Support Test when child has a Special Needs Trust

This situation is confusing to me and something I have never dealt with. The client moved to CO in 2020 from PA and was referred to us for her tax preparation.

The mother is single and her main job is taking care of the special needs child who is the beneficiary of a Special Needs Trust. The mother legally adopted the child several years ago. I do not know the source of the funds that are in trust and do not prepare the trust 1041. The trust pays the mother, who is a register nurse, about 37K per year to take care of the child and she has a small Sch C from which she nets about 9K. The W-2 to the mother has the trust as the payor. The child gets a K-1 from the trust with about 30K of dividend income. The trust owns their Colorado house which was purchased in 2020 for 325K.

The prior preparer of the mom's return was deducting the wages and employer share of payroll taxes as Sch A medical expenses on the child's return (these amounts are provided as footnotes on the trust K-1 but the footnotes do not specifically say that these are deductible as medical expenses on child's return). The child was claimed as a dependent on the mom's prior returns with her getting head of household status and the child tax credit. I don't know that this is correct. For the support test, I assume that the child must be considered as having paid at least the 30K of dividend earnings towards his own support? However, if the child is deducting the full wages and payroll taxes as a medical expense, I assume that the child has to be considered as contributing the other non-taxable portion of the trust distribution for the wages and payroll towards his own support, correct? If not, and that is considered support provided by a third party, the trust, can the child still deduct the the full wages and payroll taxes as medical expense or just the amount up to income reported to him on the trust K-1? Are other items paid directly by the trust on the child's behalf, such as the purchase of the house and the child's income tax, considered support provided a third party or the child? Does all this depend on the wording of the trust where I need to find out more about the trust?

As an additional note, the trust is a PA trust the trustee for which is a corporate trustee located in WV and the trust 1041 is prepared by a WV CPA firm.

You most certainly need to find out more about the trust. Basically you are talking about an entity written as a complex trust that may be taxed as a grantor trust. All payments from the trust are for the benefit of the disabled individual and are considered as providing for his own support. Income is not relevant to the support calculation, however the payments are considered paid by the beneficiary and are deductible against income where allowed.

Thank you for the input. What do I need to find out about the trust and how does that then impact the calculation of the support test? Does its status as a grantor or non-grantor trust determine whether payments made to the child or on the child's behalf are considered provided by the child for his own support. Is there anything in the trust document that would allow some or all payments made by the trust to or for the child to be considered support provided by a third party and not the child? Overall, given mom's income of only 45K(assuming she spends it all on supporting her and the child) and no significant savings or investment accounts to draw from and the child's medical care expenses of 40K paid by the trust is there really any possible way the child can be mom's dependent?

Maybe this is in no way relevant but the K-1 going to the child is an actual K-1 and not a grantor letter.

Is this a situation where the preparer of the trust return should also be preparing the mother's and the child's return?

Can't see how my speculation is going to help you. There are two accountants and a trustee to talk to. K-1 suggests both parents died with an estate plan designed to provide for their disabled child.

...There are two accountants and a trustee to talk to..

That is just it, I don't even know what to ask. I am trying to get a feel for at a few "common" scenarios with respect to these types of trusts and how the payments made by the trust on the child's behalf are treated for support test purposes. With respect to the support test for determining if the child is a dependent of the mother, are are all payments made by the trust to the child (or on the child's behalf directly to a third party) always considered as received by the child and then paid by the child. Or is every trust different and the trust language dictates how trust distributions are treated for support test purposes?

So the CPA that prepared Mom's return in the past is saying that the wages to mom are for nursing care, and is a deductible medical expense. I believe this is accurate as the child meets the criteria for needing long-term care. However they are also saying that by the trusting paying it, this is treated as a "reimbursement from insurance" and, as such, the medical expenses can be left out of the support test calculation as per the worksheet in Pub 501. (line 16 of the worksheet says: "Enter the person’s total medical and dental expenses not paid for or reimbursed by insurance"). It his right? How can the child's medical care both be a deductible medical expense for the child at the same time be a considered an expense that was "paid for or reimbursed by insurance" for purposes of the support test?

Maybe this is effectively treating the child's medical expense as paid by a third party and, therefore not considered as paid by him for purposes of him contributing to his own support such that he is not providing more than 1/2 of his own support. However, if your medical care is paid for by a third party, can you still claim it as a medical expense on your return?

are are all payments made by the trust to the child (or on the child's behalf directly to a third party) always considered as received by the child and then paid by the child.

Well, you have two clauses in this sentence. You have one thing that says “payments made by the trust to the child.” Then another that says “or on the child’s behalf directly to a third party.” It is only with this latter scenario (FBO, For the Benefit Of, payments) that we know where the money actually went. These are deemed distributions to the bene and then a deemed payment by the bene to whoever it was that ended up with the money. As such, I agree with this treatment from Post #1:

The prior preparer of the mom's return was deducting the wages and employer share of payroll taxes as Sch A medical expenses on the child's return (these amounts are provided as footnotes on the trust K-1 but the footnotes do not specifically say that these are deductible as medical expenses on child's return).

As to this comment:

So the CPA that prepared Mom's return in the past is saying that

Is the former CPA actually saying all of this…or are you just guessing? If you’re just guessing, you’re kinda getting into the weeds from one standpoint, because prior preparer may have just treated kid as a dependent, and given mom HOH status, without any thought. But on the other hand, even if you are guessing, and getting into the weeds, it has lead to this:

It his right? How can the child's medical care both be a deductible medical expense for the child at the same time be a considered an expense that was "paid for or reimbursed by insurance" for purposes of the support test?

I agree with you. Deemed distribution to the child from the trust, deemed payment by the trust for the child’s medical expenses.

That is just it, I don't even know what to ask.

Sure you do. You have raised a concern over the support test and feel like the kid is supporting himself and, if that is accurate, you wonder why mom claimed all those tax benefits that she claimed.

Thanks Jeff. In post #6 when I said the other CPA is saying..... I emailed them and this is what they came back with. It is their position that the medical expenses have been reimbursed and therefore not included the support calculation as payments made by the child for his own support. If this is the case, then I don't think this is a deductible medical expense for the child. If you do go that route, then it is still part of total support, but not support provided by the child. This may help in getting the child below half of total support, but then the child does not get the medical expense, right? The prior CPA position is one of "having your cake and eating it too" and doesn't hold water, IMO.

When I was saying I do not know what to ask, I was referring to what I need to ask about special needs trusts and how they are set up that would help resolve my dilemma. Dennis said I needed to find out more about the trust. I didn't know if the trust set up and trust wording etc affects all this and if I need to ask the trustee or trust CPA if the trust has this clause, that clause, whatever clause in it that determine how payments made for the child's care are treated with respect the support test and dependency claim.

For your purpose the k-1 tells you all you need to know about the trust. It's nice to know the required document language and the relevant provisions of state law that govern but not something you need. It's also nice to know that a third party settled special needs trust can own real estate indicating that mother's contribution to support is further limited. Lots of ways to learn more if you so choose, but you have what you need to determine the accuracy of prior preparer's analysis.

Based on some online articles written by law firms and Special Need Alliance when the trust owns the house that the mother and child live in, it is not a countable asset of the child for government benefits but the child is considered as having a "beneficial interest" in the house for Supplemental Security Income (SSI) purposes. This probably has no bearing on my inquiry, but just wanted to throw this out there in case it does.

In calculating the support test, when the home is owned by the SNT, is the fair rental value of the home considered support provided by the child or support provide by a third party (the trust)?

Any one have a guess?

Prior to my OP, I spoke to the client regarding the issues and told her I need to talk with the prior CPA and do some research.

Now, based on my findings I think we need to do a support test calc to see. So I sent a spreadsheet and instructions to the client asking to provide financial data needed to calculate the support test. She called back said its too much and she will just have to the prior CPA prepare the returns.

Honestly, I don't blame her. The prior preparer with just list the child as her dependent with out any real concern for support test (or they honestly believe their position (see below) is correct). She gets all the benefits with no work on her part. Oh well.

Here the is the prior CPA's final position per an email from them (personal info has been replaced with Mother and Child):

Child's income has a direct correlation to the deduction on Schedule A. I stand by our determination and believe that the return we prepared is correct. I believe this statement supports our determination that the medical benefit should not be part of support, so I stand by the preparation of the Mother's return.
"Medical insurance benefits. Medical insurance benefits, including basic and supplementary Medicare benefits, aren't part of support."

Mother is providing for herself and Child with her income the same as any other taxpayer. In my opinion, that is the spirit of the law. The coverage of a large medical bill by a third party should not be a factor. There is coverage of medical bills and free medical treatment for children every day. Those children are still dependents of their parents.

Any thoughts? Am I being overly concerned with or over-analyzing the situation?

Any thoughts?

He’s totally off base. Sure, there is coverage of medical bills and free medical treatment each day. The rules just say to ignore medical expenses to the extent of the reimbursement (which typically comes from insurance). This makes sense: If someone has $100k of medical bills and a third party, like an insurance company pays it, then the taxpayer didn’t pay it, nor did any potential dependent of the taxpayer. Thus, ignore it for support purposes. And for deduction purposes.

This guy wants to ignore it for purposes of the support test, but then take a deduction for it on the kid’s 1040. If it is true that these really are “reimbursed” medical bills, then there would be no deduction. This guy is taking inconsistent positions.

The coverage of a large medical bill by a third party should not be a factor.

Except the Third Party here is the child. He even admits it:

Child's income has a direct correlation to the deduction on Schedule A.

Couldn’t agree more. Deemed distribution of trust income to the bene, then deemed payment of the medical bills by the bene.

This guy wants to treat the trust as an Insurance-Company-Like third party, but then he doesn’t for deduction purposes, as per his income correlation comment.

Compare and contrast to a situation wherein parents legitimately gift $100k to kid and it’s sitting in kid’s bank account, which the kid later uses to pay medical bills. This guy would say the kid gets a deduction, but then he’d say it wasn’t self-support.

Mother is providing for herself and Child with her income the same as any other taxpayer.

No one is disputing that, per se. We are just wondering how much of mother’s income is going towards the child’s support and how much of the child’s “own resources” are doing the same. We’re not saying that the mom isn’t expending any of her wages on support. It works like this: Kid gets an FBO payment from the trust for a valid medical expense (wages paid to mom). That is the kid supplying his own support. Then, to the extent mom expends her wages on other support items, that counts as support provided by her. We’re not saying to ignore that piece. We’re just saying that when the house is in the trust and when the kid is covering his own medical bills, it’s pretty hard to see how mom is supporting kid.

Mother is providing for herself and Child with her income the same as any other taxpayer.

I did say “per se” and that’s because Mother isn’t “the same as any other taxpyayer.” Mother has a child who is supporting himself.

In my opinion, that is the spirit of the law.

The guy comes to this position from a flawed starting point. He’s basically saying that the spirit of the law is that if we have a mom and a child, the mom is automatically entitled to all tax benefits that normally flow from that relationship. That’s not the spirit of the law. The spirit of the law is that if a parent is supporting a kid, only then does the parent get the benefits.

Also note that when it comes to trusts, there is a body of law that says when the parent (or anyone else for that matter) sets up a trust and said trust makes support-type payments on behalf of the child beneficiary (to which there is a duty to support on the part of the parent), the parent is taxed on that income. Now, this rule could be applicable in your case. I’m not entirely sure about the child’s age and adoptive Mother’s duty to support. But it sure doesn’t sound like things have been treated as if adoptive mother is discharging her own support obligation since she’s not the one getting the K1, the kid is. In addition, it sure doesn’t seem like the other CPA firm is making that argument anyway.

Child's income has a direct correlation to the deduction on Schedule A. I stand by our determination and believe that the return we prepared is correct. I believe this statement supports our determination that the medical benefit should not be part of support

What does he mean by “this statement?” If he is referring to his comment about the correlation…I agree that the correlation makes sense. The correlation is deemed income to the kid, a deemed payment by the kid, and therefore, a deemed deduction by the kid. The correlation itself stops there. The logical next step is to say that the kid’s deemed payment is support supplied by the kid for himself. But the CPA goes in the opposite direction and concludes that the payment deemed made by the kid, which the kid deducted, shouldn’t be treated as if the kid made it for support purposes.

Thank you, Jeff, for your time and input. I told the client that if you don't agree with me and/or don't want to put in the effort to get the information together to calculate the support test, that I would at least get another opinion before having your original CPA prepare your return. I also told her that she gets about 3K worth of tax savings from HOH and the child tax credit and if audited she's looking at possible repayment of that with interest and penalties plus possibly the same for your last couple years as well.

I did speak with an employee at the trustee bank who said the trust was funded from a medical malpractice lawsuit settlement. I didn't ask anything further and haven't asked Mom any of the details about how the trust was funded. Plus, I don't have the trust document. The child is eleven years old.

What does he mean by “this statement?”

He means this statement from the Pub 17:
"Medical insurance benefits. Medical insurance benefits, including basic and supplementary Medicare benefits, aren't part of support."

He means this statement from the Pub 17:

Just seems off-base to me. I think that sentence is pretty easy to understand. But CPA seems to be giving it a whole new definition. We’re not dealing with “medical insurance benefits” in the first place. The trust was funded with proceeds from a malpractice claim, not from medical insurance benefits (even though the source of funds may have been from an insurance company on the payer’s end). But this doesn’t really matter. We’re talking about significant interest/dividends, etc. that were earned by the trust. These are items on top of the initial trust corpus. Even if some original corpus was distributed, to argue that that amount represents a “medical insurance benefit” flowing from the trust’s initial funding isn’t quite accurate. However, I can see how if some original corpus (i.e. from the initial claim) was distributed, that might make sense. It makes sense to me that the person that paid the damages shouldn’t be treated as providing any support to the injured party.

You haven’t really given us any numbers here, so it’s hard to nail things down precisely. But let’s say it’s this:

$300k initial malpractice claim. Tax-free under Sec 104. In the current year, there’s $30k of dividends. Kid receives “distributions” of $47k, of which (1) $37k was associated with the wage payments to mom and (2) assume the other $10k was support-type stuff. Thus, there’s $17k of corpus that was distributed. And there’s $47k of tentative support payments. I can see how the $17k should be ignored for purposes of the support test. This is basically the delayed receipt by the child of a portion of the malpractice claim, one could argue, which was then expended on non-countable support. (Although it is not “medical insurance benefits” as the CPA states). I don’t see how the other $30k (i.e. the earnings) can be ignored for purposes of the support test. Again, this is earnings on the initial claim (and, perhaps, earnings on prior earnings). Sure seems like other CPA would like us to remove all $47k of distributions/expenditures from the support test. It seems his position is that anything that ever comes out of this trust (original corpus plus earnings) can’t be support because it all relates back to a malpractice claim.

Finally, this kid is a minor, so there is some duty to support on the part of adoptive mother. I just don’t know what that duty is under the laws of the client’s home state. Not sure it matters, though, given that it is the kid that is getting the K1. Someone must have made a determination that Mother shouldn’t be taxed on any of the trust income.

Thanks again Jeff. I don't know how much is in the trust and the details surrounding its funding. The trustee was going to get me in touch with the trust CPA but I have not heard from them. All I know is what is on the K-1 and in the K-1 footnotes. The footnotes indicate there was $32K in net wages and $7.3K in payroll taxes w/h/paid for the caregiver/mother. These agree with Mom's W-2, more or less (after factoring in ER portion of the pr tax). The K-1 footnotes also indicate the trust paid the child's 2020 state income tax estimates of $2400 and $200 tax prep fee. That is it. Mom has not given me any support figures so I don't know what she spends nor do I know how much SSI the child gets and how it is spent. Mom nets about 41K, after tax, from her W-2 and Sch C. My inquires to the mom regarding all this "overwhelmed" her and that is when she said she would just have her original CPA prep the 2020 returns. I did previously reach out to the trustee to see if there was anything else paid by the trust FBO the child but never heard back.

No need to spend anymore time on this. I just wanted to throw out the figures I do know.

However, what do you think about the trust owning the house and the rental value of the home for the support test. See post #10.

No need to spend anymore time on this.

I get it. She’ll go back to friendly CPA. But this is a good thread. Good concepts at play. One of which is the duty of support. I can’t say how that plays out here, but based on the kid only getting the K1, that position is consistent with the trust not discharging any of Mother’s support obligation (if she has one). Here’s a treatise on that issue, in case you’re interested:

https://kb.osu.edu/bitstream/handle/181 ... 3_0753.pdf

All in all, it seems like the CPA’s position is a bit weak and shallow. For one thing, he cites a Pub. And what he’s citing in the Pub, about insurance benefits, isn’t on point. Nonetheless, there is a similar concept when the injurer (or the injurer’s insurance company) covers medical bills of the injured party. In that case, those payments don’t count towards the support test. But here we have a K1 with $30k of income on it. I’m hard pressed to see how that income, deemed received by the child and used (in large part, from what we know) to cover child’s medical expenses, wouldn’t be treated as support. Original corpus, I get it. Maybe no support to the extent those funds are expended. But with respect to earnings on the corpus, I don’t see how those could be viewed as funds supplied by the injurer/injurer’s insurance company.

The CPA acknowledges the inextricable link between the K1 income and the medical deduction. But then he argues that the income was really supplied by the injurer. I just don’t buy it. That income is above and beyond the settlement. Again, corpus, yes. I do buy it. If the kid got a K1 with all zeros, but the Mother was still paid $30k by the trust, I think the kid still gets a deduction. In that case, though, an argument can be made that the funds (corpus) really were supplied by the injurer. (But then we might get into a debate about taking deductions associated with tax-free Sec 104 income).

It is an interesting situation and I can't really find any guidance, even informal, on this specific situation. With your last post I keep going in circles with whether or not the original non-taxable (assumed) settlement proceeds (trust corpus) are/could be considered reimbursing medical expenses. And, like you said, if the original settlement proceeds were nontaxable, are the medical expenses paid with it, then, non-deductible and can these be left out of the support test entirely? I agree that the portion of the medical expenses paid by the trust, which carry out the income, should be considered support provided by the child since the K-1 is issued to the child. Payments made with trust corpus, I just don't know. But if these are considered "reimbursements" or payment of medical expenses with non-taxable settlement proceeds and left out of the support test, I would think this portion of the medical expenses would have to be non-deductible. Whether support obligation laws impact this and if any of the trust income could/should be considered Mom's income, I have no idea. I haven't ready the treatise in full but quick glance at first page looks like it comes into play in income shifting situations where the parents want the child to be taxed on the income at lower rates but the parents are using the money for the kids support = parents income not the kids. I sure there is more in the treatise than just that situation. Regardless, I assume the trustee and/or trust return preparer would be responsible for determining this so that the K-1 goes to to the correct person, no?

With your last post I keep going in circles with whether or not the original non-taxable (assumed) settlement proceeds (trust corpus) are/could be considered reimbursing medical expenses.

A few thoughts…

Thought #1: As we know, there is a body of law that says if you incur a medical expense that is covered by your own insurance, the amount the insurance company pays (i.e. a “medical insurance benefit”) doesnT’t factor into the support calculation, whether paid directly by the insurance company to the provider or paid as a reimbursement to the taxpayer. The tax consequence is aligned with this idea: No income to the taxpayer for the value of the benefit received. And, at the end of the day, no deduction to the taxpayer either. The third party (insurance company) is deemed to have paid the expense.

Thought #2: There is also a body of law that says that if an injurer causes you harm and the injurer (or his insurance company) ends up paying your medical bills (if you will), that “benefit” you receive doesn’t factor into the support test. See, for example, Rev Rul 64-223. The concept here is very similar to a benefit received via one’s own medical insurance policy. And the tax result is the same as Thought #1. In effect, we have the injurer (or injurer’s insurance company) paying our medical expenses instead of our own insurance company.

Even though the other CPA is hanging his hat on “medical insurance benefits” (Thought #1) there is a similar line of reasoning that could make the other CPA’s conclusion correct (Thought #2).

Importantly, we don’t know the terms of the settlement. As a general proposition, if the settlement designates an amount as being for future medical care, then that piece will be treated in accordance with Thought #2. If there is no designation/allocation in the settlement, things get gray, in terms of whether or not a designation will be imputed. (See Rev Rul 79-427, for example. But some courts have refused to follow it). But if we end up with no designation, then the injurer will not be treated as paying for the injured party’s future medical care. Thus, medical amounts expended by the taxpayer will factor into the support test.

So, let’s say we have an injured party and that party directly receives a settlement. And then let’s say the injured party uses those funds to pay medical bills.

Before concluding, we have to stop there.

Let’s say we’re dealing with a situation where there was no designation in the settlement agreement as to future care (and said amount was not otherwise determinable, so a designation can’t be imputed). In that case, the taxpayer has excludible personal injury income and he can deduct everything. I would say 100% of the expenditures do factor into the support test. The taxpayer is deemed to have paid them, not the injurer.

Now let’s say we’re dealing with a situation where there was a designation. In that case, medical expenses paid up to the designated amount will not produce a tax deduction (although that portion of the settlement, and the entire settlement for that matter, is still excludible from income). Amounts paid up to the designated amount will not count towards the support test pursuant to Thought #2. That is, amounts up to the designated amount were (deemed) covered by the third party injurer, albeit in advance via the up-front settlement.

In my view, if we alter the above fact pattern such that the settlement ultimately went into trust, that doesn’t change anything. The initial trust corpus would have to be evaluated to determine if all or it, or some of it, will be deemed a “reimbursement” of future care as funded by the injurer. To that extent, I would say the payout of that portion of corpus would not count towards the support test.

It sure seems that the other CPA has not done a deep dive as we have done here. He is basically taking the simplistic position that 100% of everything that comes out of the trust doesn’t count towards the support test. That is definitely flawed, for starters, because we know the payout of the trust income is on top of the settlement. You also indicated that the K1 income was $30k, yet the medical expenses paid through the trust were at least $37k. This implies a $7k payment of corpus. CPA implies the full $37k is deductible. Thus, CPA wants to deduct the $7k of medical associated with the corpus. That’s fine. That’s consistent with the idea that there was no settlement designation for future medical care. But his problem here is his inconsistent position that the $7k was funded by the injured party such that it doesn’t factor into the support test. He can’t have it both ways.