Basic Concepts in Taxation of First Party Special Needs Trusts

Overview of First Party SNTs

First-party special needs trusts, often referred to as “self-settled” or “payback” trusts, play a crucial role in providing financial security for individuals with disabilities. These trusts are established using the assets of the individual with disabilities and are designed to maintain their eligibility for government benefits while safeguarding their future. In this blog post, we’ll explore the taxation aspects of first-party special needs trusts, helping you understand how these trusts work from a tax perspective and their implications for the beneficiary.

Understanding First-Party Special Needs Trusts

First-party special needs trusts are legal instruments created to hold and manage the assets of an individual with a disability. These trusts are typically utilized when a person with disabilities receives a lump sum of money through an inheritance, lawsuit settlement, or another form of windfall. By placing these funds into a special needs trust, the individual can preserve their eligibility for means-tested government benefits like Supplemental Security Income (SSI) and Medicaid, which are critical for their financial well-being.

Taxation of First-Party Special Needs Trusts

  • Tax-Neutral Entity: From a federal income tax perspective, first-party special needs trusts are considered “grantor trusts.” This means that the trust itself is not a separate taxable entity. Instead, the trust’s income is attributed to the beneficiary for income tax purposes.
  • Taxation at the Beneficiary’s Rate: Income generated by the trust is reported on the beneficiary’s individual tax return. The beneficiary is responsible for paying taxes on trust income, just as if it were their own income. This taxation occurs at the beneficiary’s individual income tax rate.
  • Income Inclusion: The trust income that must be included on the beneficiary’s tax return includes interest, dividends, capital gains, rental income, and any other income generated by the trust assets. Distributions for qualified disability expenses, on the other hand, are not considered taxable income.
  • Tax Deductions: Certain deductions may be available to the beneficiary, such as medical expense deductions if the trust income is used for qualified disability expenses. However, the beneficiary’s ability to claim deductions may vary based on their individual circumstances.
  • State Taxation: State tax laws vary, and the taxation of first-party special needs trusts can differ from one state to another. It’s advisable to consult with a tax professional who is knowledgeable about your specific state’s tax regulations.
  • Capital Gains Tax: When assets within the trust are sold, any capital gains realized are subject to capital gains tax. The tax rate for capital gains can vary based on factors like the beneficiary’s total income and the duration of ownership.


First-party special needs trusts are a valuable tool for individuals with disabilities who need to manage their assets while preserving eligibility for vital government benefits. Understanding the taxation of these trusts is essential for both beneficiaries and trustees to ensure compliance with tax laws and to make informed financial decisions.

The taxation of a first-party special needs trust is unique, and it’s important to understand how it works:

It’s important to seek the guidance of legal and tax professionals who specialize in special needs trusts to navigate the complexities of trust taxation. By doing so, individuals with disabilities can effectively manage their financial resources, maintain their eligibility for government benefits, and achieve greater financial security for their futures.