Special Needs Planning involves many layers, one of which is managing the finances of those with special needs. A guardian of the estate, power of attorney for financial management, or trustee of a special needs trust are all individuals who should be able to effectively manage the financial affairs of someone with special needs. Each of these individuals should be educated to understand how to appropriately manage cash flow requirements, how to invest to ensure resources last for the individual's lifetime, and, finally, how to manage the tax impacts of investing.
Tax planning for special needs families can be an integral part of Special Needs Planning. To that end, trusts are tools that maintain an important role in protecting the financial assets of the individual, or assets inherited by the individual from other members of the family. These financial assets are subject to the same, if not higher, tax rates than individuals. However, depending on how trusts are integrated into a Special Needs Plan, different trusts offer different benefits and create different consequences. For example, consider someone who becomes disabled later in life. As the grantor, they can use an Intentionally Defective Grantor Trust (IDGT) to transfer property, via a gift or sale. In return the grantor receives a stream of income from the trust, presumably at a rate lower than the growth rate of the asset transferred, for a defined period of time. This transfer effectively qualifies as a "completed transfer" to an irrevocable trust which removes it from being classified as a "available asset" for Special Needs Planning purposes. While the beneficiary receives interest payments from the trust, those payments are not considered taxable income. Instead, during the payment period any income generated in the IDGT is passed on to the beneficiary and taxed at their individual rate instead of at the trust's tax rate. Thus if the primary investment strategy in the IDGT is appreciation instead of income, then the potential capital growth can be eliminated from their estate and the income, if invested in tax-exempt fixed income securities, could potentially be tax free. Of course individual situations will vary and not everyone's situation will qualify for this simple example.
The intention of this article is to help you understand how Special Needs Trusts (i.e. General, Supplemental, and others) are taxed, ways to manage the tax impact, and strategies for reducing future tax liability. To help with our task we interviewed Enrolled Agent, Julie Piché*, with Foster Financial Group, LLC. The following are some of the more common questions faced by families with special needs individuals.
HRWM: Special Needs Planning starts with understanding an individual's disability, then assessing their financial situation, and finally determining which tools should be used to best meet that individual's needs. Part of the planning process also requires understanding how taxes will affect financial resources in the future. In your professional opinion, what are some tax considerations a special needs parent should begin planning for as they help their family establish a Special Needs Plan?
FFG: Tax planning is a very fluid process requiring reassessments annually and revisions as needed. When I sit down with a client to assess their situation I review these basic items:
- The exemption and deduction amounts allowed for individuals (who may or may not be dependents of another) vs the exemption and deduction amounts allowed for trusts. Typically, individual exemptions and deductions are more, allowing for more income before taxes are assessed.
- Whether their current special needs trust(s) are setup as 'Grantor' trusts (i.e. an IDGT) or 'Non-Grantor' trusts (i.e. Supplemental Needs Trust). If the trust is a 'Grantor' trust then this is considered a disregarded entity, as far as the IRS is concerned, and income from these trusts is taxed at the Grantor's tax rates, on their 1040, which are usually more beneficial than a 'Non-Grantor's' trust tax rates. Alternatively, 'Non-Grantor' trusts are deemed to be separate entities and as such are taxable as separate entities, which are typically are in a higher tax bracket than an individual or Grantor. Understanding this distinction allows me to work with a family, or guardian, to evaluate strategies to minimize the trust's tax liability in the future.
- The tax structure of Special Needs Trusts (SNT) vs that of Qualified Disability Trusts (QDT) can be very important. Understanding how a trust was established and who funded the trust will help determine who will ultimately be responsible for the taxable income generated in the trust.
- Different trusts are allowed to be setup and funded from different parties (i.e. Self-Settled Payback Trusts, Intentionally Defective Grantor Trusts, or Third-Party Supplemental Trusts). Determining whether the initial and consecutive contributions to the trusts are considered gifts, causing Gift Tax consequences, or taxable sales generating capital gains or interest income, can be vital in determining who pays the taxable liability.
HRWM: It is our understanding that as families create their Special Needs Plan there are some additional tax filing requirements. What, if any, additional tax forms are needed to be filed for trusts?
FFG: Trusts that are regarded as their own taxable entity require their own TIN (Taxpayer Identification Number), granted through the IRS, and are required to file a Form 1041. The 1041 is similar to a 1040 in the way that it “rolls up” income from different schedules onto the main form, but the tax rates for trusts are higher than for individuals. In certain circumstances, even if a Form 1041 is required, the income generated in a 'Non-Grantor' trust can still flow through to the beneficiary of the trust via a Form K1, however this is determined by the type of trust formed.
HRWM: Trust planning can be confusing, but when you layer in Special Needs Planning we quickly learn there are different types of special needs trusts. For tax planning purposes, are there tax strategies that can be employed between the different special needs trusts that should be taken into consideration when creating a special needs estate plan?
FFG: In many cases clients come to me with special needs trusts already established which makes tax planning challenging. However, for those looking to "plan ahead" the following are some important factors to consider:
- The origin of the amount that will be used to initially fund the trust. For example, if it is a 'Grantor' trust, and it is being funded with the special needs individual's money, then it is not considered a completed transfer and, correspondingly, is not considered a gift. However, if you are funding a 'Non-Grantor' trust for a special needs individual, then the amount you fund the trust with is considered a gift, and could have gift tax consequences for you. It is important to note, self-settled trusts cannot be established by individuals over age 65 which may require the consideration of alternative trusts. Depending on the trust established, alternative tax consequences should be considered.
- Tax brackets for the beneficiary, grantor, and trust should all be considered when choosing the type of trust. In addition, the principle amount and projections for potential earnings growth to maintain financial support over the life of the beneficiary should be assessed, in order to estimate potential future income tax liability.
- Needs based government benefits, such as SSI or Medicaid, can be impacted by unearned income (as defined by Social Security – rather than by the IRS) from special needs trusts distributions. The income generated from special needs trusts, if passed on to the beneficiary, can create a large tax liability without the necessary income or cash needed to pay the corresponding tax bill.
- Which type of trust is going to be established, a 1st party or 3rd party Special Needs Trusts? While 3rd party trusts are generally more beneficial to protect assets, 1st party trusts are the more typical scenario for special needs individuals with adult onset disabilities. Each special needs family needs to understand the tax pitfalls, such as the gift tax consequence, and the different trust tax rates.
While there does not seem to be one magic bullet, when considering all of the above factors together, typically one type of trust will stand out for your particular situation. Knowing which tax strategies would benefit your family before establishing a special needs trust can go a long way toward managing current and future tax liabilities of the special needs individual and/or your family.
It is important to work with a qualified estate attorney who specializes in Special Needs Planning, a qualified tax professional such as an Enrolled Agent, or CPA, and a financial professional who understands Special Needs Planning, like a Chartered Special Needs Consultant.
About Foster Financial Group, LLC
Foster Financial Group has been preparing tax returns for over 30 years for individuals, trusts, corporations and partnerships. All of their preparers acquire extensive continuing education each year, including attending the IRS convention every summer to receive the latest updates to tax law, rules, and regulations. They also offer the latest in technology and environmental friendliness, with electronic filing of every return, a secure, online portal for easy and safe two-way document sharing, and .pdf versions of tax documents for those who are striving to eliminate paper files. They take great pride in explaining every line of the return to our clients, so that they understand everything they are signing and filing. Their partnership with their clients is of primary importance to their firm, and their commitment to them is a year-round availability with prompt return of communication, whether by phone, email, or appointment.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. The information has been obtained from sources considered to be reliable, however, we do not guarantee that the material provides a complete description of the services mentioned.
Horizon Ridge Wealth Management representatives offer access to Trust Services through The Private Trust Company N.A, an affiliate of LPL Financial.
Tax preparation services are not provided by Horizon Ridge Wealth Management, LLC.
Horizon Ridge Wealth Management LLC and Foster Financial Group LLC are separate entities.
*Julie Piché, with Foster Financial Group, is not endorsed by Horizon Ridge Wealth Management LLC.