One of the difficulties in administering a special needs trust is that irrevocable trusts reporting on Form 1041 have a lower personal exemption than individuals. Normally, the personal exemption is limited to only $100 or $300. However, if a trust is a Qualified Disability Trust (“QDT”), the personal exemption in 2013 is $3,900.
To be treated as a QDT, the trust must be (1) a disability trust as described in 42 U.S.C. §1396p(c)(2)(B)(iv); and, (2) all of the beneficiaries of the trust, as of the end of the taxable year, are determined by the Commissioner of
Social Security to have been disabled (as defined by the Social Security Act) for some portion of the tax year.
To satisfy the first criteria, the QDT must be (a) irrevocable, (b) established for the sole benefit of the disabled beneficiary(ies), (c) who is/are under the age of 65, and (d) who is/are disabled according to the terms of the Social Security Act. Prudent attorneys often create a standalone special needs trust for the lifetime benefit of a single person, to eliminated confusion regarding whether the trust is irrevocable or whether there are multiple beneficiaries. So the real inquiry in most situations is whether the special needs beneficiary is disabled according to the terms of the Social Security Act.
Simply stated, if the beneficiary has been ruled eligible for SSI, SSDI, or, in some cases, Medicare (typically when extended due to the Medicare disability eligibility rules), they are disabled according to the terms of the Social Security Act. Their trust, therefore, may elect treatment as a QDT on Form 1041 and take the higher personal exemption.
One caveat: If the trust is a first party special needs trust being reported as a grantor trust for tax purposes, it is not eligible for QDT treatment on Form 1041. Instead, all income will pass through to the grantor and the grantor will use their own personal exemption. However, if the trust is a third party special needs trust or is not otherwise reported as a grantor trust, the trustee may elect QDT treatment on Form 1041, and then distribute enough income to or for the benefit of the special needs beneficiary to receive the benefit of a second personal exemption.
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