Mar 13 MY IRREVOCABLE TRUST HAS BEEN PAYING STATE INCOME TAX FOREVER. IS THERE ANY WAY TO AVOID STATE INCOME TAX?
State income taxes can be onerous. Rates can reach 14%+ and the effects of a high state income tax on trust income over years, or decades for long term trusts, can exact a significant toll on the growth of trust assets. Here are some resources that can help:
Join us on Thursday, March 16 at 4:00 pm for part two of the Estate Planning webinar series led by Martin Shenkman and Joy Matak. The discussion will include how to address the state income tax costs incurred by a non-grantor trust, and several strategies to handle its impact on asset protection, beneficiaries and charitable contributions through real life examples and proven results.
New York, New Jersey, California and other states are known for their high state income tax rates. While most of estate planning is focused on grantor trusts, where the settlor creating the trust (and sometimes another person deemed to be the grantor) is charged with paying the income taxes on trust income, many trusts start off as non-grantor or so-called complex trusts that pay their own income taxes. Further, every grantor trust will at some point become a non-grantor trust so that every trust will face the issues of paying state income tax at some point. A trust that might initially be formed as a grantor trust might change into a non-grantor trust by actions taken during the trust term. When the settlor of a grantor trust dies, that trust will be recharacterized as a non-grantor or complex trust.
As with so many areas of planning, addressing the state income tax costs incurred by a non-grantor trust should be addressed in a broad holistic manner. You cannot just focus on avoiding state income taxes in a vacuum as that may have other significant non-tax consequences. Also, it should be addressed in many cases from a wide angle lens as asset protection, impact on beneficiaries, which family bucket pays charitable contributions, etc. may all have bearing on the plan.
Perhaps one of the most important developments in recent years has become the malleability of irrevocable trusts. Not so long ago “irrevocable trusts” were described to those creating the trusts as if they were “carved in stone.” That was the concept of an irrevocable trust. But nowadays even irrevocable trusts might be modified. Not all the time and not in every way, but if the necessary modifications to a trust can be achieved that may facilitate a better state income tax result that years ago may not have been viewed as feasible. For example, a change in trustees, restructuring of trust property, decanting (merging) the existing trust into a new trust with new administrative provisions, changes in a trustee by a resignation and appointment of a new trustee outside of the high tax state, actions of the trust protector, etc., might enable a trust that had been subject to high state estate tax to minimize or avoid that tax. In some instances, no modification might be necessary, just a change in investments or distributions.
The take home point is that trustees who are paying high state income taxes should explore options to possibly mitigate that tax burden. Even if the decision is made not to make changes that might reduce state income taxes, communicating the reasoning and decision to beneficiaries might deflect a later challenge that the trustees did not properly manage the trust in a tax efficient manner. Documentation of having considered and rejected a course of action, even if not communicated to beneficiaries, may still prove protective of a trustee. The trust’s professional advisers should also be alert to this state tax issue. When CPAs prepare trust income tax returns, Forms 1041, they should consider the state income tax implications and at minimum perhaps include a short memorandum or letter to the trustee suggesting that post-tax season a meeting be scheduled to review the state income tax implications of the trust.
This article will explore many different aspects of this planning.