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Question:

My sister is the sole beneficiary of a small irrevocable third-party supplemental benefit trust which on her death provides for distribution of accumulated principal and undistributed income equally among the grantor’s surviving children, per stirpes. The trust was judicially approved in 2022 with an EIN and funds currently held as a CD. Before the beneficiary’s death, what tax reporting obligations does the trustee have? After the beneficiary’s death, what tax reporting obligations does the trustee have for the final distributions of principal and income? Payment of the principal and income to surviving children will essentially end the trust. Is there a tax form to communicate to the IRS that a trust has ended?

Response:

The trust should file an annual 1041 tax return and a final one for the year in which your sister passes away. The trust will almost certainly pay no taxes since it can deduct its expenses, such as accounting fees, as well as any income distributed to your sister or used on her behalf. For tax purposes, use of the funds for your sister are treated as distributions. The trust will issue your sister a K-1 each year reporting such income and she will report it on her tax return.

One common concern with K-1s going to beneficiaries of special needs trusts is whether reporting income to them will affect their eligibility for public benefits such as Medicaid, Supplemental Security Income (SSI), and subsidized housing. If the funds are used on your sister’s behalf rather than distributed to her, such use should not affect her eligibility. This is because the definitions of income for tax purposes and for public benefits eligibility are different. For the most part, payments made on behalf of a beneficiary rather than distributed to her are not considered income for eligibility purposes even if they are for income tax purposes.

The one exception is the payment of rent or a mortgage. For purposes of SSI, this is considered to be “in kind” income and will result in the beneficiary losing a third of their monthly SSI benefit.

Also, even though the definitions of income are different, sometimes public agencies get it wrong and the distinction has to be explained to them.

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