Trusts are often established to grant legal protection for a party’s assets, ensuring they’re distributed according to the owner’s wishes. In most states, Uncle Sam will still be owed a portion — it just depends on where you live.
A trust can be taxed as a resident trust in multiple states or in no states. The individual or party that creates the trust should pay attention to these four factors for both existing and new trusts to understand how they may be impacted by their location:
- Where the trust was created.Several states impose a tax if the party who created the trust (known as the trustor or grantor) resided in that state when the trust was created. In other words, a person could draft a will or establish a trust while briefly residing in the state and the trust will be taxed there — even if that person died after living elsewhere for decades.
- Where the beneficiaries reside.A handful of states will tax a trust that has one or more beneficiaries (the trust’s recipients) residing within their borders. For example, California imposes taxes on trust income that is distributed or distributable to a state resident.
- Where the trustee resides. Some states will tax a trust if a trustee (the entity that manages the trust) resides in the state. States also may consider the residence of co-trustees, including trust advisors and other non-trustee fiduciaries. For example, a trustee could reside in Nevada, but if the trust also has a fiduciary living in California, California treats the trust as subject to its income tax.
- Where the trust is administered. A trust may be taxed by the state in which it’s administered.
Tax nexus trap
Several states don’t impose any income taxes on non-grantor trusts. These are separate taxable entities from the party who created the trust, who retains no control in it. But those states — including Florida, Nevada and Texas — are in the minority.
Moreover, trusts that ostensibly “reside” in those states may be subject to income taxes in other states. That’s because many states find ways to establish tax nexus with trusts that appear to have minimal connection to the state. The term “tax nexus” generally refers to the minimum contacts with a state that are required to subject an entity to taxation in that state.
Minimizing tax risks
It’s worthwhile to review a trust’s connections to high-tax states on an annual basis. Trustors, beneficiaries or trustees may have moved, potentially creating or eliminating tax nexus with different states.
There are also steps you can explore to help cut down the tax liability. For example, the Supreme Court acknowledged that in states that base tax on a beneficiary’s residence, the beneficiary could delay taking distributions until after relocating to a state with a more favorable tax regime. In addition, trusts may avoid taxation in states that base tax on a trustee’s residence by appointing non-resident trustees or replacing resident trustees.
A similar approach could be taken to avoid taxation based on where a trust is administered. Another alternative is removing certain nondiscretionary powers and rights from trustors or beneficiaries.
Proceed with caution
Trusts are generally created to shield assets from taxes, not to create additional tax burdens. As you can surmise from the general information above, they’re a pretty complex undertaking. Be sure to consult with trusted legal and financial professionals to help ensure the outcome you envision
If you have any questions about the tax rules involving a trust, count on Magone & Company as a knowledgeable resource. Reach out today at (973) 301-2300.
This post is for informational purposes only and should not be considered legal or financial advice. Be sure to consult with a knowledgeable tax advisor regarding your particular situation.