When creating a supplemental needs trust (“SNT”) for our clients, we are often asked whether the trust requires a separate Tax ID number. The short answer is, “Not until you fund it.” The majority of our clients who create SNTs leave them unfunded until they die, at which point the trust needs its own tax ID number. A tax ID number is like a Social Security number for a trust, which the trust must use for its investment and bank accounts and for reporting its interest and dividend income. The trust files an annual 1041 tax return, as opposed to the 1040 return used by individuals.
The Exception to the Rule
While all third-party special needs trusts—those funded by one or more people for the benefit of someone else—need their own tax ID number, a self-funded, or "first party" SNT, often called a “(d)(4)(A) trust,” does not necessarily require it's own tax ID number. This is something of a gray area, but using the beneficiary's own Social Security number on accounts if possible avoids the need to file a separate tax return for the trust. And it doesn't change the taxation, since (d)(4)(A) trust income is taxed to the beneficiary in any case.
How the Taxes Work
While a third-party SNT must report it's income on a separate tax return, it's unlikely that it will ultimately pay any taxes. This is because any income, whether capital gains, dividends or interest, are considered to pass through to the beneficiary to the extent the trust either distributes funds to them or uses them on their behalf. In addition, the trust may have its own deductions.
For example, if a special needs trust earned $12,000 in a year, and $10,000 was spent on behalf of the beneficiary, the $10,000 would be taxable to the beneficiary. The remaining $2,000 retained in the trust would be taxed at the trust tax rate and the tax payable by the trustee directly with the tax return filed by the trust. However, if the trust spent $2,000 on expenses, perhaps trustee, legal and accounting fees, it could deduct those expenses and pay no tax.
As a final note, beware larger special needs trusts retaining too much income, since the graduate tax rates for trusts increase much more rapidly than those for individuals.