Clients want to save taxes. In fact, saving taxes often seems more important to clients than ensuring that assets are distributed according to their wishes. In trying to achieve a client’s varied goals, the impact of state trust income taxes can be overlooked. State trust income taxes can be substantial–up to 9.3% in California, compared to zero in states such as Delaware, Alaska, Florida and South Dakota.
Planning for state trust income taxes requires more than considering just the laws of the state where the trust is created. Many people move from one state to another so trusts are likely to have contact with another state. Trusts or their beneficiaries can be taxed on the same income by two or possibly more states. One state may not permit a credit for taxes paid to another state. Double taxation is definitely possible.
Approaches that states take to taxing trust income
A state may impose income tax based on the residence or domicile of the grantor, beneficiaries and/or trustees; the location of the trust property; and where the trust is being administered.
States have the constitutional right to tax all income of resident trusts. All states define a nonresident trust as any trust that is not a resident trust. So what is a “resident trust?” The different factors used to determine a “resident trust” include:
? Where the grantor is domiciled or resides. For an inter vivos trust, when the trust became irrevocable or for testamentary trusts, the state is where the testator was domiciled at death.
? The state where the trust was created.
? The place where the trust is being administered. States may base the place of administration on:
–The trustee’s residence or principal place of business.
–The location of assets.
–The location of trust’s books and records.
–Where investment decisions are made.
–Where any court administration occurs.
–Where trust property is located.
? The beneficiaries’ domicile. Most states don’t tax a trust’s income solely because a beneficiary resides in the state. If they do, they generally apportion the tax between resident and non-resident beneficiaries. A beneficiary could be taxed on the trust income by one state even if the trust was taxed on the income by another state.
? The trustee’s domicile. Because the trustee is the legal owner of the trust assets, the trustee’s presence in the state may be sufficient to tax the trust income, even if the trust has no other contact with the state. If there are both resident and non-resident trustees, most states apportion the income between the resident and non-resident trustees. Other states use a majority rule and tax the entire income if a majority of trustees reside in the state.
Credits for taxes paid to other states
States generally allow trusts an income tax credit for taxes paid to other states on the same income. All states that allow credits provide resident trusts with a credit for taxes paid to other states.
States that allow credits for nonresident trusts require the resident state to provide a reciprocal nonresident credit. For example, California allows a credit for a nonresident trust if the trust’s resident state either doesn’t tax California residents on income from that state, or allows California residents a credit against that state’s taxes for California income taxes paid on that income.
States limit credits to avoid unintended benefits, such as circular credits avoiding all state taxes on the income. This is usually accomplished by denying resident trusts credits if the trust receives a credit from the nonresident state. For example, California denies resident trusts the credit if a nonresident state allows a California resident trust a credit for taxes paid to California.
States also restrict the credit so the credit allowed does not exceed the portion of tax paid to the other state attributable to the income taxable in both states. This may be done by:
? Restricting the credit to the tax due on the income if taxed at the resident state’s rates.
? Limiting the credit to the same proportion as the out-of-state income has to the trust’s total income.
? Limiting the credit to the tax saved if the resident state did not tax the income.
A father, domiciled in New York, sets up an irrevocable trust for his son, a California resident. New York taxes all the trust income because the grantor is domiciled in New York. California taxes all the trust income because the only beneficiary resides in California.
New York will allow a credit for a resident trust for taxes paid to another state, unless the taxes are on income from intangibles.
California allows a resident trust to claim a credit for taxes paid to another state in certain situations:
(1) The income subject to tax is derived from N.Y. sources and taxable to N.Y. regardless of where the recipient lives.
(2) The credit isn’t allowed if N.Y. allows Calif. residents a credit for N.Y. taxes for the tax paid to Calif.
(3) The credit is limited to the proportion of the tax payable to Calif. as the income subject to tax in N.Y., and Calif. bears to the trust’s Calif. taxable income.
State trust income taxes can be considerable. Planning to minimize them could produce significant savings while still accomplishing the client’s goals.