Each month, I host a presentation called “Special Needs Planning for Parents” aimed at taking a look at the complex issues involved in creating an estate plan centered around an individual with special needs. Part of the presentation talks about the cons of implementing a special needs trust. One of those, sometimes significant, cons is the potential for a high income tax rate. The reason for that is pretty simple: the income tax rate for irrevocable trusts, regardless of the amount of income earned in a year, is the highest tax bracket – currently 39.6%. So, even a modest amount of income generated by a special needs trust can equate to tax at a rate almost identical to the federal estate tax. Not a great outcome. But, there is hope.
Under the current tax code, special needs trusts operate a lot like a business for the purposes of tax deductions. Businesses can deduct business expenses, wages paid, etc. from their yearly gross income. Similarly, special needs trusts can deduct amounts paid for qualified expenses of the special needs trust beneficiary. With an “active trust” – meaning one that is actively supporting an individual with special needs – the qualified expenses will generally outpace the income earned on the assets, unless there is a significant amount of wealth in the trust. So, for most people, the trust tax issue won’t be much of a concern. Most people will see significantly more expenses than income in any given year, even in a strong market.
The issue becomes, then, that “stagnant trusts” – those trusts holding income-producing assets but not actively supporting an individual with special needs – will be the ones most likely to take the tax hit mentioned above. A stagnant trust will not be making qualified expense payments, but will still be realizing taxable income. One way to reduce the impact would be to reassess the types of assets and investments held in a stagnant trust and shift to assets with lower returns while the trust is stagnant. Another option would be to wait to fund the special needs trust until it will be an active trust.
While income tax can be a significant issue for irrevocable special needs trusts, most active trusts would not be impacted. It’s always a good idea to work with an experienced special needs planning attorney and a financial advisor versed in these issues.
Paul Yokabitus is the CEO and Managing Partner of Cary Estate Planning, a Cary, NC, estate planning law firm. With years of experience in estate and elder law, he has zealously represented clients in various legal matters, including estate planning, guardianship, Medicaid planning, estate administration, and other cases.
Paul received his Juris Doctor from the Campbell University School of Law and is a North Carolina Bar Association member. He has received numerous accolades for his work, including being named among the “Best Attorney in Cary” in 2016 and 2017 by Cary News and Rising Star in 2020-2023 by Super Lawyers.