If a Trust exists solely to pay medical expenses of it's beneficiary and nothing else. Are those payments Disbursements (non-Taxable) Distributions (taxable)?

[mseklem]

The Trust can pay either income or principal in order to cover the specific, documented medical expenses it's sole beneficiary and not for anything else.  So are those payments, which are not for the beneficiary's indiscriminate use taxable to them?

[M-MTax]

So are those payments, which are not for the beneficiary's indiscriminate use taxable to them?

Yes, the distributions are taxable to the bene to the extent they come from taxable income such as interest, dividends, capital gains, and the like........unless the trust pays any tax due. The bene can of course deduct medical expenses on the bene's own income tax return.

[Opus 17]

Any income (from investments, etc.) is taxable like all income is taxable.  The trust pays the income tax on the interest (form 1041, different version of turbotax, trust needs its own separate tax ID number).   Possibly the trust can pass the income through to the beneficiary, who would pay the tax.  

To the best of my knowledge, the beneficiary can't list medical expenses as itemized deductions on their schedule A except to the extent they paid tax on interest.  In other words, if the trust pays $10,000 of medical expenses, and the beneficiary paid no tax (because the trust filed a tax return and paid the tax), the beneficiary can't deduct any expenses on the beneficiary's tax return.  If the trust paid $10,000 of expenses, of which $500 was interest and the beneficiary paid income tax on the interest, the beneficiary can list $500 of deductible medical expenses (which will likely result in no or only a very small tax benefit due to the other rules on itemized deductions.)

Someone has to pay tax every year no matter what.  If the trust earns $1000 of interest and dividends in 2024, that interest is taxable to someone in 2024, even if it stays in the trust for future expenses.   And if the trust has (for example) $100,000 of assets, and earns $5000 of interest, and pays $5000 of medical expenses, it doesn't matter if the trust considers the expense to have been paid from interest, principle or both, the $5000 of interest is taxable income to the trust in the year it was earned, even if it wasn't paid out.

You may want to consult with a tax professional.  

[M-MTax]

To the best of my knowledge, the beneficiary can't list medical expenses as itemized deductions on their schedule A except to the extent they paid tax on interest. 

You're misinformed. Whether it comes from taxable interest..... or any other type of taxable income......... or from corpus it becomes the beneficiary's money and a medical expense would be potentially deductible for the beneficiary.

[NCperson]

@M-MTax @Opus 17 - can we go back with a cleaner example? 

Trust generates $10,000 of income; beneficiary of the trust has $10,000 of medical expenses (and for simplicity not reimbursed by insurance).  

Under the typical "HEMS" standard imbedded in the trust document, the beneficiary requests that trust reimburse the beneficiary for the medical expenses (the "H" for health in HEMS).

The trust has income of $10,000 but has a distributable net income deduction of $10,000 so it has no taxable income.

The beneficiary receives a K-1 for $10,000 of income (what was distributed), so the beneficiary is paying any tax due on the trust's income.

as the beneficiary paid the medical expenses, to the extent the beneficiary can itemize, this $10,000 (subject to the 7.5% medical exclusion on Sch A.), the $10,000 can be listed on Sch A.  It has nothing to do with the trust payment to the beneficiary.

comments? thoughts? 

[mseklem]

That's how I thought it worked.  Thanks to you all for the quick response.]

If the Trust reimburses the beneficiary for medical expenses amount to more that the Trust's taxable income.  Is the amount above the Trust's taxable income (paid from corpus) taxable to the beneficiary?

Thanks again

[NCperson]

@mseklem - no - it is not taxable.  - in my example, any distribution that exceeds the $10,000 of income is a distribution of principle of the trust; principle is not taxable. 

let's make the example even simpler: the trust has no income for the year but the beneficiary requests that $10,000 be sent from the trust to the beneficiary to cover health (medical) expenses under the HEMS standard. 

the trust has no income to distribute, so it has to be principle that it is distributed.  Tax is paid on 'income' - not 'principle'.  🙂 

[M-MTax]

comments? thoughts?

Your statements are correct. I certainly did not mean to imply that the trust needed to distribute funds to the beneficiary for the beneficiary's medical expenses.....paid by the beneficiary.....to be deductible on Schedule A. The other person in this thread is the one who said that they didn't think the expense was deductible unless it came out of income from the trust. I never said that.

Not to be a stickler or anything but it's PRINCIPAL not "principle". 

[mseklem]

Your answer was clear.  Just wanted to clear about distributions larger than Trust income.  Thanks for the spell/definition check (not my strong suit)  ;-}

[Opus 17]

My issue is with how the trust is funded.  I don't understand how, if the trust is funded by someone else (relative, lawsuit settlement, etc.) and the beneficiary never paid tax on it, how does the beneficiary have a basis to deduct the expense?  If I have tax-free money in an HSA or FSA (I never paid tax on it because it was deducted pre-tax), I can't deduct expenses paid with FSA or HSA reimbursements.  If I have insurance paid with pre-tax premiums, I can't deduct expenses paid for by insurance.

So going back to @NCperson 's two examples.  In example #1, the trust distributes $10,000 of earnings.  That's taxable to the beneficiary, and the beneficiary can include the expenses as schedule A deductions.  That's exactly what I would expect.  But what about example #2, where the trust distributes principle.  No income, no tax for the beneficiary.  Can the beneficiary take schedule A, and if so, why?  

Or example #3, the trust distributes $5000 of principle and $5000 of earnings, the beneficiary reports $5000 of taxable income.  How much can the beneficiary deduct?

Separately, if I was wrong on the tax being owed on the earnings every year, and only owed when the earnings are paid to the beneficiary, then I learned something today. 

[M-MTax]

Can the beneficiary take schedule A, and if so, why?  

Yes and the reason is because it's the beneficiary's money after it's distributed to the beneficiary. This is no different than if a relative gave you $10,000 and you used it to pay a medical bill or your real estate taxes......you could take a deduction on Sch A if you itemize. Not the same as an FSA or HSA because the trust was not funded with "pre-tax" money......taxes were paid on those funds.

Separately, if I was wrong on the tax being owed on the earnings every year, and only owed when the earnings are paid to the beneficiary, then I learned something today. 

Not wrong.....either the trust will assume the income tax liability or pass it through to the beneficiary who will be responsible for any tax due. What the trust CAN'T do is take a deduction for the medical expense.

[mseklem]

Thanks for all of your knowledgeable comments!

[NCperson]

@Opus 17 - let's try this: 

<<But what about example #2, where the trust distributes principle.  No income, no tax for the beneficiary.  Can the beneficiary take schedule A, and if so, why?>>

because the beneficiary paid the medical bills! it's that simple! 

The existence of the trust (and any distributions to the beneficiary) has no bearing on the medical expense deductibility issue.  

Let's say, instead of receiving $10,000 from a Trust, the OP received $10,000 from Mom and Dad as a gift.  The gift doesn't impact the deductibility of the medical expenses, right? ...and neither does a $10,000 payout from a trust!  Regardless of where the money comes from, the fact is that the OP paid the medical bills himself with after tax money,  and that makes him eligible to deduct them on Sch. A (subject to the 7.5% limitation, etc). 

The a) money flowing from the Trust to the Beneficiary (and whether it some of it gets reported on a K-1) and the b) Beneficiary taking the medical deduction have nothing to do with each other.

<<Or example #3, the trust distributes $5000 of principle and $5000 of earnings, the beneficiary reports $5000 of taxable income.  How much can the beneficiary deduct?>>

Answer: all the medical bills, just like if there was no trust.... see the bolded statement above 🙂

does that help? 

[NCperson]

@Opus 17 I guess I should take a stab at this as well: 

<<My issue is with how the trust is funded.  I don't understand how, if the trust is funded by someone else (relative, lawsuit settlement, etc.) and the beneficiary never paid tax on it, how does the beneficiary have a basis to deduct the expense? >>

While the beneficiary never paid taxes on the money funded into the trust, it is funded with after-tax funds to begin with!* Think of it as a form of inheritance with controls  (the trust) on it so the beneficiary doesn't go out and buy a dozen Rolls Royce's and a half dozen yachts instead of paying critical medical bills!! 

An inheritance would all be after-tax dollars, right? 

Maybe this helps: since assets in the trust are after tax* dollars, then any distribution is an asset and therefore not income, so no tax impact; however, those assets generate income, and to the extent there is income, those income dollars are 'first out' in any distribution. 

Compare the tax rates for a trust versus an individual.  The trust tax brackets are quite compressed, so the motivation is for the beneficiary to pay any tax on the income and not the trust! (Trust top tax bracket is 37% at only $13,000 of income - it is quite compressed !!!!).

<<Separately, if I was wrong on the tax being owed on the earnings every year, and only owed when the earnings are paid to the beneficiary, then I learned something today. >>

the earnings are taxed each year - you are correct.   The question is who is responsible to pay the tax!  While chapter and books are written on the the optimal strategy and the trade-off of asset control, the beneficiary pays the income tax a lot lower tax rate, so financially (at the risk of control), best for the beneficiary to pay the tax. 

does that help? (I have a lot of real world experience with these trusts as the trustee of a small family trust myself).  Ask away as necessary.  

* and let's not worry about situations where someone left a Trad IRA to a Trust under Secure2.0, with a named beneficiary of the IRA .  That is whole other can of worms!