Earlier this summer, the Supreme Court unanimously sided with a trust in its fight to reclaim more than $1.3 million in income taxes paid to North Carolina. Although the case likely will not have broader implications in other states, it serves as a reminder of the importance of state income tax planning when creating and administering trusts. With proper planning, these taxes can be minimized and, in some cases, even eliminated. In high-tax states like New York, where combined city and state income taxes are approximately 13%, this can mean significant savings, particularly when compounded over time.
As with individuals, whether or not a trust owes income tax to a state (and on what income) is determined by whether or not the trust is a resident of that state. Although there tend to be common factors that states use to determine if a trust is a resident (e.g., where the grantor (i.e., the creator) of an irrevocable trust is resident, where the trustees and/or beneficiaries are resident, and where the trust is administered), each state has its own rules and there is no uniform approach. When unaccounted for in the planning process, this lack of uniformity can result in a trust being resident in more than one state, leading to greater income tax exposure, not less. When accounted for, however, it can lead to opportunities. Depending on the circumstances, some or even all of these factors can be controlled, allowing the thoughtful practitioner either to “select” the state(s) where a trust will reside or to take advantage of income tax exemptions offered by states for resident trusts. The following example can help illustrate the point:
Jane, a New York resident, wants to create an irrevocable trust for her children that will own a portfolio of publicly traded securities. Under New York law, the trust will be a resident since Jane is a resident. If Jane selects a fellow New Yorker as trustee, the trust will pay New York income tax. If Jane selects a California resident as trustee, the trust will avoid New York income tax due to an exemption for resident trusts meeting certain criteria, including no New York trustees. However, a California resident trustee causes the trust to be subject to income tax there. If Jane instead selects as trustee a resident of Florida, a state which has no income tax, the trust would only pay Federal income tax.
Also, it is important to note that these opportunities are not present just at the time of a trust’s creation. Changes to existing trusts can often be implemented to reduce or eliminate state income tax.
With the current Federal gift and estate tax exemption of $11,400,000 per person ($22,800,000 per married couple), there is an opportunity to transfer significant wealth gift and estate tax free and there are many reasons to use a trust to do so. Minimizing or eliminating state income tax liability on trusts is an important component in preserving that wealth and knowledge of the complex and nuanced state residency rules is the key to doing so.