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Special Needs Trusts and the New Medicare Tax

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MARCH 25, 2013 VOLUME 20 NUMBER 12
You may have heard about a potentially significant new tax liability for special needs trusts. With adoption of the Patient Protection and Affordable Care Act (what is often referred to as “Obamacare”) Congress created a new tax intended for high earners to contribute to Medicare. A fairly complicated formula attempts to capture investment income (as distinct from income from employment) and impose a tax.

Enter the doctrine of unintended consequences — or at least we hope this consequence was unintended. Because of the definition of income subject to the tax, it is possible that some special needs trusts will end up paying a significantly higher tax. Here’s how it works:

The new tax is imposed on “net investment income.” That is defined as dividends, capital gains, interest, rents, royalties — pretty much income other than wages. It was intended to cover relatively higher-income individuals, so it will kick in only for the highest tax brackets for each category of taxpayer. That means, for instance, that a married couple will owe the 3.8% Medicare tax only if their total income (including that investment income) exceeds $250,000.

But here’s the problem: the highest tax bracket for trusts kicks in at a much, much lower figure — $11,950 in 2013. So a special needs trust subject to income taxation will pay an extra 3.8% on any investment income in excess of that amount.

Let’s use an illustration. Mildred’s will included a special needs trust for her daughter Diana. Mildred died in 2011, and the trust was funded with $500,000 of property from her estate. The trust is now invested in an appropriate mix of stocks and bonds, and last year it generated about 4% in interest, dividends, recognized capital gains, etc. That means income of about $20,000; the tax would be about $6,000 on that amount. Because of the 3.8% surtax, however, the tax bill will rise by almost another $1,000.

That’s not too bad, but of course the tax on Mildred’s trust is already much higher than it would have been had it been taxed to Mildred herself. The trust paid the highest marginal tax rate (39.6%) on nearly half of the total income — whereas Mildred herself would have still been in the 15% tax bracket if she were still alive in 2013. Now the total tax paid by the trust has gone from more than double to nearly three times Mildred’s individual tax burden.

Don’t panic. It’s not as bad as that. There are several reasons why the new Medicare tax will have an effect on special needs trust planning, but not that broad of an effect on the actual tax paid.

First, let’s clear up one confusion: the higher tax rates — both the Medicare tax and the highest, 39.6% rate on trust income — only applies to trusts set up by someone else to hold an inheritance or gift, and usually only after the death of the donor. A special needs trust set up to handle personal injury settlement proceeds does not have any separate tax effect at all — it is what is called a “grantor” trust, and is taxed as if it actually was the individual whose money went into the trust. The Medicare surtax, and the highest marginal tax rate, will only affect that kind of special needs trust if the total income is at least $200,000.

Next, even the “third-party” trust established by Mildred (the third party in the trust’s name) has a significant way out of paying high taxes. It just has to provide some benefits for Diana. If, for instance, the trust paid for a companion to take Diana out of her assisted living apartment once a week in 2013, the income tax gets paid by Diana and not the trust. The higher tax levels never kick in, because Diana’s income is not high enough to be subjected to the top level OR the Medicare tax.

It’s actually even better than that. Mildred’s trust is almost certainly a “qualified disability trust.” That means it gets to take the equivalent of a personal tax exemption, as if it was Diana — meaning that the first $3,900 of the trust’s income escapes taxation altogether. Plus the administrative expenses (trustee’s fees, some of the investment fees, lawyer’s and accountant’s fees) are all deducted from income. So Mildred’s trust’s $20,000 of income only gets reported on Diana’s return to the extent of about $5,000 — and Diana probably won’t pay any income tax at all.

Diana is lucky in another way, and Mildred’s trust shares that luck. Diana is pretty healthy, and does not have significant medical expenses. In another, similar trust with large medical payments, the ultimate tax paid can also be reduced simply by claiming large medical deductions on the beneficiary’s return.

Nonetheless, the new Medicare tax is a concern for trustees of third-party special needs trusts — especially very large trusts. Double the size of Mildred’s trust (or quadruple it) and it is easy to see that the tax burden might rise steeply. The trustee of a third-party trust with several million dollars might find it prudent to invest in assets that will appreciate in value but not throw off much income — presuming, of course, that the appreciating assets will not be sold during the beneficiary’s lifetime.

5 Responses

  1. I am studying a third Party SNT for my disabled son as to taxes. Income from this trust would be far less than $200,000. The following article from The Special Needs Alliance, dated Feb, 2010, is very contrary to this article as to reducing trust taxes:
    No way is stated to lower taxes to that of the beneficiary.
    Have tax laws changes since that time? Some comments please.
    Thank you.

    C T McCracken

    1. Mr. McCracken:

      Actually, the Special Needs Alliance article and our newsletter agree. That’s not surprising, since the
      SNA Voice article you cite was co-written by Lisa Davis, a friend, colleague and co-author (with me) of the Elder Law Answer Book.

      I think the confusion is caused by two things:

      1. This is a confusing topic.
      2. The Special Needs Alliance Voice article comes at the same issue from a different direction. But if you read closely, you will see that we are saying the same thing. If a third-party special needs trust has investment income, the tax effect will be passed out to the beneficiary to the extent that there are distributions for the benefit of the beneficiary. But if income is accumulated, the trust will pay higher tax rates on lower total income amounts than an individual would.

      To be clear, very few special needs trusts will pay high income taxes. First, the trust would have to be a non-grantor trust — and that means self-settled special needs trusts will not ever have the high-tax problem (the beneficiary might, but not the trust). Second, the trust’s income would have to be greater than distributions, and by a large enough amount ($11,950 in 2013) to get the trust into the highest income tax brackets.

      Of course, the trust’s income tax consequences are not the only issue. If the tax effect flows out to the beneficiary, his or her tax bill could be large. But the primary concern is for cases where the existence of the special needs trust could actually increase the total tax bill — and that is going to crop up when there is a large trust which does not pay most or all of its taxable income on services and items for the beneficiary.

      We hope that helps clarify a confusing topic.

      Robert B. Fleming
      Fleming & Curti, PLC
      Tucson, Arizona

  2. Mr. Fleming,

    I am finally grasping this. After having read several Special Alliance Newsletters and yours as to taxing SNT’s it’s making sense to me. Thanks very much for a well written article and your follow up comments. Very helpful information.

    C T McCracken

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Robert B. Fleming


Robert Fleming is a Fellow of both the American College of Trust and Estate Counsel and the National Academy of Elder Law Attorneys. He has been certified as a Specialist in Estate and Trust Law by the State Bar of Arizona‘s Board of Legal Specialization, and he is also a Certified Elder Law Attorney by the National Elder Law Foundation. Robert has a long history of involvement in local, state and national organizations. He is most proud of his instrumental involvement in the Special Needs Alliance, the premier national organization for lawyers dealing with special needs trusts and planning.

Robert has two adult children, two young grandchildren and a wife of over fifty years. He is devoted to all of them. He is also very fond of Rosalind Franklin (his office companion corgi), and his homebound cat Muninn. He just likes people, their pets and their stories.

Elizabeth N.R. Friman


Elizabeth Noble Rollings Friman is a principal and licensed fiduciary at Fleming & Curti, PLC. Elizabeth enjoys estate planning and helping families navigate trust and probate administrations. She is passionate about the fiduciary work that she performs as a trustee, personal representative, guardian, and conservator. Elizabeth works with CPAs, financial professionals, case managers, and medical providers to tailor solutions to complex family challenges. Elizabeth is often called upon to serve as a neutral party so that families can avoid protracted legal conflict. Elizabeth relies on the expertise of her team at Fleming & Curti, and as the Firm approaches its third decade, she is proud of the culture of care and consideration that the Firm embodies. Finding workable solutions to sensitive and complex family challenges is something that Elizabeth and the Fleming & Curti team do well.

Amy F. Matheson


Amy Farrell Matheson has worked as an attorney at Fleming & Curti since 2006. A member of the Southern Arizona Estate Planning Council, she is primarily responsible for estate planning and probate matters.

Amy graduated from Wellesley College with a double major in political science and English. She is an honors graduate of Suffolk University Law School and has been admitted to practice in Arizona, Massachusetts, New York, and the District of Columbia.

Prior to joining Fleming & Curti, Amy worked for American Public Television in Boston, and with the international trade group at White & Case, LLP, in Washington, D.C.

Amy’s husband, Tom, is an astronomer at NOIRLab and the Head of Time Domain Services, whose main project is ANTARES. Sadly, this does not involve actual time travel. Amy’s twin daughters are high school students; Finn, her Irish Red and White Setter, remains a puppy at heart.

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Matthew M. Mansour


Matthew is a law clerk who recently earned his law degree from the University of Arizona James E. Rogers College of Law. His undergraduate degree is in psychology from the University of California, Santa Barbara. Matthew has had a passion for advocacy in the Tucson community since his time as a law student representative in the Workers’ Rights Clinic. He also has worked in both the Pima County Attorney’s Office and the Pima County Public Defender’s Office. He enjoys playing basketball, caring for his cat, and listening to audiobooks narrated by the authors.