Fifty States of Grey – The Complex Rules of State Income Taxation for Trusts
Fifty States of Grey – The Complex Rules of State Income Taxation for Trusts[1]
Currently, seven states do not subject trusts to income tax. However, the remaining forty-three states tax trusts to varying degrees and have developed various sets of rules to determine which trusts are taxable.
Individuals are generally subject to state income tax based on their residence and source of income. Trusts are similarly subject to state income tax based on the source of trust income. However, the concept of “residence” does not easily translate to trusts, which have many components, each of which may be located in a different state. Furthermore, due to differences in state tax rules, a trust may be a “resident” of more than one state (or, conversely, no state).
In general, states base their taxation of trusts on one or more of the following factors:
- In the case of a testamentary trust, whether the testator was a resident of the state at the time of his or her death;
- In the case of an inter vivos trust, whether the grantor was a resident of the state when the trust was created and funded (or funded with additional assets after the initial creation) or became irrevocable;
- Whether any real or tangible personal property or business is located within the state (i.e., whether any income has its source within the state);
- Whether any trustee or other fiduciary is a resident of the state;
- Whether any beneficiary is a resident of the state; and
- Whether the trust is (wholly or partially) administered within the state.
Delaware, for example, does not tax income accumulated by a Delaware resident trust (defined as a trust with at least one trustee located in Delaware) for future distribution to non-resident beneficiaries. Thus, a Delaware resident trust will not be subject to Delaware income tax unless: (1) there is Delaware-source income; or (2) there are Delaware beneficiaries (in which case, only the Delaware beneficiaries’ portion of the accumulate trust income will be taxed).
New York, however, subjects any trust established by a New York resident to income tax unless: (1) no trustee is a New York resident; (2) the trust has no real or tangible personal property located in New York; and (3) the trust has no New York-source income.
California, on the other hand, disregards completely the residence of the grantor. Instead, California subjects trusts to income tax if: (1) any fiduciary is a California resident; (2) any “non-contingent” beneficiary (i.e., a beneficiary with a mandatory distribution right) is a California resident; or (3) the trust has any California-source income.
If the right circumstances exist, a trust may benefit from moving to or being established in a no- or low-tax state. For example, if a trust were funded with highly appreciated assets (or assets that are expected to appreciate in the future) and such assets were subsequently sold by the trust, then any gain would be taxed at the trust level, which, if properly structured, could avoid, defer or even eliminate taxation in the grantor’s home state and reduce or eliminate the overall state income tax payable.
Whether a trust can be moved to or established in a particular state to avoid taxation in another state depends on the circumstances and the basis for taxation in that state. Some circumstances may be easier to change than others (and some may be impossible to change). For example, if a trust is subject to income taxation in a state due to real or tangible personal property or a business being located within that state, options for avoiding income tax in that state may be limited. In addition, it may not be realistic to expect beneficiaries to move out of state solely for trust income tax planning.
Furthermore, the residence of the grantor or testator, determined as of the date the trust is established, can never be changed. However, planning opportunities exist where the sole basis for a trust being subject to income tax in a state is 1) a fiduciary being a resident of that state or 2) the trust being administered in that state. In both of those cases, depending on the terms of the trust and the governing law, the trust may avoid income taxation in that state simply by removing and replacing the resident fiduciaries.
That being said, despite the potential opportunities for tax savings, trust income tax is just one factor to take into consideration when choosing a trustee or a trust jurisdiction. Other important factors include the expertise of the trustee as well as the jurisdiction’s governing law, court system and availability of other benefits for the trust, such as creditor protection. Fortunately, Delaware excels in all of these areas, which is why it continues to be considered one of the top trust jurisdictions.
Post By: Alexander J. Lyden-Horn, Esquire, Trust Counsel for Commonwealth Trust Company
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[1] For purposes of this article, the term “trust” refers only to irrevocable trusts that are not treated as “grantor trusts” for income tax purposes.
Commonwealth Trust Company is pleased to provide this article as a guide. Commonwealth Trust Company is not engaged in the practice of law and is not providing legal advice by the provision of these materials. Commonwealth Trust Company recommends that clients seek the opinion of their attorney regarding the specific legal and tax issues addressed in this article.