The “Victims of Terrorism Tax Relief Act of 2001” created a new tax entity: the Qualified Disability Trust. What are these trusts, and what benefits do they offer?
Revisions to section 642 of the Internal Revenue Code spell out what is required. In order to receive the special tax treatment, a trust must have been created for the sole benefit of an individual with a disability as defined by the Commissioner of Social Security. So what does the special treatment get you? A qualified disability trust can claim a personal exemption in the same amount as an individual ($3400 for tax year 2007) rather than the measly $300 permitted for other trusts.
As is so often the case with tax law, however, the code gives no hint about the real advantages or disadvantages. That’s why we’re here.
First, in order to understand the effect of qualified disability trust status one must consider general rules of trust taxation. Trusts pay taxes at the same rates as individuals – except that the graduated tax rates are very sharply compressed. In 2007, for example, a trust with $30,000 of taxable income would pay $9,543.50. An individual with the same $30,000 of taxable income would pay $4,774. In other words, the trust will incur a tax penalty of $4,769.50 just by being a trust.
The Victims of Terrorism Tax Relief Act reduces the disparity, but not by much. If our imaginary trust could meet the definition to be treated as a Qualified Disability Trust, its income tax bill would be reduced by $1,085 – but it would still pay $3,684.50 more than an individual taxpayer.
What difference does it make that trusts and individuals are taxed differently? A healthy percentage of trusts for individuals with disabilities are set up with their own money, either from personal injury lawsuits, or inheritances, or accumulated wealth. Those trusts, even though irrevocable, are inevitably taxed as “grantor” trusts, which means that the individuals claim all the income and deductions. Because of that status there is no benefit from the purported tax relief – and if there were, it would be far less than the increase in tax liability from treatment as a trust for the vast majority of them anyway.
If, however, a trust is established and funded by, say, a parent or grandparent, and the funds never belonged to the person with a disability, there may be some value to the Qualified Disability Trust treatment – though it is almost certain to be a very slight benefit. Assuming the trust is being used to pay for items benefiting the person with a disability, those payments are essentially a deduction from the trust’s taxable income. That means that unless the trust is accumulating income it will likely see no benefit from the additional deduction.
The same may not be true for the beneficiary, however. Even though the trust may pay not income tax because of its distributions for the benefit of its beneficiary, that beneficiary will have a tax liability to report. If the beneficiary is paying some tax, the extra deduction for the trust may have the effect of reducing the reportable income on which the beneficiary is taxed – and that might reduce the tax itself by between $510 and $1225. Not exactly a windfall, but better than the proverbial poke in the eye.
So who, exactly, will benefit from this provision of the Victims of Terrorism Tax Relief Act? Not, particularly, victims of terrorism. In order to benefit the following things must be true:
- The trust cannot be a “grantor” trust – it must hold money that was a gift from someone other than the beneficiary’s estate or a lawsuit on his or her behalf.
- The trust must have income sufficient to make the beneficiary pay some income tax – that is, its income must exceed its expenses plus the beneficiary’s deductions (including the standard deduction and personal exemptions – about $8500 for a single person with no dependents in 2007).
That all assumes, incidentally, that the law is read
broadly. Under one interpretation, the only way any trust would get the modest
tax benefit would be if it included a provision directing that the state should
be repaid for its Medicaid expenditures on the death of the trust’s beneficiary
– a provision that should not be considered, much less included, in any trust
not funded with the beneficiary’s own money.
What is the practical result? In our experience, almost no trusts can meet the requirements for treatment as a Qualified Disability Trust, and any benefits are so modest as to hardly make it worth trying. Apparently no one in Washington wanted to find out what might actually amount to tax relief for trust beneficiaries with disabilities.
Robert B. Fleming
Fleming & Curti, PLC
Tucson, Arizona
www.elder-law.com
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