If you’ve been procrastinating on reviewing that old trust, now is the time to take a second look.
Smart state income tax planning for trusts, in particular, can offer some surprising benefits. That’s why it’s important to regularly review your documents in order to maximize savings. Many trusts operate on autopilot for years if not decades. Financial advisers with experience in trust taxation can help implement the best tax-savings strategies for your trusts.
Consider the case of Gloria:
Gloria created a trust for the benefit of her two sons, Jason and Max, with her cousin Shelly as trustee. The trust was irrevocable, which means it generally cannot be amended or revoked. At the time of the trust’s creation, everyone lived in the Bronx. The trust was initially created as a “grantor” trust, meaning that Gloria was personally responsible for paying the tax generated by the trust’s income. Even when a trust is irrevocable, its tax status can sometimes be changed from grantor to non-grantor (or vice versa). So, when Gloria retired and became sick of paying the trust’s tax bill, she decided to “turn off” grantor trust status, thereby making it a “non-grantor” trust. She also decided to move to Florida. To be close to his aging mother, Jason soon followed. But Max and Shelly, both die-hard Yankees fans, stayed in the Bronx.
The key feature of Gloria’s trust is that it is irrevocable. This is different from a “revocable” or “living” trust, which can be revoked at any time for any reason. With revocable trusts, the grantor is always the taxpayer. An irrevocable trust, on the other hand, can be treated as either a grantor trust or a non-grantor trust for income tax purposes.
When her trust was a grantor trust, Gloria was responsible for paying all taxes owed on the trust income. Once Gloria’s trust became a non-grantor trust, however, the responsibility for paying tax on the income generated shifted to the trust (and Shelly, as the trustee) — unless there was a distribution to Max or Jason. If Max or Jason received a distribution from the trust, either would generally be responsible for all or a portion of the tax due.
States differ in their rules on taxation of non-grantor trusts. Many states, including New York and New Jersey, impose income tax on a non-grantor trust created by a person while a resident of that state, whether created during the grantor’s life or under her will. Other states impose income tax on trusts that are administered in the state, or have trustees or beneficiaries in the state.
Yet, some states offer exceptions to their rules of taxation. In New York and New Jersey, for example, there is a three-pronged exception from the imposition of state income tax if:
In many states, periodically asking these two simple questions can assist the trustee of a non-grantor trust in determining the state income tax consequences of an action:
Let’s examine how these factors impact the taxation of Gloria’s trust.
After Gloria retired and moved to Florida, the trust would have to continue to pay New York income taxes, because Gloria created it when she was an Empire State resident and the trust continues to have New York ties, via Shelly, the trustee. What can be done?
Since New York carves out the three-pronged exception described above, it may be wise to replace Shelly with a non-New York trustee. It will be important, however, to ensure that Shelly’s replacement doesn’t live in a state that taxes non-grantor trusts based on the residency of the trustee as this could result in trading New York taxation for taxation in another state.
If distributions are made to Max or Jason, knowing the tax impact on each is key. Assume Shelly has been replaced and the trust no longer pays New York income tax. Jason asks for a trust distribution and the trustee agrees. Max doesn’t need distributions now, but because he worries Jason’s distributions will deplete the trust, he begins receiving distributions as well. Jason will not pay state income tax on his distribution because Florida has no income tax. Max’s distributions, however, will be subject to New York income tax.
One way to address this situation is to structure the distribution to Max and/or Jason as a loan, which could be more tax-efficient, particularly for Max. If the trust agreement permits, another alternative is to segregate the trust into two sub-trusts: one for Jason and one for Max.
In doing so, Jason’s distributions would only deplete his share. As an added advantage, each share would have a separate investment allocation. This can be valuable if the beneficiaries receiving distributions live in different states. For example, it may make sense for Max’s share to have a municipal bond allocation with a New York bias, whereas this would not be appropriate for Jason.
Many state income tax planning opportunities exist when administering an irrevocable non-grantor trust. Your financial adviser can help you understand and implement these strategies and ensure your trust is set up in the most tax-efficient way, especially if there has been a change of residence for any party in the trust.
Eric Dostal contributed to this article.
In her role as Director of Trusts and Estates at Sontag Advisory, Nicole’s primary focus is to provide trust and estate advice to the advisers and clients of the firm.
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