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.