Who pays tax on income in a special needs trust?

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Q. Under New Jersey and federal law, is the accumulated interest earned on special needs trust taxable to the trustee who funded the trust or the beneficiary who is entitled to the interest? How does it work?
— Planning

A. There are two primary types of special needs trusts.

One is when the beneficiary funds the trust with their own assets, known as a first-party trust, and the other is when a third party funds the trust.

First-party funded trusts are taxed as if the assets are owned by the beneficiary, said Catherine Romania, an estate planning attorney with Witman Stadtmauer in Florham Park.

“The beneficiary is taxed on the income whether it is distributed to or for the benefit of the beneficiary or accumulated in the trust,” she said.

Third-party funded trusts may be taxed in one of two ways.

If it’s created as a grantor trust, the income will be taxed to the third party who created the trust together with his or her other income, she said.

If it’s not created as a grantor trust, the trust itself will file its own return and be taxed on the income, but obtain a deduction for any income distributed to or for the benefit of the beneficiary, Romania said.

“Such a beneficiary will be taxed on the income so distributed,” she said. “In the case of a third-party non-grantor trust, the trust will have its own taxpayer identification number. As this type of trust is generally not required to distribute all income annually, it is classified as a complex trust and an income tax return must be filed if gross income exceeds $100.”

“However, for federal tax purposes, if the trust qualifies as a qualified disability trust, the trust is entitled to an exemption equal to $4,300 for the 2021 tax year and equates to what would have been the personal income tax exemption for an individual if the Tax Cuts and Jobs Act had not eliminated it through 2025,” she said.

In order to qualify as a qualified disability trust, among other requirements, the trust must be irrevocable, all beneficiaries must be receiving SSI or SSDI benefits, the trust cannot be a grantor trust, and the trust must be for a disabled person age 65 years or younger, she said.

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This story was originally published on May 12, 2022.

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