How Is A Special Needs Trust Taxed?

Most special needs trusts are third party special needs trusts, and they are taxed as a pass-through entity. What this means is that the trust has to file a tax return each year showing the income that it earned. Rents, dividends, interest, and any realized gains on sale must be reported. From that amount, the trust may deduct any distributions that were made to the beneficiary. So the trust does not pay taxes on any income that it earns as long as that income is passed on to the beneficiary. If there is any undistributed income, the trust will pay taxes on that. Trust tax rates are generally higher than individual tax rates. So, to the extent possible, the trustee wants to distribute income each tax year to the beneficiary if that’s appropriate. The income that is passed on to the beneficiary is taxable to the beneficiary at the beneficiary‘s income tax rates.

So the trust income doesn’t become tax free, it just becomes taxable at the beneficiary’s tax rate which generally is lower. If for some reason the beneficiary has a higher tax rate, the trust always has the option to just pay the taxes and distribute the proceeds to the beneficiary after the taxes have been paid; in this case, the beneficiary is now not responsible for the taxes. Some special needs trusts are first party special needs trusts that are self-funded special needs trusts. These are never taxable at a trust level. For those, the income is always taxable to the beneficiary, even if it’s not all distributed in the current year.

Who Is Responsible For Paying The Taxes On A Special Needs Trust?

It is the trustee’s responsibility to have all the tax returns prepared and to pay all the taxes that a trust owes from the trust. It is also advised that the trustee make sure that the beneficiary files all of his or her tax returns and the trustee can use some of the trust funds to pay the taxes for the beneficiary for that portion that was required because of the trust.

How Do I Choose An Investment Advisor For The Special Needs Trust?

You would do it much the same as you would choose your own professional advisor for investing. You want to be sure that the person you are selecting is qualified, that they have their appropriate licenses, and that they are a person that you are comfortable with, who you can call and ask questions and you understand the answers that they give you. You want to be sure it’s someone who can adequately explain the purpose for the investment decisions they are making. It would also be a benefit if they have prior experience doing fiduciary investment accounts, or investment accounts specifically for trusts. It helps because there are some investment decisions that may be different because of the requirements of the fiduciary.

Then you want to figure out what their fee structure is and how it’s calculated, and find one that is compatible with the trust investment model. Generally, trusts do not generate a lot of investment activity. They buy assets and tend to hold them and generate income from them, so it would be best to have an advisor whose fee structure is appropriate to that type of investing.

Do I Need A Professional Investment Advisor?

My opinion is that yes, you need a professional investment advisor. Unless the trustee has a lot of investment experience, then it’s like anything else. If you don’t have experience in that field, you don’t know what you don’t know and there are things that you may be able to do that are better that you don’t even know are available. The trustee has this fiduciary duty, this responsibility to invest the proceeds and assets of the trust in a way that is beneficial to the trust beneficiary. So if the trustee does not get professional advice and invests inappropriately, the trustee will be personally liable for any harm that it causes to the beneficiary or the trust.

What Kind Of Oversight Is Required For A Special Needs Trust?

The trustee wants to monitor what the investment advisor is doing to be sure that they were following the plan that is set up at the time and that the investments are the appropriate type of investments, and that the advisor is not causing more activity to occur on the account than is appropriate. Activity on investment accounts generally generates costs to the trust, so you need to be sure that those costs do not become inappropriately large. In the end it is always the trustee’s obligation to be sure that the funds are invested appropriately and that they are getting a fair return on the investment for the beneficiary.

Therefore, I advise the trustees on at least a quarterly basis to review all of the investments, and if they are not experienced in investing and don’t understand the statements that are sent to them, then they should sit down and meet with the investment advisor every quarter and go over the investments and determine why the investment advisor made the choices that he or she did for the trust.

For more information on Taxation For Special Needs Trusts, a free initial consultation is your next best step. Get the information and legal answers you are seeking by calling (626) 385-6303 today.


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