A special needs trust beneficiary died. What taxes are due?

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Q. I am the trustee of a special needs trust where the beneficiary recently passed away. Per the trust, the remaining assets will pass to two family members. What are the tax consequences to the remainder beneficiaries? There are substantial capital gains.

— Trustee

A. We’re sorry for your loss.

The answer to this question depends on how the special needs trust was established and funded.

A special needs trust is a special type of trust that is intended to allow the beneficiary with disabilities to qualify for or continue to receive certain needs‑based government benefit programs, such as Supplemental Security Income (SSI) and Medicaid even though there may be thousands — or hundreds of thousands — of dollars in trust for his or her benefit, said Shirley Whitenack, an estate planning attorney with Schenck, Price, Smith & King in Florham Park.

She said there are two main types of special needs trusts.

One is known as a first party or self-settled special needs trust. It’s funded with the assets of the beneficiary with disabilities, such as proceeds of a personal injury settlement or jury award or inheritances or gifts received by the beneficiary before the creation of the trust.

The other kind is a third-party special needs trust. This is funded with the assets of someone other than the beneficiary with disabilities, such as a parent who has created a special needs trust “funded with gifts made during lifetime by them or others for the benefit of a disabled child who receives some type of public assistance, or a testamentary special needs trust created by a parent, spouse, domestic partner or other third party in his or her will,” Whitenack said.

If the deceased beneficiary was receiving Medicaid benefits, then any assets in the trust after the death of the beneficiary, net of trust termination expenses, must be paid back to Medicaid dollar-for-dollar, Whitenack said.

“Any assets left over in the trust will be includable in the estate of the deceased beneficiary and may be subject to inheritance tax depending on the relationship of the remainder beneficiaries to the deceased beneficiary,” she said.

The assets remaining in the trust will get a step up in basis so that the remainder beneficiaries will receive the date of death value of the appreciated assets, she said. This reduces or eliminates capital gains taxes depending on when the appreciated property is sold.

The assets in a third-party special needs trust are not subject to a Medicaid payback, she said.

“However, the assets in the third party trust never belonged to the deceased beneficiary,” she said. “Therefore, the remainder beneficiaries will not get a step up in basis and will have to pay capital gains on appreciated property when they sell it.”

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This story was originally published May 15, 2020.

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