What is a Qualified Disability Trust?
The legal authority to create a Qualified Disability Trust (QDisT) falls under §642(b)(2)(C) of the Internal Revenue Code. To qualify as a QDisT, the trust must meet the following criteria:
- A QDisT must be irrevocable.
- All beneficiaries must be disabled and receiving Supplemental Security Income (SSI) or Social Security Disability Income (SSDI) benefits. There can be more than one beneficiary, but all beneficiaries must be disabled.
- A QDisT cannot be a grantor trust; the trust must be the taxpaying entity. A self-settled special needs trust can never qualify as a QDisT.
- The trust must be established for the benefit of disabled individuals 65 years of age or younger. The QDisT does not cease to be a QDisT after the beneficiary turns 65, but it must be established beforehand.
- According to IRC 642(b)(2)(C)(ii), a trust can still qualify as a QDisT if the corpus of the trust transfers to someone who is not disabled after all disabled beneficiaries are deceased.
Benefits of a QDisT
The main benefit of a QDisT is taxation. Under IRC §642(b)(2)(C), a QDisT is allowed the same exemption as an individual when filing their tax return. The Tax Cuts and Jobs Act (TCJA), which became effective January 1, 2018, eliminated personal exemptions. However, it also stated that in any year in which there isn’t a personal exemption, the amount of $4,150 in 2018 (indexed for inflation in following years) shall be considered as the exemption to be taken by the QDisT. Compare this $4,150 exemption to the usual $100 exemption (or $300 exemption if a trust is required to distribute all of its income each year) afforded to other trusts, and you can see how the savings add up.
Another tax benefit of the QDisT is that the income of this particular type of trust is not subject to the Kiddie Tax, in accordance with IRS §642(b)(2)(C)(ii). The Kiddie Tax is a tax on unearned income of a child. (Under certain circumstances, an individual can be considered a child until 24 years of age.) It came to fruition when the Internal Revenue Service (IRS) realized some wealthier taxpayers were diverting income to their children because the children oftentimes were afforded a much lower tax bracket. In response, the IRS came up with the Kiddie Tax and stated that any unearned income for folks under a certain age and meeting certain criteria would be taxed at their parents’ bracket. The TCJA made the Kiddie Tax even harsher and ruled that the Kiddie Tax rate would not be at the parents’ tax rate, but at the higher tax rate of Trusts and Estates.
Besides taxation, QDisTs are useful tools to accomplish other goals. The main goal of a QDisT is to have assets somewhat available to the beneficiary without the beneficiary losing state or federal public benefits. If the disabled person owned these assets outright, their eligibility for government benefits would most likely be in jeopardy. If the QDisT owns the assets and the Trustee has discretion to make purchases for the beneficiary, then the assets are not countable assets when trying to qualify for public benefits. The Trustee would not give money in the QDisT directly to the beneficiary. Rather, the Trustee would make purchases that benefit the beneficiary, like a vacation or the services of a tutor, in accordance with the Social Security Program Operations Manual System and other laws and guidelines.
What are the tax filing requirements of a QDisT?
As with all non-grantor trusts, the trust will be responsible for filing a tax return, Form 1041, under its own Employer Identification Number (EIN). Any distributions to the beneficiary will be taxed on the beneficiary’s own Form 1040 tax return.
For example, let’s say Bob is an independent Trustee of Lucy’s QDisT. The QDisT has a stock portfolio worth $500,000, which generates $50,000 in taxable income. During the tax year, Bob paid for Lucy’s vacation that cost $5,000. Bob also paid for educational expenses of $5,000 for books, tutoring, and extracurricular activities. Bob took a reasonable compensation of $2,500 for the year.
Bob causes a Form 1041 to be filed for the trust, reporting the $50,000 income. As discussed above, there will be a $4,150 exemption used. Bob’s $2,500 in fees will be deducted for administrative expenses, and Lucy’s $10,000 in distributions will be deducted. The trust will have a taxable income of $33,350. The QDisT will send a K-1 to Lucy showing her distribution, and she will be responsible for reporting that $10,000 distribution on her personal Form 1040 tax return.
Common Pitfalls for Estate Planning Attorneys
Beware of testamentary trust language. The beneficiary of the QDisT must be named in the will or trust that creates the testamentary QDisT. The beneficiary cannot elect to have their testamentary trust treated as a QDisT if the language in the deceased’s will simply states the beneficiaries are “my issue.” Rather, the disabled person’s actual name must be listed as one of the beneficiaries in the will or trust of the decedent.
Trustee selection can often be a difficult process. Unlike some types of trusts, the Trustee of a QDisT will have serious ongoing duties and obligations. The Trustee should be sophisticated enough to understand not only the trust and its language, but the ongoing needs of the disabled beneficiary. A Trustee should also know how to budget, manage, and invest the funds in the trust. When selecting a Trustee, it is imperative that he or she understands the time commitment of the obligation. The Trustee also needs to be well-versed in Medicaid and Social Security rules, to ensure that distributions from the trust will not disqualify the beneficiary from government benefits. It may be a mistake to think that an aunt or uncle will have the skills necessary to be the Trustee, or that he or she will do it for free. It may be prudent to select a corporate Trustee. If this is not feasible, the Grantor can always appoint a family member as an Advocate who can work with the disabled individual when communicating with and submitting requests to the Trustee.
A QDisT can be a powerful tool when planning for a disabled individual. Each attorney must do a case-by-case analysis to determine if a QDisT is the best planning device for your client. To know if a QDisT is right for a client, it’s important to analyze the facts of the case, including whether the client qualifies for a QDisT under statutory rules, the costs to maintain the QDisT, tax considerations, and more. Thankfully, the QDisT is one formidable tool when planning for a disabled person and can offer some great benefits.
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