A trust that qualifies as a qualified disability trust can help lower the trust’s taxable income. Getting that benefit may not be as straightforward as it first appears.
What is a Qualified Disability Trust?
A qualified disability trust is a special designation for trust income taxation. The requirements to qualify for this designation are specified in Internal Revenue Code Section 642. Generally, this requires the trust be established for a beneficiary that is:
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- An individual.
- Under 65 years old.
- Determined by the Social Security Administration to be disabled at some point during the year.
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The definition of disabled is extensive. At its core, a person is disabled if the person is unable to engage in any substantial gainful activity due to a physical or mental impartment that either:
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- Is expected to result in death.
- Has lasted or can be expected to last for at least 12 consecutive months.
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Qualified disability trusts are designed with flexibility—they do not need to benefit only disabled individuals indefinitely. Once the trust no longer has a qualified disabled beneficiary, the trust may distribute its principal to non-disabled persons. For example, a grantor may create a qualified disability trust for the benefit of a qualified disabled child and have the remaining assets distributed to the grantor’s surviving descendants upon the disabled child’s passing.
What is the Key Benefit of Qualified Disability Trusts?
The key benefit of qualified disability trusts is increased exemptions that lower taxable income on a trust income tax return. The default exemption for a trust is $100, while a trust that is required to distribute all its income can qualify for a $300 exemption. In 2022, a qualified disability trust is allowed a $4,400 exemption.
The increased exemption becomes critical given the design of most qualified disability trusts. It is common for trusts to allow or require distributions of trust income to the beneficiaries. This generally allows the trust to qualify for an income tax deduction based on the amount distributed, which in turn lowers the trust’s taxable income.
Many qualified disability trusts, although not mandated to do so for the increased exemption, typically retain the trust’s income and principal instead of distributing them immediately. Distributions are usually less frequent and made only under specific circumstances. The trust is therefore less likely to have an income distribution deduction and will have higher taxable income.
Is a Special Needs Trust a Qualified Disability Trust?
Qualified disability trusts are often confused with special needs trusts. However, they are two distinct terms with two separate purposes.
Special needs trusts, also called special purpose or supplemental needs trusts, do not have one definition. Traditionally, special needs trusts were drafted to benefit disabled beneficiaries with two main goals:
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- To allow the beneficiary to remain on government aid programs, such as Medicaid, Security Supplemental Income, or any additional state needs-based program.
- To protect the trust assets from depletion by limiting the beneficiary’s access.
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Both goals were typically accomplished by giving a third-party trustee broad discretion to make any or no distributions from the trust to the beneficiary. The trustee could also be provided guidance to help determine when a distribution may cause the beneficiary to become ineligible for a needs-based program.
The modern approach has expanded this trust structure to include, among other things, individuals with spendthrift or addiction issues. While those beneficiaries may not qualify for any needs-based program, the same trust structure can protect the assets from exhaustion with the trustee’s broad discretion.
In comparison, qualified disability trusts are specifically designated under Internal Revenue Code Section 642 as trusts that meet specific requirements. The designation allows the trust to use the higher exemption on a trust income tax return.
Since special needs trusts are often designed for the benefit of disabled individuals, they frequently qualify for the qualified disability trust designation. However, since the same trust structure can also be for the benefit of a non-disabled person, the qualification is not guaranteed. Additionally, the qualified disability trust designation is not limited to trusts as restrictive with distributions as special needs trusts. If the other requirements of Section 642 are met, the trustee does not have to limit distributions for a particular purpose.
We Can Help
Whether you are interested in creating a trust that qualifies for the qualified disability trust designation or need help with an existing trust, Boulay advisors can assist you and your family with finding the best solutions for you. Learn more by contacting a Boulay advisor at 952-893-9320 or learnmore@boulaygroup.com and asking about our estate and trust services.
Legal services provided by Andrew Kremer Law.