SEPTEMBER 23, 2013 VOLUME 20 NUMBER 36
We write a lot about taxation of trusts, and especially of special needs trusts. But there is one type of trust that we haven't written much about, and we can't find other explanations for. "Pooled" special needs trusts are a special kind of trust, and there is much confusion about how they should be treated for federal income tax purposes.
First, we don't think there are a lot of other tax issues about pooled special needs trusts (other than income taxation, that is). They are seldom -- perhaps never -- large enough to raise gift tax issues or estate tax concerns. We can imagine an occasional parent wondering about the gift tax treatment of contributions to a pooled trust account, but only the wealthiest parents are going to need to worry about that, and they are probably getting an abundance of good tax advice from their lawyers and accountants.
So let's just talk about income taxation of pooled special needs trusts. But first perhaps we need to define terms.
What is a pooled special needs trust?
Pooled trusts are just what the name suggests: a single trust consisting of money held for the benefit of a number of individuals. Usually those separate trust accounts are managed together but accounted for separately. In other words, your contribution to a pooled special needs trust will be used just for you (or for the other person you designate), not for other beneficiaries. But your money and theirs will be pooled into a single investment structure, so that your administrative costs will probably be lower and your earnings higher than they would be if you were on your own.
By convention pooled special needs accounts tend to be smaller. There is no reason that needs to be true, but it often is. People with substantial money to be set aside in a trust tend to want separate treatment, separate management and different structures. But that is not always true, so some pooled accounts are large.
Most pooled special needs trusts include only money that once belonged to the beneficiary -- like personal injury lawsuit settlements, or inheritances from someone who never set up an appropriate trust, or even back payments from Social Security. Increasingly, though, parents (and others) wanting to set aside money for a child with a disability are looking at pooled trusts as a convenient and cost-effective alternative.
When money comes from personal injury settlements or unrestricted inheritances, the resultant pooled trust share is referred to as a "self-settled" or "first-party" pooled trust. When the trust is set up by a parent or another person, the pooled trust share is called a "third-party" pooled trust. That's important for income tax purposes.
Taxation of self-settled pooled trust accounts
If a person with a disability transfers funds to a trust for their own benefit (or someone else does it on their behalf), the trust share is called a "grantor" trust. That means that the self-settled share does not pay separate income taxes, or even file a return. The larger trust may have to file a return, but none of the income attributable to the self-settled share (and none of that share's portion of deductible expenses) gets reported on a trust (or fiduciary) income tax return. For income tax purposes, the self-settled pooled special needs trust share simply doesn't exist.
That doesn't mean that there is no income tax. The beneficiary may still have to file an individual tax return, including any income and deductible expenses. Of course, the beneficiary may not have sufficient income -- even with the trust's income added in -- to need to file a return, and the fact of the trust won't change that.
Of course, the beneficiary only knows what he or she has to do if the trustee passes information along to them. So the federal government requires that the trustee give the beneficiary all the information they need to fill out their own tax return. But the trustee doesn't file anything for the trust, except the brief statement that the trust is a grantor trust and is not filing a separate return.
Taxation of third-party pooled trust accounts
If someone else puts the money into a pooled trust account, that may (or may not) set up a requirement for separate tax filings. Often, the person contributing the money will be treated as the "grantor" and have to report the income and take the appropriate deductions -- even if they are not benefiting from the trust. That decision is based on a complicated set of rules known as the "grantor trust" rules. Volumes have been written about the peculiar twists those rules may take, but let's make the simple over-generalization that, during the lifetime of the donor, it is likely that the donor will be liable for the income tax on a third-party pooled special needs trust share.
If the third-party trust share is not a grantor trust, then the trustee will need to file a federal Form 1041 -- the fiduciary income tax return -- if the larger trust has more than $600 of income. That return will list all income and deductible expenses, and then may result in taxable income being assigned to the beneficiary -- to the extent that the beneficiary receives assistance from the trust. Did the trust pay dental bills, or moving expenses? There may be an income tax consequence to the beneficiary (but only to the extent of taxable income received by the trust -- not usually the full value of services or goods purchased by the trust).
Does a pooled special needs trust need an Employer Identification Number -- an EIN?
Yes. always. It's always fun to be able to give a simple and absolute answer. There is a lot of detail behind that simple answer, but the answer is always simple: yes.
We hope that helps. The follow-up questions can be bewilderingly complicated, but go ahead -- we'll see if we can give at least generalized answers. If you have specific legal questions based on your trust's particular circumstances, you should ask your lawyer (or a lawyer) rather than posting your query online. But we'll (gently) let you know if we think that's the case based on your question.