Location, location, location, writes Lee Miller. Where a trustor lives and in which state a trust is considered resident can affect how an estate plan is carried out and can add (or save) serious tax liability. There are state law based choices that need to be made on an informed basis otherwise the best planning can be an expensive error.
State Income and Capital Gains Tax
Many states (all but eight) assess income tax on a trust's undistributed net income and realised capital gains. These taxes can add up but can often be avoided with careful planning. They are in addition to federal income and capital gains tax; state tax paid is deductible against federal income tax, but it is often a worthless deduction if the trust is subject to the Alternative Minimum Tax (AMT).
Basically, there are four factors on which a state may base its tax jurisdiction:
– Location of the trustor: residence of the grantor when the trust became irrevocable or domicile of the testator at death.
– Residence of the trustee.
– Where the trust is administered.
– Residence of a beneficiary.
The problem, and what can catch planners and families off guard, is that each state determines whether the trust is subject to state income tax based on differing combinations of these four factors. Also, they are not mutually exclusive and so it is possible for a trust to be taxed in more than one state. For a trust that is accumulating income or realising significant capital gains, it is a critical consideration.
The first factor is if the grantor of a trust was resident in that state when the trust became irrevocable or if the testator of a will creating a testamentary trust was domiciled in that state at death. For example, once a New York resident grantor dies leaving a trust with a New York resident trustee, his or her trust is forever subject to New York state income tax. For 2007, the rate was 6.85%.
Imagine that the trust has a concentrated stock position which the trustee must diversify according to the Prudent Investor Act. If the trustee sold $5 million worth of stock in 2007, with a tax basis of $3.00/share and a then market price of $80/share, the capital gain would have been $4,812,500 and the NY state income tax (in addition to federal income tax) would have been $329,650, paid from the trust.
The scenario gets worse when the family says to the trustee that they don't think they should have to pay this tax because no one in the family lives in New York and it is the presence of the trustee in New York that is causing the imposition of the tax.
This is the second ground for assessment of state income tax: residence of a trustee. This will be true whether the trustee is a life-long friend and trusted advisor who lives in New York or a New York trust company and not its Delaware affiliate, for example.
In California, it is almost the exact opposite. If the trustee is a California resident at any time, then the trust will become subject to California income tax on a pro-rated basis for the number of trustees who are resident, regardless of the residence of the trustor or beneficiaries.
I have frequently come across lawyers who drafted trusts for non-California clients naming California trustees who were not aware of the expense to which they were inadvertently subjecting the trust corpus.
Trust administration is the third ground on which a state may base tax jurisdiction and is the law in 15 states. Additional states tax a trust on this basis if there is another basis also present.
The fourth ground for state income tax of a trust is the residence of trust beneficiaries. This is less easy to control. But advisors to a family should be aware of which states assess state income tax dependent on there being resident beneficiaries in that state. At present, there are six that tax on this basis. We can't easily ask/tell a beneficiary to move before the trustee can diversify the portfolio, but it is important to know the facts.
State estate tax decoupling from the federal transfer tax system
It is not new news, but EGTRRA (the Economic Growth and Tax Relief Reconciliation Act of 2001) repealed the state death tax credit on the federal estate tax return. The repeal was gradual until fully eliminated in 2005. Previously, many states had (understandably) tied their state estate tax systems to the federal tax code and imposed a state estate tax equal to the federal credit (a "pick-up" tax). This essentially shared federal estate tax revenue with the states and didn't increase the total tax paid by the estate.
EGTRRA caused many states to completely lose their state estate tax due to this linkage. As a result, many states enacted legislation to "decouple" or un-tie the state estate tax from reference to federal law and to impose a separate state estate tax system. An estate can have both federal and state estate tax liability, depending on the decedent's domicile and the estate plan.
A wealthy testator may want to consider changing domicile in his/her older years to a state that does not have a state estate tax, and wills must be drafted with careful attention paid to both federal and state estate tax laws because they are likely not the same (not all states provide for QTIPs, for example) and a mis-match could result in unnecessary taxes being paid.
Oh yes, and EGTRRA is set to expire in 2011 and the estate tax exemption amount returned to pre-law levels of $1 million, unless new legislation is passed, so stay tuned.
Rule against perpetuities
State law determines how long a trust can last. This affects planning for a "dynasty trust" – a trust typically funded with the grantor's generation skipping transfer tax exemption. The rule against perpetuities states that a trust must vest within 21 years after lives in being at the time the trust was created. It is law in 28 states, abolished in 18, and is an extended period of years (150 to 1000) in five.
For example, South Dakota, New Hampshire, Delaware, Idaho, New Jersey and Rhode Island abolished the rule, and other states have provisions that suspend or make it inapplicable including but not limited to Alaska, Arizona, Idaho, Illinois, Maine, Maryland and Wyoming. Trust companies have been formed in several of these states – and especially in those that also do not have a state income tax – that can serve as trustee of a truly multi-generational dynasty trust that will be able to grow without the imposition of state income tax on its accumulated income and capital gains.
Investment delegation/directed trusts
The Prudent Investor Act codified a major shift in fiduciary investment law by allowing a trustee to delegate the investment function, following certain parameters. Only a limited number of states enacted this particular part of the Act, however, most notably Delaware, and South Dakota. Again, these are states with an active corporate trust industry.
To be clear, investment direction is different. This is where the trust is drafted giving a party other than the trustee the power to direct the trust's investments. The other party may be an investment committee, for example. The trustee is relieved of investment responsibility and liability. Generally, a trust that is not drafted to provide for an investment committee that directs investments, cannot just become one. It requires amendment, and the trust may or may not be amendable.
Notice requirements for trust beneficiaries
Disclosure requirements have broadened in recent years and most states have enacted legislation requiring a trustee to inform beneficiaries about the existence of a trust for their benefit and often other details about the trust as well. Often, notice requirements cannot be changed by the governing document.
Advisors can discuss at length all the benefits of financial education of children, but the simple fact of the matter is that many of the most open-minded and enlightened trustors, rightly or wrongly, don't want to tell his or her children or grandchildren "how much money they have" for fear of inhibiting drive and motivation, creating expectations, and unbalancing social relationships. At least, not when they are told to do so by state law! This may be a consideration for a trustor creating a dynasty trust, and so the state governing law designated in the governing instrument should be considered with regard to that state's notice statutes.
Courts, legislatures and friendly bars
It is certainly not the purpose of this article to recommend one state over another, but it can be important to know when preparing an estate plan whether a particular state is more (or less) familiar with and responsive to different planning tools, such as dynasty trusts, family limited partnerships or limited liability companies.
Also, some states have more onerous and costly probate procedures, some require periodic judicial trust accountings, and in some states it is harder to change trustee, change jurisdiction or decant a trust into another trust.
For generations, it had been the practice for wealthy families to establish trusts with a local trustee and provide that the law of their home state applied.
After reviewing the costs and possible limitations of this simple planning, it behooves families and their advisors today to consider establishing trusts in jurisdictions that will best accomplish their objectives and to consider the state tax consequences of the residence of each of the parties to a trust.