Special Needs Trust Taxes and Distributions

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geobrick
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Joined: Sun Jun 19, 2016 2:47 pm

Special Needs Trust Taxes and Distributions

Post by geobrick » Mon Mar 12, 2018 6:41 pm

I'm the Trustee of a 3rd party Special Needs Trust for the benefit of my brother (set up by my dad and funded with my brother's portion of my dad’s estate as directed). 2017 was the first full year the Trust has any reportable income so I want to file the Taxes correctly. I may end up hiring a professional tax expert but I want to understand everything I can first.

My questions below relate to the Trust’s Income and how it's reported on the 1041 but more importantly what gets reported on the K-1 used to prepare his personal 1040. He receives SSI and I'm concerned about how the SSA may react to his reported income (I'm also his Representative Payee for SSI).

The Trust language doesn't require any specific distributions but it does have specific language to not do anything that would impact his benefits. It's probably language typical of Special Needs Trusts. I know I need to be careful with how I use the Trust’s money for his benefit because of the Trust language and SSI restrictions.

The way I understand it, anything I spend for his benefit using the Trust’s money during the tax year is considered to be a distribution to him (even if he never personally touches the money). When I use Trust funds to supplement his rent, pay for transportation, or clothing etc, that’s considered money for his benefit and should show up on his K-1.

Here are my questions:
1) If the Trust has distributable net income (DNI) of $10,000, and I’ve spent $15,000 for his benefit what would be go on the Form 1041 Schedule B line 9 and 10? My assumption is $0 would go on line 9 since the Trust language doesn’t specify any required amounts to distribute and the full $15,000 would go on line 10 (though I know he will only be responsible for the tax on the DNI amount less deductions on his personal 1040 return). Is my assumption correct?

2) How will the Social Security Administration react to a situation like this? Will they know that this is not his individual income and know it was spent appropriately for his benefit? Will they contact me to review how the money was spent so they can assess how much, if any, of his SSI benefits could be impacted? Does the IRS make his K-1 or 1040 available to the SSA?

3) To avoid #2, can I chose to distribute only non-income (principle/corpus) to limit the amount of taxable income distributed to him? In situation #1 above, can I put $0 on line 9 and $200 on line 10, thus keeping the DNI tax burden with the Trust (similar to how capital gains are kept with the Trust)? I know the Trust would have a higher tax burden but it may avoid the SSA review. Is it true that even if the Trust allows me to distribute principle instead of income, the rules say all distributions are counted against DNI first for tax purposes? If so, can you provide a link to a reference?
Last edited by geobrick on Thu Mar 15, 2018 12:54 pm, edited 2 times in total.

Gill
Posts: 4575
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Location: Florida

Re: Taxes for Special Needs Trusts

Post by Gill » Mon Mar 12, 2018 8:17 pm

To the extent you have DNI, all distributions to him will carry out income to him whether you pay it from income or principal. As for SSA, I can’t answer that question but I assume they would treat it as any other income.
Gill

geobrick
Posts: 48
Joined: Sun Jun 19, 2016 2:47 pm

Re: Taxes for Special Needs Trusts

Post by geobrick » Mon Mar 12, 2018 10:00 pm

Thanks Gill.

Nutmeg
Posts: 111
Joined: Wed Jul 26, 2017 12:52 pm

Re: Special Needs Trust Taxes and Distributions

Post by Nutmeg » Sat Mar 17, 2018 5:07 pm

geobrick wrote:
Mon Mar 12, 2018 6:41 pm
I'm the Trustee of a 3rd party Special Needs Trust for the benefit of my brother (set up by my dad and funded with my brother's portion of my dad’s estate as directed). 2017 was the first full year the Trust has any reportable income so I want to file the Taxes correctly. I may end up hiring a professional tax expert but I want to understand everything I can first.

My questions below relate to the Trust’s Income and how it's reported on the 1041 but more importantly what gets reported on the K-1 used to prepare his personal 1040. He receives SSI and I'm concerned about how the SSA may react to his reported income (I'm also his Representative Payee for SSI).

The Trust language doesn't require any specific distributions but it does have specific language to not do anything that would impact his benefits. It's probably language typical of Special Needs Trusts. I know I need to be careful with how I use the Trust’s money for his benefit because of the Trust language and SSI restrictions.

The way I understand it, anything I spend for his benefit using the Trust’s money during the tax year is considered to be a distribution to him (even if he never personally touches the money). When I use Trust funds to supplement his rent, pay for transportation, or clothing etc, that’s considered money for his benefit and should show up on his K-1.

Here are my questions:
1) If the Trust has distributable net income (DNI) of $10,000, and I’ve spent $15,000 for his benefit what would be go on the Form 1041 Schedule B line 9 and 10? My assumption is $0 would go on line 9 since the Trust language doesn’t specify any required amounts to distribute and the full $15,000 would go on line 10 (though I know he will only be responsible for the tax on the DNI amount less deductions on his personal 1040 return). Is my assumption correct?

2) How will the Social Security Administration react to a situation like this? Will they know that this is not his individual income and know it was spent appropriately for his benefit? Will they contact me to review how the money was spent so they can assess how much, if any, of his SSI benefits could be impacted? Does the IRS make his K-1 or 1040 available to the SSA?

3) To avoid #2, can I chose to distribute only non-income (principle/corpus) to limit the amount of taxable income distributed to him? In situation #1 above, can I put $0 on line 9 and $200 on line 10, thus keeping the DNI tax burden with the Trust (similar to how capital gains are kept with the Trust)? I know the Trust would have a higher tax burden but it may avoid the SSA review. Is it true that even if the Trust allows me to distribute principle instead of income, the rules say all distributions are counted against DNI first for tax purposes? If so, can you provide a link to a reference?
I don't have all the answers but will tell you what I believe to be correct. A CPA prepares the taxes for the trust that is funded for which I am a trustee (I am also a trustee for trusts that are not funded).

1) If your trust doesn't require any distributions, I believe your assumption is correct.

2) I don't know exactly how the SSA will treat this. The SSA will know the income came from a Trust because Part III of Schedule E of your brother's individual income tax return on Form 1040 will report "Income or Loss from Estates and Trusts." Then the name of the trust, which should indicate it is a Special Needs Trust, will be listed on line 33A.

3) I don't think it is necessary to jump through the hoops you are proposing. The whole purpose of a Special Needs Trust is to allow a person with special needs to hold assets and receive supplemental income for certain needs without jeopardizing government benefits. If one had to adjust how one would normally report income taxes in order to get the benefit of a SNT, the whole purpose of a SNT would be defeated. Keep in mind that the definition of income is different for tax purposes than it is for assessing whether one is eligible for government benefits, so preparing a trust tax return, including a Form K-1, and reporting the trust income that flows through to the beneficiary on the beneficiary's tax return should not jeopardize benefits, as long as the regulations concerning disbursements have been followed.

This site has some useful information, including information on taxes: https://www.specialneedsalliance.org. I also highly recommend consulting a CPA with trust tax return expertise.

I hope this helps!

Nutmeg
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Re: Taxes for Special Needs Trusts

Post by Nutmeg » Sat Mar 17, 2018 5:14 pm

Gill wrote:
Mon Mar 12, 2018 8:17 pm
To the extent you have DNI, all distributions to him will carry out income to him whether you pay it from income or principal. As for SSA, I can’t answer that question but I assume they would treat it as any other income.
Gill
I believe that the assumption that the SSA will treat income from a Special Needs Trust as any other income is incorrect. That would defeat the purpose of a Special Needs Trust. The key question when the SSA views a Special Needs Trust is not how much taxable income it generated, but rather how the disbursements from the SNT were spent.

geobrick
Posts: 48
Joined: Sun Jun 19, 2016 2:47 pm

Re: Special Needs Trust Taxes and Distributions

Post by geobrick » Sat Mar 17, 2018 6:54 pm

Nutmeg, Thanks for your reply. I've found your reply's on this forum to be very helpful.

I do plan to use a CPA but I always want to understand the rules as much as possible in advance before I consult a professional so it saves time and I know what information is relevant to the professional and what questions I should ask.

My goal is to avoid having to prove to someone at SSA that all my distributions were proper. I have the records but it would be an added burden on my time.

I've used the resources at the special needs alliance website and they're great. One of their articles implies you have to have the Trust reviewed by the SSA in advance to have it go through some approval process and also to let them know if you are paying any in-kind expenses so they can assess the SSI reductions up front (which could be beneficial so we don't have to payback any potential overpayments later). However, I'd rather not have to do that. While some people at the SSA are really knowledgeable, the ones I typically interact with at our local field office don't seem to have the depth of knowledge needed for special needs trusts. There was someone I talked to a few years ago at the Atlanta regional office (3000 miles away from me) who was much more informed. She was extremely helpful. Maybe I'll call her about this situation (I hope she still works there).

geobrick
Posts: 48
Joined: Sun Jun 19, 2016 2:47 pm

Re: Special Needs Trust Taxes and Distributions

Post by geobrick » Sat Mar 17, 2018 10:32 pm

There's one remaining item in my original question that wasn't specifically addressed.

Why does the consensus seem to be that all trust distributions count against income first? Where is that written in the code or regulations?

If I as a Trustee decide to distribute $10,000 to the beneficiary why can't I report it all as corpus (even if there were $15,000 in income) then show $0 of income distributed to the beneficiary on the K-1? The income would stay in the Trust and the Trust would pay all the associated tax on it (likely at a higher rate) so it's not like I'd be attempting to avoid paying taxes on the income.

mrsbetsy
Posts: 120
Joined: Mon Jun 26, 2017 12:16 am

Re: Special Needs Trust Taxes and Distributions

Post by mrsbetsy » Sat Mar 17, 2018 11:16 pm

Another way around it is to make all distributions filter through an ABLE account. You can fund the ABLE account about 14K a year and use those funds for his benefit without any impact to SSI.

This may be state specific, but we use this book is as great resource for understanding how to make distributions without harming government entitlements.

https://www.amazon.com/Administering-Ca ... n+urbatsch

The trust attorney should also be able to guide you. Truly, you must be very careful about any funds used for his benefit.

geobrick
Posts: 48
Joined: Sun Jun 19, 2016 2:47 pm

Re: Special Needs Trust Taxes and Distributions

Post by geobrick » Sun Mar 18, 2018 12:10 am

mrsbetsy wrote:
Sat Mar 17, 2018 11:16 pm
Another way around it is to make all distributions filter through an ABLE account. You can fund the ABLE account about 14K a year and use those funds for his benefit without any impact to SSI.

This may be state specific, but we use this book is as great resource for understanding how to make distributions without harming government entitlements.

https://www.amazon.com/Administering-Ca ... n+urbatsch

The trust attorney should also be able to guide you. Truly, you must be very careful about any funds used for his benefit.
Thanks. I'm in California so the book would be good for me. I'll look into the ABLE account but do you know if the book answers my question about the requirement to distribute income first for tax purposes?

geobrick
Posts: 48
Joined: Sun Jun 19, 2016 2:47 pm

Re: Special Needs Trust Taxes and Distributions

Post by geobrick » Sun Mar 18, 2018 5:19 pm

mrsbetsy wrote:
Sat Mar 17, 2018 11:16 pm
This may be state specific, but we use this book is as great resource for understanding how to make distributions without harming government entitlements.
https://www.amazon.com/Administering-Ca ... n+urbatsch
There's an updated version of the book on amazon: https://www.amazon.com/Administering-Ca ... 037&sr=1-5

It's also available for kindle at a much lower cost (if you like e-books).

mrsbetsy
Posts: 120
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Re: Special Needs Trust Taxes and Distributions

Post by mrsbetsy » Sun Mar 18, 2018 10:48 pm

I have to say that we have not done this because we are extremely careful in distributing money/support. Everything goes through the ABLE account and thus is not subject to any of this.

However, I am looking at the 2nd edition book and it says:


1) Yes, you must file a 1041 for anything over $600. You also must file a FTB form 541, a CA Fiduciary Income Tax Return.

I'm certainly not going to advise you on taxes, but yes it is all included in this book.

Distributing $15,000 (!) in a year, this beneficiary will most certainly experience a reduction in SSI. The ISM amount per month will be prorated over the year. Did you do this on a monthly basis or was it a lump sum? It must be reported to SSA.

If you were supplementing his housing, then that comes from federal. Here's an example:

Beneficiary receives $900 a month SSI which is to provide food and shelter. But, they want to move and pay $1200 a month for rent. The extra payment is counted as ISM and the SSI check will be reduced by the PMV rule by around $265 per month.

As Trustee, you must decide if this is a good move. Perhaps it is in the beneficiaries best interest and there is enough in the estate to manage the reduction and preserving public assistance is not the ultimate goal. You, as the Trustee must make that call.

mrsbetsy
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Re: Special Needs Trust Taxes and Distributions

Post by mrsbetsy » Sun Mar 18, 2018 11:19 pm

You really need to set up a spreadsheet to document exactly how you have used the funds. You *cannot* use trust funds to supplement food or shelter without a significant reduction in benefits. Separate out things like soap, toilet paper, etc. as these are not food items. Definitely pay for things like clothing, transportation, furniture, haircuts, vacation, and entertainment etc directly to the agency. Do not give the beneficiary money directly.

It truly depends on how the trust was set up Generally, if you do it right, there is not a tax liability on the principle because these are inherited funds, but the growth would be treated differently depending on how it is set up (invested, etc.)

If this is too much of a burden at the moment, consider hiring someone to administer the trust properly. Depending on the age of the beneficiary, disrupting those public entitlements could have a devastating effect on his future.

geobrick
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Joined: Sun Jun 19, 2016 2:47 pm

Re: Special Needs Trust Taxes and Distributions

Post by geobrick » Sun Mar 25, 2018 1:20 pm

Mrsbetsy, Thanks for the updated response. I still haven't gotten the book but I will. It's perfect for my situation.

I did read a little more about the ABLE accounts. It seems like it's designed for situations where there wasn't already a Special Needs Trust or to be used as a low cost alternative to a Special Needs Trust. Though there's nothing preventing having both. I believe the rule about the onset of the disability before age 26 makes it unavailable to my brother. His mental illness came about in his early 20s but he was not officially diagnosed until much later. In the early phase we didn't recognize it as a mental illness because we assumed it was related to drug use.

In my tax question about specific rules on what gets distributed first, I'm trying to understand the 'mechanics' when deciding what portion of the Trust's funds to use for his benefit. It's clear that using what's considered to be the Distributable Net Income first has tax advantages because it reduces the income that would be taxed on the Trust's 1041 and moves that tax burden to the beneficiary's 1040 (through the K-1). The advantage is the beneficiary is likely to have a much lower tax rate. So there are advantages to doing it that way but I haven't seen a rule that says DNI has to be 'first out' and only after all DNI is fully distributed would you start using the Corpus (principle) of the trust assets. Everything I've read leads me to believe this is the case and tax software seems to be set up to calculate distributions that way but I haven't seen where that understanding comes from. What rule, regulation, or tax code document references that? (I'm just reiterating my question to the general forum in this reply).

When someone funds an ABLE account using funds from a special needs trust, I assume it still counts as a distribution to the beneficiary reportable as such when the 1041 is filed. Or are you saying we can use the Trust Corpus to fund the ABLE account so it's not part of the distributions listed on the 1041?

mrsbetsy
Posts: 120
Joined: Mon Jun 26, 2017 12:16 am

Re: Special Needs Trust Taxes and Distributions

Post by mrsbetsy » Sun Mar 25, 2018 2:50 pm

Well the ability to establish an ABLE account might be moot, but the advantage is that it can be used by the beneficiary for housing and health, in addition to other things. If SNT funds are used for housing, you risk reduction of government subsidies. If SNT monies are spent on healthcare, you risk losing Medi-cal. In fact, if a medical professional takes private money for medical services and they find out the patient has Medi-Cal, they could be in big time trouble. Think dermatology or other needs that might require a doctor but might take a long time to get there through the Medi-Cal system.

There's a chart in this book which compares and contrasts the difference between an ABLE account and a SNT.

Under taxation:

SNT - taxed as a grantor trust at person with disability's tax rate

Third party SNT - taxed as a non-grantor trust except to the extent funds are used on behalf of the benficiary

ABLE account - no income tax on growth but gross income plus 10% penalty for non-qualified distributions.

ABLE accounts are limited to 14K a year.

mrsbetsy
Posts: 120
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Re: Special Needs Trust Taxes and Distributions

Post by mrsbetsy » Sun Mar 25, 2018 3:06 pm

Just to add a bit more.

Not only are you able to invest in the ABLE account contributions, but the growth is tax free. It can grow up to 100K. Most states have a "claw back" after the recipient dies, but CA eliminated the claw back.

There is a current proposal under AB 2039 in CA that would actually make contributions to an ABLE account tax deductible. It has not passed yet, but that is the proposal.

geobrick
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Joined: Sun Jun 19, 2016 2:47 pm

Re: Special Needs Trust Taxes and Distributions

Post by geobrick » Sun Mar 25, 2018 11:08 pm

The ABLE account is a great option. I saw that other family members can contribute as well.
If CA makes the contributions tax deductible it would be an added incentive for relatives to contribute. Growing tax free is also a great benefit.

So just to clarify, if I use Trust funds to supplement my brother's rent so he could live somewhere nicer than what SSI can cover, he will lose SSI benefits (up to ~$265). If I put the trust funds into an ABLE account then use those funds to supplement his rent, his SSI won't be reduced? That's a great benefit. What about direct cash for the beneficiary? I know I can't give him more than $20 cash in a month from the Trust money because there's a dollar for dollar reduction on SSI (with no limit until it gets to $0). Is that the same for an ABLE account?

I need to look up when he was officially diagnosed. When they say eligibility for an ABLE account required the disability onset occur before age 26, what evidence do I need to show? In the case of some mental illnesses, it could have been there for years before recognizing it.

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