My daughter has special needs. Does the IRS have the authority to take money from a trust that I set up in her name?

Dear Tax Guy,

I have a special-needs daughter who is under the court-appointed care of her mother. Her mother is remarried, but we get along fine and I totally trust her with the care of our daughter.

Does the Internal Revenue Service have the authority to freeze or take money in a trust, which I intend to establish either in my daughter’s name or her mother’s name?

Just to clear: I am not in any trouble and nor do I currently owe any money to the IRS. However, I’ve had several expensive run-ins with the IRS in the past.

Because of this history I am always worried that history might repeat itself, either before or after I die at the expense of my handicapped daughter.

Again, I am square with the IRS at the present, but I always have a fear that they might find some reason to try to claim more like they did when I owned my contracting business.

Concerned Father

Dear Concerned Father,

For starters, there are two types of trusts. If you are putting your assets in a revocable trust, the IRS could go after your assets in the trust.

However, if you are putting the assets in an Irrevocable trust, the IRS generally cannot go after your money. If you do have an existing IRS lien against you (you should check on this) and you do put the assets in an irrevocable trust, there could be issues.

Now a little bit on the type of trust that could be set-up by you. A trust used in special needs planning is a special needs trust, also known as the supplemental needs trust (SNT). This is a trust you will establish that will allow your daughter with special needs to receive her share of your estate.

A third-party special needs trust is the most common trust used in such scenarios. One of the benefits of this type of trust is to set aside money for the kids without disqualifying them for any governmental benefits.

Once an SNT is funded, it becomes irrevocable, and the terms of the trust cannot be changed, which as noted earlier addresses your concern about the IRS and also any claims of other creditors you may have to take the money you set aside in a trust fund.

The money in the trust can then be used for your child’s supplemental needs but will not be accessible to you for your personal needs anymore.

On the compliance side, there will be annual tax filings by this trust and any earnings of the trust will be taxed and paid by the trust which may be at a higher rate than your personal income-tax rate.

Also, any distributions from the trust are deemed to have been made first from income and, hence, any money spent on behalf of your daughter will pass the income-tax liability to your daughter.

It is, however, possible to design these trusts to make it a grantor trust, where the grantor — you, in this case — remains the owner and is responsible for both income and estate taxes.

Varun Vig is partner at Eisner Advisory Group LLC in New York City.

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