In an environment in which states are continuously searching for methods of increasing tax revenues, a major consideration for any settlor, beneficiary or trustee of a trust should be where the trust might be subject to income tax. The days of a trust being taxed in the state where it has its “principal place of administration” are quickly fading, as we enter into a new era in which states are increasing attempting to tax trusts with minimal contacts to the jurisdiction.
In fact, because the laws related to taxation of trusts vary so widely from state to state, a single trust could end up being subject to income tax in multiple jurisdictions—almost certainly not the intent of the settlor, the trustees, or the beneficiaries. It may be possible to get a credit in one state for tax payable in another state, but that will not always be the case. On the flip side, if the settlor, trustees and/or beneficiaries plan properly in advance, it may be possible for a trust to avoid being subject to state income tax entirely. That is possible because Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming do not impose an income tax. If a trust can establish or move its situs to a state with no income tax while also avoiding income tax triggers in the 43 other states that do impose a tax, the trust may be able to create significant savings.
There are a number of criteria that states currently use to determine when a trust will be subject to income tax in that jurisdiction. Nearly every state with an income tax will tax income derived from activities being carried out in that state (state-source income). However, state-source income will not cause the entire trust income to be taxable in that state. Any one or more of the following are “activities” of a trust could cause its entire income to be subject to tax in a given state: 1) the testator of a will creating a trust lived in the state at the time of death, 2) the settlor of a lifetime trust lived in the state at the time of creation of the trust, 3) the trust is administered in the state, 4) one or more trustees live in or do business in the state, and/or 5) one or more beneficiaries live in the state.
For instance, in California, having just one trustee or beneficiary who resides in the state can subject the trust income to tax in a proportion equal to the number of trustees and/or beneficiaries who are California residents, based on an allocation formula designed by the state taxing authority. A number of other states will also attempt to tax trusts based on one or more trustees residing there. Thus, if a trust has a settlor who resided in one state when the trust became irrevocable and three trustees and three beneficiaries all residing in other states that tax on the basis of trustee/beneficiary residency, the trust could potentially be subject to income tax in seven different states. California in particular has begun aggressively pursuing trusts with contacts in the state for failure to file income tax returns.
Therefore, if a trust has earned any income during the taxable year, it is crucial to analyze the laws in all states to which the trust has a “nexus” before deciding where fiduciary income tax returns are required to be filed, and perhaps more importantly, to determine how the “activities” of the trust can be changed to limit or avoid taxation. Better yet, for new trusts, if the settlor takes these considerations into account in advance, the trust itself can be drafted with the flexibility not only to limit or avoid tax liability now but to respond in the future to the changing landscape of fiduciary income taxation.
Of course, if the trust is subject to tax in a given state on the basis that the testator of the will creating the trust resided there upon his or her death, there is little that can be done to remedy the tax result, short of mounting a constitutional challenge to the income tax statute. Likewise, it may also be difficult to avoid an income tax that is imposed by virtue of a beneficiary living in a given state, unless the state taxes the trust only if the beneficiary is a noncontingent beneficiary (such as California) in which case, the trust may, depending on state law, be able to be modified in some way to convert noncontingent beneficiaries to contingent beneficiaries.
Perhaps the easiest income tax triggering situation to remedy is the taxation of a trust based upon the residence of a trustee. A trustee can usually simply resign as trustee of the trust and the tax problem will be avoided. If the trust instrument allows it, the resigning trustee may even be able to appoint his or her successor, which could be an individual or corporate trustee. Alternatively, in some instances, the taxation of a trust based on trustee residency can even be alleviated by appointing additional individual trustees. This will be the case in states where a trust is taxed only when a majority of the trustees are residents of the state. Delaware is an example of a state that taxes trusts based on such criteria. Likewise, if a trust is subject to tax based upon its principal place of administration, the trustees may be able to move the situs of the trust to a state with more favorable tax laws, particularly if the trust was drafted with flexibility in that regard.
The bottom line is that an accurate assessment of the potential state income tax liability of a trust requires a detailed analysis of the laws of the various states in which the settlor(s), beneficiary(ies) and trustee(s) reside or with which the trust otherwise has contacts. However, with some advance planning, that analysis can be undertaken and resolved before any adverse tax consequences accrue to the trust, potentially saving the trust an unexpected bill when tax time rolls around.