Calvetti Ferguson

Decisions, Decisions – The Impact of State Tax Rules on Trusts and Estates

Decisions, Decisions – The Impact of State Tax Rules on Trusts and Estates

Texas taxpayers dealing with trusts need to be aware of fact patterns that can sneak up and surprise them in negative ways. This word of caution applies to certain other states that, similar to Texas, are tax friendly to trusts. Such fact patterns can materialize, over time, even when thoughtful pre-planning has taken place.

Trusts can be exceptionally effective tools for managing, protecting and distributing a family’s financial legacy. The settlor/grantor (the one setting up the trust) faces many decisions. For instance, who will serve as the trustee, what distribution rules the trustee must follow, and many more. State taxation rules can further complicate those decisions in matters ranging from establishing a trust to managing its operations in the future.

Non-grantor Trusts
Texas and seven other states do not tax trusts on their income. All 42 other states have varying rules regarding when a non-grantor trust must file a tax return and pay taxes. A non-grantor trust is one where the trust itself, rather than the settlor/grantor, is responsible for paying income tax on the trust’s taxable income. These rules can result in unexpected, negative tax consequences, especially with state income tax rates on trusts reaching levels as high as 13.3%.

The rules differ greatly from state to state. Several states only tax trusts administered in their state. Others add requirements that a trustee or beneficiary be a state resident. Others will tax any trust set up by a resident of that state or by a resident’s will regardless of the beneficiaries’ state(s) of residence. Yet, others require a state resident trustee in order for tax to apply. Iowa bases taxation on the “relevant facts of each case” requiring detailed reading of their rules. This brings us to California.

California
The state of California requires apportionment of a trust’s income to the state if a trustee or non-contingent beneficiary is a California resident. Calvetti Ferguson has seen California require tax filings/tax payments from out of state/non-California trustees. It appears likely that such trustees were identified through the information exchange program with the IRS. These rules can result in unanticipated and painful consequences as illustrated by the following examples.

Example 1: A mother, who is a Texas resident, establishes a trust that will be administered by a Texas-based trustee. The sole beneficiary is her son who is also a Texas resident. When her son moves to California, the Texas trustee must begin filing California trust returns and paying taxes based on the state’s apportionment rules.

Example 2: Assume the same facts as above. However, the son stays living in Texas. The Texas-based trustee dies and the successor trustee is the son’s uncle. The twist is that the uncle happens to live in California. You may have guessed the result at this point. Similar to Example 1 above, California will tax the trust based on its apportioned income.

In both examples above, the trusts were established thoughtfully and with expectations that no state income taxes would be paid; nonetheless, the facts changed and suddenly the trusts were paying California income taxes. One potential solution to this dilemma can come from allowing for replacement of the trustee when deemed necessary and beneficial. For instance, if the trust gives the son the power to replace the trustee, he could exercise such power, replace the trustee with one in a different state, like Texas, and successfully remove the trust from California’s tax reach.

Summary
Careful consideration of potential state tax implications, during the drafting of trust agreements and wills, can provide future flexibility to make favorable changes should the need ever arise. Where trusts currently exist without such flexibility, the trustee may consider decanting the trust into a new trust in order to bring about needed changes. Decanting is a topic we will save for another day.

Jim Oliver, Partner

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If you have questions about managing, protecting, and distributing your financial legacy; please contact Jim Oliver who can assist you with the answers and advice you need.