By David Seiden and Matt Stein
Over the past 20 years, there has been a significant increase in the popularity of trusts. There are many reasons for this increase, including the potential for individuals to save estate taxes, avoid probate, and protect assets for future generations. While most advisors who recommend trusts to their clients understand the federal income tax implications and benefits of establishing a trust, very few understand the state tax implications and potential pitfalls.
In general, a trust is considered a stand-alone entity and is therefore subject to federal and, potentially, state income tax laws. Similar to partners in a partnership, beneficiaries in certain types of trusts (e.g., simple trusts) are responsible for reporting the income earned by the trust on their personal federal and state income tax returns. Alternatively, other types of trusts (e.g., complex trusts) do not "flow-through" the income to the beneficiaries but are instead required to file and pay the applicable federal and state income taxes.
The challenge that many trustees (trustees are typically responsible for ensuring all trust taxes are paid) and advisors face is determining the state(s) in which the trust is required to file and pay state taxes. Trusts that are remiss in filing the required state tax returns can incur significant penalties.
Resident Trusts
In general, states tax trusts using many of the same principles that apply to individuals. For example, a "resident" trust is typically taxed on all of its undistributed income (i.e., income that is not reported by the beneficiaries); while a "nonresident" trust is only taxed on undistributed income sourced to a particular state. Most states use a combination of the following four "Trust Factors" to determine if a trust is a resident or nonresident:
- Grantor's state of residence (either at death or when the trust becomes irrevocable);
- Location of the trustees;
- Location of the beneficiaries; and
- Location of the trust assets.
Given the significant difference in tax cost of being a resident versus a nonresident trust, it is very important for trustees and advisors to understand how the Trust Factors apply to a specific set of facts. Depending on the circumstances, three out of the four Trust Factors (numbers 2, 3 and 4 above) can be changed after the trust has been established, potentially resulting in state tax savings. For example, Georgia considers a trust to be a "resident" if it is managed by an in-state trustee. Therefore, a trust can avoid paying Georgia income tax by simply changing the location of its trustees to a state that does not use the location of trustee rule.
Once a trust has been established, the one Trust Factor that cannot be changed is the grantor's state of residence. For example, Illinois considers a trust to be a resident if it is established under the will of an Illinois decedent. Once a trust is designated an Illinois resident, it will remain a resident of Illinois until the trust is terminated.
However, even in situations where a trust cannot change its state of residency, there may be an opportunity to minimize or eliminate a trust's state tax liability. For example, New Jersey considers a trust to be a resident if the grantor is a New Jersey resident at the time the trust becomes irrevocable. However, New Jersey tax law also provides that a resident trust cannot be taxed on its income if the trustees and trust assets are located outside the State and the trust has no New Jersey source income. We have seen many situations where a trust could have avoided paying significant state taxes simply by changing a Trust Factor that was not otherwise important to the trustee or beneficiaries (e.g., location of trust assets).
Finally, many trustees and advisors incorrectly assume that a nonresident trust (i.e., a trust that is not classified as a resident) does not incur state tax or is not required to file an income tax return in the nonresident state. In fact, most states require a trust to file and pay state tax, regardless of whether the trust is classified as a resident or nonresident, if the trust has income derived from the state. For example, a trust that is classified as a nonresident in New York would likely be required to file and pay tax on the rental income it receives from property located in the state.
Given the complexities involved with determining if a trust is required to file and pay state income tax, we strongly suggest that trustees and advisors consult with state tax experts when establishing a trust. Alternatively, even if a trust is already established, there still may be opportunities to minimize state taxes depending on the particular facts and circumstances.
David Seiden is a leading authority on state and local tax ("SALT") matters. He is a partner with the accounting and consulting firm Citrin Cooperman, where he leads the firm's SALT Practice. He can be reached at (914) 949-2990 or dseiden@citrincooperman.com.
Matt Stein is an associate in Citrin Cooperman's SALT practice. He can be reached at (914) 949-2990 or mstein@citrincooperman.com.
Citrin Cooperman is a full-service accounting and business consulting firm with offices in New York City; White Plains, NY; Norwalk, CT; Livingston, NJ; and Philadelphia.