requiring a verification from a medical professional. There are challenges along the way. A child with autism may grow up to be an adult who can work and hold a job, for instance. However, estate planning attorneys recommend setting up the SNT just in case. If your family member qualifies, it will be there for their benefit. If they do not, it will operate as an ordinary trust and give the person the income according to your instructions.

SNTs require a trustee and successor trustee to be responsible for managing the trust and distributing assets. The beneficiary may not have the ability to direct distributions from the trust. The language of the trust must state explicitly the trustee has sole discretion in making distributions.

Because every state has its own system for administering disability benefits, the estate planning attorney will tailor the trust to meet the state’s requirements. The SNT also must be reported to the state. If the beneficiary moves to another state, the SNT may be subjected to two different sets of laws and the trustee will need to confirm the trust meets both state’s requirements.

SNTs operate as pass-through entities. Tax treatment favors ongoing distributions to beneficiaries. Any earned investment income goes to the beneficiary in the same year, with distributions taxed at the beneficiaries’ income tax rate. Trust assets may be used to pay for the tax bill.

As long as all annual income from the trust is distributed in a given year, the trust will not owe any tax. However, a return must be filed to report income. For any undistributed annual investment income, the trust is taxed at one of four levels of tax rates. These range from 10% and can go as high as 37%, depending on the trust income.

An SNT can be named as the beneficiary of a traditional IRA on the death of the parent. Investments grow tax deferred, as long as they remain in the retirement account and the SNT collects the required minimum distributions for the retirement account each year, with the money passing as income. However, any undistributed amount of the required distribution will be taxed at the trust’s highest tax rate.

Reference: Kiplinger (June 8, 2022) “Estate Planning: A Special Trust for a Special Need”

When Can Estate Assets Be Distributed?

Just as an individual pays taxes, so do estates. An estate is required to file an annual income tax return for each calendar year it is open, even if only for part of the year. This is in addition to the estate tax return and the decedent’s final tax return, explains a recent article “The Dangers Of Distributing Estate Assets Too Soon” from Forbes.

The estate tax return is based on the assets in the estate, the income received and deductible expenses paid during the calendar year. Only one estate tax return is required. However, as long as the estate is open, an annual estate income tax return needs to be filed.

To minimize income, many executors distribute income to beneficiaries shortly after it comes into the estate. The estate takes a deduction for the income distributed to beneficiaries in the same year it is received by the estate. Beneficiaries are required to include the distribution in their gross income.

However, if the estate does not distribute income before the end of the year, the estate will owe income taxes. There are further complexities to be aware of, including what happens if an executor receives unexpected income or does not know the tax impact of certain transactions. The estate has to pay taxes, but what happens if all assets have been distributed?

The estate still owes those taxes.

The executor may be personally liable for paying the taxes.

If some of the expenses the estate pays are not deductible, but the executor thinks they are, then the estate will have an income tax liability, possibly without the cash to pay it.

The estate often receives property taxable as income if it is not distributed to beneficiaries, like a stock dividend. The estate receives the stock, and its taxable income based on the value at the date of the distribution.

If the estate does not distribute the stock to beneficiaries until later in the year and the stock’s value declines, the estate is still required to recognize the income equal to the stock’s value on the date it was received. If the executor deducts the lower value of the stock, then the estate will be liable for the income tax on the difference.

In some cases, these kinds of issues can be prevented by maintaining a certain level of cash in the estate account until the final estate tax return is filed. The beneficiaries receive distributions once all of the taxes—estate income, estate and final individual or final joint—are paid.

For larger or more complex estates, it is wise to have a discussion with the estate planning attorney, the family CPA and the executor, so all parties are prepared for tax liabilities in advance.

Reference: Forbes (Feb. 16, 2022) “The Dangers Of Distributing Estate Assets Too Soon”