Date: March 11, 2014

Each year as we approach tax season we receive a number of questions from clients about the taxation of income generated on assets held in Special Needs Trusts. With this newsletter we thought we would try to lay out some of these rules in as simple a manner as possible.

As you will read below – and like many areas of Special Needs Trust practice – rules differ depending on whether the trust is a “first party” trust funded with the assets of an individual with a disability (such as a trust funded with proceeds from a lawsuit), versus a “third party” trust funded with the assets of someone else (such as a trust funded with the assets of a parent as part of the parent’s estate plan). We think it important to emphasize this point because in our experience, many professional tax preparers fail to understand the distinction, leading to incorrectly filed returns and, in some cases, interest and penalties on underpayments.

Does the trustee of a Special Needs Trust have to file an income tax return?

As a general rule, trusts are considered separate taxable entities for income tax purposes and the trustee must file an income tax return for the trust.

First Party Special Needs Trusts

First Party Special Needs Trusts are funded with the assets of an individual with a disability who is usually participating in a means-tested government benefit program such as Supplemental Security Income (SSI) or Medicaid. In most instances, First Party Special Needs Trusts receive the tax classification of a “grantor trust.” This tax classification means that all of the items of income, deduction and credit generated by the trust should be reflected on the personal income tax return of the individual with the disability (the trust beneficiary). Phrased differently, with First Party Special Needs Trusts, the grantor (for tax purposes) and the beneficiary are the same person, because these trusts are designed to be funded with the beneficiary’s own assets.

This may seem complicated to a reader who is looking at a First Party Special Needs Trust document and sees that someone else is named as the “grantor.” If the trust is drafted correctly, that ‘someone else’ will be a parent or grandparent of the beneficiary, because under federal law, only a parent or grandparent can establish a First Party Special Needs Trust without a court order or court appointed guardian. So for the purpose of establishing­ the trust – the act of signing the document – a parent or grandparent may be listed as the ‘grantor.’ But for income tax purposes, the ‘grantor’ is actually the person who put money in the trust (the individual with the disability).

This can be confusing stuff, and is one of the reasons that we find ourselves preparing so many tax returns here in our office. Indeed, some of our long time readers may remember our May 2008 newsletter describing the difference between ‘taxable income’ and ‘Medicaid income,’ another area where the rules tend to create confusion. If you are interested in receiving a copy of that newsletter, just let us know. But to repeat: First Party Special Needs Trusts are “grantor trusts” for income tax purposes, and the ‘grantor’ is the individual with the disability.

Practice varies regarding how to report this income. Some trustees obtain a separate taxpayer identification number for the First Party Special Needs Trust when it is established. As a result, when the time comes for financial institutions to report how much income the trust has earned, a Form 1099 will be issued to the trust reflecting the trust’s separate taxpayer identification number.

The question then becomes: how does this income, which is reported to the IRS under the trust’s separate taxpayer identification number, make its way onto the personal income tax return of the trust beneficiary? The answer is that the trustee of the First Party Special Needs Trust files an “informational” Form 1041 with a “Grantor Trust Information Letter” attached. The mechanics of this informational filing are described in greater detail below.

Alternatively, in situations where the trustee of a First Party Special Needs Trust does not obtain a separate taxpayer identification number for the trust, the beneficiary’s social security number is reflected as the taxpayer identification number for the trust. Since the beneficiary’s social security number is reflected on the Form 1099s issued by the financial institutions reporting the income earned by the Trust, a separate informational Form 1041 is not generally filed.

Third Party Special Needs Trusts

Third Party Special Needs Trusts are funded with someone else’s money, and as a general rule are considered “complex trusts” or “qualified disability trusts” for income tax purposes. With these trusts, the trust itself is responsible for reporting its own items of income, deduction and credit. This filing is also made on Form 1041, but as described below, there is significantly more that goes into completing an income tax return for a complex trust or qualified disability trust than for a grantor trust.

What is a Form 1041?

Form 1041 is the U.S. Income Tax Return for Estates and Trusts. Similar to a Form 1040 on which individuals report their income annually to the federal government, Form 1041 is the form on which most trustees and other fiduciaries (i.e. executors, personal representatives and administrators of estates) report income to the federal government.

In states where trusts are also subject to a separate state income tax (like New York), there is a separate state form on which estate and trust income needs to be reported. These forms differ from state to state, so if a trustee is unsure about whether or not a separate state return needs to be filed, and which form is to be used, the trustee should be sure to consult with an attorney and/or accountant who has familiarity with trust income taxation.

When must a Form 1041 be filed?

In the case of a First Party Special Needs Trust which is a grantor trust for tax purposes and where a separate taxpayer identification number is obtained for the trust, the general rule is that if there is at least $1.00 of income, an informational return must be filed in order to provide the IRS with information about the taxpayer to whom that income should be taxed.

In the case of all other trusts, a Form 1041 generally must be filed if any one of the following three circumstances is applicable: (1) the trust had any taxable income for the tax year; (2) the trust had gross income of $600 or more (regardless of taxable income); or (3) the trust has a beneficiary who is a non-resident alien.

Since Special Needs Trusts, regardless of type, must file on a calendar year basis, the Form 1041 return is due at the same time personal income tax returns are due, April 15th of the year following the year for which the income is being reported. It is possible to request an extension of time to file a Form 1041, but unlike the extension granted to individuals, only 5-month extensions are granted to trusts.

How does the Trustee of a Special Needs Trust Complete Form 1041?

Every year, the Internal Revenue Service updates the Form 1041 (as it does for the Form 1040) and issues instructions. The instructions are very detailed and are very helpful in navigating the completion of the Form 1041. These forms and instructions can be found on www.irs.gov.

First Party Special Needs Trusts

As referenced above, if the trustee of the First Party Special Needs Trust has obtained a separate taxpayer identification for the Trust, this trust is likely classified as a “grantor trust” for income tax purposes. In these circumstances, the Form 1041 is fairly straightforward.

The trustee will check the box on Form 1041 indicating that the trust is a grantor trust and provide some general information about the trust (name, address, tax identification number, and the date the trust was established). No income is reported on these returns. Typically, a statement will be added to the first page of the return indicating that the trust is a grantor trust and that the income is taxable to the grantor under sections 671-678 of the Internal Revenue Code.

The income reporting is actually completed on an attachment to the Form 1041 that is often referred to as a “Grantor Trust Information Letter.” The attachment itself needs to reflect the following: (1) the name, social security number and address of the person to whom the income is taxable (generally the beneficiary with a disability in the context of First Party Special Needs Trusts); (2) a detailed description of the taxable income; and (3) a detailed description of any deductions or credits that are applicable. Each of these items are then carried through and added to the personal income tax return of the grantor/beneficiary.

Third Party Special Needs Trusts

Sometimes, Third Party Special Needs Trusts are grantor type trusts. This occurs when the person creating (and funding) the trust reserves certain rights, powers and authorities that cause grantor trust status. In the case of Third Party Special Needs Trusts, if the trust is considered a grantor trust, all items of income, deduction and credit are generally taxed to the individual(s) who created and funded the trust (typically parents or other relatives of the individual with a disability). Whether the “grantor” for income tax purposes is the trust beneficiary with a disability in the case of First Party Special Needs Trusts, or a relative of the beneficiary as is the case with Third Party Special Needs Trusts, the reporting method described above is the same.

If you are a trustee of a Third Party Special Needs Trust which has received funds from a number of different sources, you may want to have the trust reviewed by an attorney with experience in this area to determine what type of return needs to be filed.

For Third Party Special Needs Trusts that are not grantor trusts, Form 1041 must be thoroughly completed. The trustee will first need to determine the tax classification of the trust – typically this will be either a “complex trust” or a “qualified disability” trust. Trusts which are classified as qualified disability trusts receive an exemption equivalent to a personal exemption (for 2013 income tax filing purposes $3,900), whereas trusts classified as “complex” only receive a $100 exemption.

All items of income, deduction and credit are reported on Form 1041 consistent with the Form’s instructions. Given the complexity of the Form 1041 and the rules that relate to the reporting of trust income in general, it is strongly recommended that trustees consult a tax preparer or attorney who specializes in fiduciary income taxation and Special Needs Trusts.

What is a Form K-1 and when are they issued?

A “K-1” is a tax form which is issued by a non-grantor trust to a beneficiary when the trust makes distributions to that beneficiary that “carry out” income. For example, if a non-grantor trust had $5,000 of interest income in 2013 and made $6,000 worth of distributions for the benefit of the trust beneficiary, for income tax purposes the trust is considered to have distributed all of the trust income to the beneficiary for tax reporting purposes. As a result, when the trust’s income tax return is prepared for 2013, a form K-1 will be issued to the trust beneficiary advising him or her that $5,000 of interest income must be reported on his or her personal income tax return. If the $5,000 of interest income was the only income earned by the trust, the trust will not report any taxable income but rather will show that income as having been “carried out” to the trust beneficiary by issuing a form K-1.

If, on the other hand, instead of making $6,000 worth of distributions on behalf of the trust beneficiary, the trustee only made distributions of $3,000, the trust would still issue a K-1 to the trust beneficiary showing that $3,000 of interest income should be reported on the trust beneficiary’s personal income tax return but it would also report $2,000 of interest income taxable to the trust (“retained income”).

And to reiterate, “taxable income” is different than “Medicaid income” or “SSI income,” so showing this income on a personal income tax return of a beneficiary with a disability will not create a benefit eligibility issue if the distributions from the trust were made correctly (ie., so long as the trustee purchased goods and services by paying the merchant or service provider, and did not make payments directly to the beneficiary). Again – if you are a glutton for punishment and have an interest in this area, contact our office and ask for a copy of our newsletter: “You Say Tomato,” “The Special Needs Estate Planner:”, May 2008.

When tax is due on income generated by a Special Needs Trust, who is responsible for paying the tax?

As a general rule, most trust documents include provisions that allow for the trust to pay any income tax which is payable by the trust beneficiary on his or her own personal income tax return. While in these circumstances the actual responsibility for paying the income tax belongs to the beneficiary (the person by whom the income is reportable) often the trust beneficiaries do not have funds outside the trust to make these payments, so the trustee will use trust assets to pay any such liability.

When the income tax is reportable by the trust and taxed at the trust level, the trustee is responsible for paying any income tax out of the trust assets,

Should a Trustee hire an accountant or attorney to assist with filing Form 1041?

Unless the trustee specializes in the income taxation of trusts (“fiduciary income taxation”), it is prudent for the trustee to consult with or hire a tax preparer and/or attorney who concentrates in this area. Consulting with and/or hiring one of these professionals should ensure that all income is reported properly and no applicable or available deductions are lost or overlooked.


Wilcenski & Pleat Sponsor Annual Autism Fair

The 3rd Annual Autism Awareness Information Fair will be held on April 27, 2014 at the Saratoga City Center from 12 to 3pm. This fair is administered by Saratoga Bridges and the Parent Network of the Capital Region and the firm is pleased to be able to sponsor this wonderful event once again this year.

Firm Notes and News

Attorneys Ed Wilcenski and Tara Anne Pleat co-authored an article for the march 2014 issue of Estate Planning magazine entitled “State Court Case Puts Trustees On Notice.” The article focused on the continuing attention of the case entitled Matter of the Accounting of JP Morgan Chase Bank NA, a case which was highlighted in our last newsletter.

On March 13th, Attorney Ed Wilcenski will be speaking to the Schenectady County Bar Association on the topic of Supplemental Needs Trusts. In addition, Ed will be giving a presentation on Guardianship and its Alternatives for Wildwood Programs on the evening of March 13th.


This newsletter is not intended as a substitute for legal counsel. While every precaution has been taken to make this newsletter accurate, we assume no responsibility for errors or omissions, or for damages resulting from the use of the information in this newsletter. If you would like to be removed from our distribution list, please email us or call us at (518) 881-1621