A qualified disability trust can help reduce the tax burden associated with special needs trusts. A qualified disability trust, or QDisT, qualifies for tax exemptions and applies to most trusts created for an individual with special needs. In most cases, explains a recent article from Investopedia, “Qualified Disability Trust: Meaning and Tax Requirements,” the person receiving income from the trust must pay income tax. However, in 2003, the IRS added a section allowing some disability trusts to reduce this tax liability. This is another example of why reviewing estate plans every few years is important.
Trusts need to meet several requirements to be considered qualified disability trusts for tax purposes. However, if a special needs trust meets these criteria, it could save a lot in taxes.
Most special needs trusts already meet the requirement to be treated as qualified disability trusts and can be reported as such at tax time. For 2022 tax year, the tax exemption for a QDisT is $4,400. For tax year 2023, the amount will increase to $4,700. Income from a QDisT is reported on IRS Form 1041, using an EIN, while distributions to the beneficiary will be taxed on their own 1040 form.
The best way to fully understand a QDisT is through an example. Let’s say a child is diagnosed with a disability, and their grandparents contribute $500,000 to an irrevocable special needs trust the child’s parents have established for the child’s benefit. The trust generates $25,000 in annual income, and $10,000 is used annually for expenses from the child’s care and other needs.
Who pays the income tax bill on the trust’s gains? There are a few options.
The parents could include income from the trust as part of their taxes. This would be “on top” of their earned income, so they will pay their marginal tax on the $25,000 generated from the trust—paying $8,000 or more.
Alternatively, trust income spent for the child’s benefit can be taxed to the child—$10,000, as listed above. This would leave $15,000. However, this must be taxed to the trust. Trust income tax brackets are high and increase steeply. Paying this way could lead to higher taxes than if the parents paid the tax.
The QDisT was designed to alleviate this problem. QDisTs are entitled to the same exemption allowed to all individual taxpayers when filing a tax return. In 2012, for instance, the personal tax exemption was $3,800, so the first $3,800 of income from QDisTs wasn’t taxed.
The deduction for personal exemptions is suspended for tax years 2018 to 2025 by the Tax Cuts and Jobs Act, except the same law said that in any year there isn’t a personal exemption, the exemption will be allowed for a QDisT.
For tax year 2022, $4,400 is the indexed tax exemption amount for these trusts, including most special needs trusts. For tax year 2023, the amount will increase to $4,700.
To be reported as a qualified disability trust, specific requirements must be met:
- The trust must be irrevocable.
- The trust must be established for the sole benefit of the disabled beneficiary.
- The disabled beneficiary must be under age 65 when the trust is established.
- The beneficiary must have a disability included in the definition of disabled under the Social Security Act.
- The trust must be a third-party trust, meaning all funding must come from someone other than the disabled beneficiary.
An experienced estate planning attorney can help set up a qualified disability trust that can help reduce the tax burden and allow you to enjoy the benefits the statute grants. If you would like to learn more about special needs planning, please visit our previous posts.
Reference: Investopedia (March 4, 2023) “Qualified Disability Trust: Meaning and Tax Requirements”
