What is a Qualified Disability Trust?

A qualified disability trust, or “QDisT” for short, is a type of irrevocable special needs trust that allows the trust beneficiary to benefit from funds in the trust without losing eligibility for critical public benefits. While all QDisTs are special needs trusts, however, not all special needs trusts are qualified disability trusts. In this blog post, we’ll talk about what makes qualified disability trusts different, the unique benefits of these trusts, and the requirements.

Qualified Disability Trust Requirements

The creation of a qualified disability trust is authorized by §642(b)(2)(C) of the Internal Revenue Code, which sets forth the following criteria for a trust to be considered a QDisT:

• The trust must be irrevocable.
• All beneficiaries of the trust must be disabled and receive either Supplemental Security Income (SSI) or Social Security Disability Income (SSDI) benefits. If, after all disabled beneficiaries of the trust are deceased, the corpus (principal) of the trust can pass to someone who is not disabled without destroying the “qualified” nature of the trust.
• The trust cannot be a grantor trust. A grantor trust is a trust for which the creator (grantor) of the trust is also considered the owner of the assets in the trust for purposes of income tax and estate tax.
• The trust must be established for the benefit of a disabled individual or individuals 65 years of age or younger. The qualified nature of the trust does not end once a beneficiary turns 65, but the trust must have been established before that point.

Tax Benefits of Qualified Disability Trusts

The primary distinction of a qualified disability trust is the tax benefits associated with this type of trust. Unlike some other types of trusts, the QDisT pays tax on income earned by the trust corpus. If any income is distributed to a beneficiary, the beneficiary pays income tax on the amount of the distribution, and the QDisT deducts the amount of the distribution from its own taxable income. (A qualified disability trust has its own Employer Identification Number (EIN) and its Income is reported on IRS Form 1041; distributions to the beneficiary are reported on the beneficiary’s Form 1040.)

A qualified disability trust is permitted to take the same exemptions as an individual when filing its tax return. As you may recall, the federal Tax Cuts and Jobs Act (TCJA) which took effect January 1, 2018, eliminated personal exemptions. However, the TCJA also provided that in years in which personal exemptions are not available, a specific QDisT exemption remains available. In 2024, that exemption amount is $5,000. This is significantly higher than the exemption available to a simple trust.

Another major advantage of a qualified disability trust is that its income is not subject to the so-called “Kiddie Tax,” which is a tax on a child’s unearned income. (The federal government created this tax when it realized that some wealthy taxpayers were diverting income to their children so that the income would be taxed at the child’s much lower rate.) Under the Kiddie Tax, the unearned income of a child under a certain age was originally taxed at their parents’ rate, eliminating any tax benefit of diverting the income to the child. The TCJA went one step further, making the Kiddie Tax rate the same as the even higher tax rates for trusts and estates. The income of a qualified disability trust avoids that steep penalty.

How a Qualified Disability Trust Works

Ann and Bob have a young son, Charles, who has a disability that makes him unable to be self-supporting; he will need to rely on government benefits as an adult. They establish an irrevocable special needs trust for his benefit, with an independent trustee, Tom. Ann’s parents, Doug and Esther, contribute $600,000 to this trust. The trust earns about $30,000 in income each year, and about $15,000 of that income is used for Charles’ needs. Tom is paid $2,000 in fees for administering the trust, which is a deductible administrative expense.

In this case, income taxation of the trust would work as follows: Tom would file a Form 1041 on behalf of the trust, reporting the $30,000 income, less the exemption and allowable deductions. In this year, those include the $5,000 exemption, the $15,000 in distributions for Charles, and Tom’s reasonable compensation of $2,000. The QDisT’s taxable income would then be $8,000. The trust would send Charles an IRS Form K-1 showing the $15,000 in distributions he received, and he would be responsible for reporting those distributions on his personal income tax form.

Qualified disability trusts can be an essential component of estate planning for families with special needs children. To learn more, contact Estate Planning & Elder Law Services to schedule a consultation or get more planning tips for families with special needs children.