MARCH 16, 2015 VOLUME 22 NUMBER 11
This time of year, we are often asked about income tax issues — especially when a trust is involved. It may take us several newsletters, but let’s see if we can’t demystify the income taxation of trusts. We will start with the type of trust we most often get asked about: self-settled special needs trusts.
We will ask you to imagine that you are the trustee of a special needs trust, set up for the benefit of your sister Allie. This trust was funded with proceeds from a lawsuit settlement. Allie is on AHCCCS (she lives in Arizona, where we renamed Medicaid “the Arizona Health Care Cost Containment System” or AHCCCS), and she receives Supplemental Security Income (SSI) benefits.
[Note: everything we explain here would be the same if Allie was your son, or your aunt, or your husband. It would also be true if the money in the trust came from the probate estate of your grandmother, who left Allie a share of her estate in cash (as opposed to in trust). It would be the same if the court established the trust for Allie, or her mother signed the trust, or if you signed the trust as Allie’s guardian. This advice will probably also be correct if Allie is receiving Social Security Disability Insurance payments — on her own account or on your father’s account — and/or Medicare instead of Medicaid/AHCCCS. If the trust does not include a provision that the Medicaid agency must be paid back upon Allie’s death, the answers we give here might be incorrect — wait until next week to read about that kind of special needs trust.]
Allie never actually signed the trust, but because she was once entitled to receive the trust’s assets outright it is treated (for most purposes) as if she did establish the trust herself. Even though the trust was created or approved by the court, or signed by Allie’s parents, or established by her guardian, it is almost universally referred to as a “self-settled” special needs trust. Those few practitioners who don’t use that term almost all prefer “first-party” special needs trust (though there may be differences regarding whether to hyphenate either descriptive title). We’re going to refer to it as a self-settled special needs trust.
Allie’s self-settled special needs trust has another descriptive name: it is also a “grantor” trust. That term really only has meaning for U.S. federal income tax purposes, but that’s a pretty important purpose and so the term is pervasive. Is it possible that Allie’s trust is not a grantor trust? Yes, barely. The key shorthand way to double-check: look for a provision that says Allie’s Medicaid expenses must be repaid with trust assets upon her death. If that language is in there, either the trust is a grantor trust or someone has created a really peculiar instrument. If that language is not in there, there’s actually a chance the trust is not a grantor trust — before going further with this analysis, go ask a qualified attorney or CPA whether the trust is a grantor trust.
Let’s assume we’ve gotten past this issue, and we can all agree that Allie’s trust is a grantor trust. What does that mean for income tax purposes? Two important things:
- Allie’s trust will never pay a separate income tax (well, at least not as long as she’s alive). The trust’s income will always be taxable on her personal, individual, non-trust tax return.
- Allie’s trust will also never need to file a separate income tax return. In fact, it will never be allowed to file a separate income tax return.
There is a lot of confusion about Allie’s special needs trust. Does it need to get its own taxpayer identification number (actually, the correct term is Employer Identification Number, or EIN)? No. Then why do accountants, bankers, brokers, even lawyers keep telling you that it does? Because they are wrong, that’s why. Many of them believe that any time a trust has a trustee who is not also a beneficiary the trust must get an EIN. That is not correct.
But just because Allie’s trust doesn’t need an EIN doesn’t mean that it can’t have one. You are permitted to get an EIN for Allie’s trust if you want to.
Let’s assume for a moment that you have not gotten an EIN. In that case, every bank and stockbroker (anyone who pays money to the trust, in fact) should be given Allie’s Social Security number for reporting purposes. The trust’s income will simply be included on Allie’s 1040 (her personal income tax return). Some trust expenses may be legitimate deductions from income, but the Internal Revenue Service effectively ignores Allie’s special needs trust.
That was easy, wasn’t it? Let’s make it just a little more difficult.
Maybe you did get an EIN for Allie’s trust. What kind of tax filings should you make in that case?
Armed with an EIN, you should give that number to banks, stockbrokers and anyone else who holds the trust’s money. The trust’s EIN should not be on Allie’s own bank account (where her SSI gets deposited), even though you might be both trustee and representative payee — and the two funds should not be mixed.
As trustee, you will need to file a fiduciary income tax return — the IRS form number is 1041. It will be easy to file, however. You simply type on the form (there’s no box for this — just type it in the middle of the “Income” section of the form): “This trust is a Grantor Trust under IRC sections 671-679. A statement of items taxable to the grantor is attached.” The exact language is not critical, but that is the sense of what you should tell the IRS. Then attach a summary statement of all items of income and deductible expenses the trust has handled (things paid directly out of Allie’s Social Security account should not be included here).
That’s it. No tax payment. No deductions on the fiduciary income tax return. You are supposed to issue a 1099 (not a K-1, if you are in to those characterizations) for the dividend and interest income received under the trust’s EIN. Those things then get listed on Allie’s personal income tax return (her 1040), and taxed as if they had come directly to Allie — even though they didn’t.
That was pretty easy, wasn’t it? Next week we’ll look at third-party special needs trusts. If you want to get a little preview, you might consider the year-old but still excellent analysis from the Special Needs Alliance about special needs trust taxation.