Taxation of Special Needs Trust Made Simple(er)

HNWEstate Planning, Special Needs Trusts for Minor Children and Adults

  • This article discusses basic tax principles of a Special Needs Trust; hereafter referred to at times as a SNT. Each Type of Special Needs Trust (first party vs. Third party) will be considered from an income, gift and estate tax perspective.

Taxation of a Special Needs TrustTaxation of a Third-Party Special Needs Trusts

A third-party Special Needs Trust (sometimes referred to as a third-party Supplemental Needs Trust) is set up and funded by a parent, friend or family member for the benefit of a person with special needs. For example, a trust set up by a parent for the special needs of a child often provides for the discretionary payment of income and/or principal for the benefit of the beneficiary, without replacing or diminishing any government benefits. Under Federal Law there is no payback requirement to the state(s) for Medicaid or other public benefits provided to the beneficiary.

Tax Consequences of Third-Party Special Needs Trusts Income Tax

A Third party SNT will be taxed separately from its creator. As a general rule, the income will be taxed to the beneficiary of the trust. If the income is not distributed in a calendar year, the trust will be responsible for the tax at the trust income tax rate, which is higher than individual tax payer income tax rates.

Here is an example:

For a single individual in 2019-2020, the top tax rate of 37% is reached at $500,000.00. However, for a trust, the top tax rate of 37 percent is reached at $12,500. Therefore, the decision as to whether income will be taxed at the trust level or, in the alternative, to the grantor or beneficiary may result in considerable tax savings.

However, if the SNT is established during the lifetime of its creator (i.e.: parent/grand-parent) then the trust can be classified as either a grantor trust or a non-grantor trust, depending upon the trust provisions. If classified as a grantor trust, trust income and expenses are taxable to the grantor (parent or a grand-parent) on their personal income tax return and not by the trust or the trust beneficiaries.

If the trust income is intended to be used for the benefit of the beneficiary with special needs who is receiving government benefits, then it is preferable to have the trust considered to be a non-grantor trust, because the income will be attributed to the beneficiary who would likely be in a lower income tax bracket than the grantor or the trust.

Gift Taxation

If the SNT is established under a will, then there are no gift tax consequences. If the trust is created by the settler while he or she is alive (called an inter vivos trust), then there may or may not be gift tax consequences, depending upon the provisions of the trust, such as whether the trust is revocable or irrevocable, grantor or non-grantor.

Estate Taxation

If the SNT is established and funded under a will, trust assets will be included in the estate of the decedent.

If the SNT was established during the lifetime of the grantor, then the trust may or may not be includible in the grantor’s estate, depending upon the trust provisions.

The benefit of inclusion for estate tax purposes is to obtain a step up basis under IRC tax code. The step up will reduce or even eliminate capital gains taxes on the later sale of the trust assets.

First-Party Special Needs Trust

A first-party Special Needs Trust can only be created for an individual with Special Needs under age 65. The trust must be funded with the assets owned by the individual who has Special Needs and must be created for his or her benefit by either an individual (who is the beneficiary); a parent, a grandparent, a legal guardian or a court. The funding of the trust will not disqualify the individual for Medicaid and/or Supplemental Security Income (SSI) benefits.

Tax Consequences of First-Party Special Needs Trust Income Taxation

Generally, for income tax purposes, this trust will be taxed to the beneficiary during his or her lifetime. All income, deductions, and/or credits earned by the assets of the SNT will be reported on the beneficiary’s individual tax return.

Gift Taxation

Generally, because the assets of the person with special needs are used to fund the type of SNT and the person with special needs is the sole beneficiary during his or her lifetime, there are no gift tax consequences.

Estate Taxation

The SNT will be includable in the gross estate of the individual for estate tax purposes even if no estate tax is actually owed. This is generally favorable since most beneficiaries do not have taxable estates.

As stated above, the benefit of inclusion for estate tax purposes is to obtain step up in basis of the trust assets under the code.

In Conclusion

Individuals who are looking to help a family member who has special needs can take advantage of SNTs to meet the needs of that family member without affecting the governmental benefits available to the individual. For individuals with special needs who are under age 65, the use of a FP SNT can ensure Medicaid and Supplemental Security income eligibility with the trust assets being used to enhance the quality of life of the individual.

To discuss your NJ Special Needs Trust matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at  Please ask us about our video conferencing consultations if you are unable to come to our office.

By Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold Township, Monmouth County, NJ Special Needs Trust Attorney

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