The Listen to Lawrence Letter: Special Needs Trusts and Income Tax

Special Needs Trusts and Income Tax

CLIENT QUESTION:

Hi Lawrence,

I am again filing the necessary tax returns for the Special Needs Trust, that you set up for my mother-in-law, upon her death to provide for my special needs brother-in-law.

Since the Trust issues a K-1 (Form 1041) to my brother-in-law, it creates a problem and extreme difficulty with his SSI. Once filed, SSI receives notification and inaccurately, (I believe), views the K-1 dividends as his personal income. They then deny him continued SSI benefits. I am of the belief that that is one of the reasons to create a Special Needs Trust.

Is there any way to avoid this problem? My accountant states that a K-1 must be filed on the trust tax return. I appreciate any advice that may save me numerous hours and arguments with SSI on his behalf. Thank you.

MY RESPONSE:

Let’s get ready to rumble!!!

Unfortunately, this is a common problem. Whenever a third party (like a parent) sets up a Special Needs Trust for someone else (like a child), the trust becomes a taxable entity and must file an income tax return reporting the annual income. Trusts are actually in very high tax brackets, but the law goes further and says that the trust will get a deduction (and pay no tax) if it paid out all the income TO OR FOR THE BENEFIT OF the beneficiary. This income paid out is listed on schedule K1 of the 1041 trust income tax return. The amount of income on the K1 is then reported on the income tax return of the beneficiary who either received the income or the benefit of the income.

In your brother-in-law’s case, if the trust income was spent on his behalf (paying for special needs) he is appropriately being given a K1 and must report the income on his personal 1040, even though he never received the income and even though it does not count as income for SSI and Medicaid

purposes. Front-line SSI and Medicaid workers are not very sophisticated in this and that is why you are having all this frustration. I get it!

Bottom line: Put the gloves on and be ready to fight for your brother-in-law.

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