The Fundamentals of a Qualified Disability Trust

Written by Jill Roamer, JD

A special needs trust (SNT) is a planning tool used to provide funds for a beneficiary’s care without jeopardizing their eligibility for means-tested public benefits. The SNT is designed to optimize the beneficiary’s quality of life, and importantly, a third-party SNT can qualify as a qualified disability trust (QDisT) to obtain better taxation treatment if certain requirements are met.

WHY CREATE A QUALIFIED DISABILITY TRUST?

The advantageous income tax treatment of QDisTs may benefit some beneficiaries, particularly if the trust generates significant income and the beneficiary incurs relatively few expenses. As discussed further below, SNTs that qualify as QDisTs are nongrantor trusts, so they are subject to the highest federal tax bracket (37 percent) on income exceeding $15,200 (for tax year 2025). Generally, a nongrantor trust is allowed only a $100 deduction for income tax purposes. A trust that is required to distribute all income (a simple trust) is allowed a $300 deduction. Because SNTs rarely require all income to be distributed, which would likely result in ineligibility for public benefits, they have historically been allowed to avail themselves of only the $100 tax deduction.

Congress often seeks to provide statutory protections for those in the special needs community. Internal Revenue Code (I.R.C.) § 642(b)(2)(C) provides a greater exemption amount for certain qualifying trusts. A QDisT is allowed the personal exemption amount, as outlined in I.R.C. § 151(d). Thus, there could be significant tax savings if an SNT qualifies as a QDisT.

Note that the Tax Cuts and Jobs Act (TCJA) eliminated personal exemptions until the sunset of that law on December 31, 2025. However, the TCJA also provides that, in any year when there is no personal exemption, a special QDisT exemption of $4,150, adjusted annually for inflation, is allowed. The QDisT exemption amount may be found in the pertinent annual Revenue Procedure document. The QDisT exemption for 2025 is $5,100. Another tax benefit of the QDisT is that, under I.R.C. § 642(b)(2)(C)(ii), its income is not subject to the “kiddie tax.” The “kiddie tax,” enacted as part of the Tax Reform Act of 1986, is a tax, at their parents’ tax rate, on the unearned income of individuals under a certain age who meet certain criteria. It was designed to prevent wealthy taxpayers from diverting income to their children, who are often taxed at a much lower rate. The TCJA increased the kiddie tax to the higher trust and estate income tax rates. However, the changes were unpopular and were later repealed by the SECURE Act of 2019, which reinstated the previous kiddie tax rates for 2020 and subsequent years and provided taxpayers with the option to use the previous rates for 2019 and amend their 2018 returns.

REQUIREMENTS FOR CREATING A QUALIFIED DISABILITY TRUST

The definition of a QDisT is provided in I.R.C. § 642(b)(2)(C)(ii):

. . . the term “qualified disability trust” means any trust if—such trust is a disability trust described in subsection(c)(2)(B)(iv) of section 1917 of the Social Security Act (42 U.S.C. 1396p), and all of the beneficiaries of the trust as of the close of the taxable year are determined by the Commissioner of Social Security to have been disabled(within the meaning of section 1614(a)(3)of the Social Security Act, 42 U.S.C. 1382c(a)(3)) for some portion of such year.

A trust shall not fail to meet the requirements of subclause (II) merely because the trust’s corpus may revert to a person who is not so disabled after the trust ceases to have any beneficiary who is so disabled.

To break it down a little further, 42 U.S.C. § 1396p(c)(2)(B) (iv) describes a trust that is established solely for the benefit of an individual who is under 65 years old and disabled. The following is a plain-language list of requirements for a trust to qualify as a QDisT . . . 

Continue reading the full article for free by subscribing to the WealthCounsel Quarterly—the legal magazine for estate planning and elder law attorneys!