The situs is a key element in designing an irrevocable trust. For the purposes of this post, situs refers to the place of administration of a trust and the governing law of a trust for purposes of interpreting the provisions of a trust agreement. Tax attorneys who regularly deal in estate planning often choose to designate a trust’s situs in jurisdictions that offer maximum tax and asset protection and administrative flexibility. State laws must be considered when selecting the situs for a trust, as different states have different rules. Below are some factors to consider when determining where an irrevocable trust’s situs should be:
- Rule Against Perpetuities (Maximizing the Deferral). The common-law “Rule Against Perpetuities,” or “RAP,” limits the duration of trusts and is still applicable to trusts with a situs in several jurisdictions. Alternatively, several states have either abolished the RAP, provided for an opt-out from the RAP, or extended the maximum duration that a trust may exist. As “Dynasty trusts” (long-term trusts designed to benefit multiple generations) are often used in legacy planning, choosing a situs in a jurisdiction that has abolished or provides for an opt-out from the RAP may help facilitate wealth transfers to future generations.
- Asset Protection. To maximize asset protection for a trust beneficiary, trust terms may be designed to limit the beneficiary’s access to, and ability to direct, trust income and principal, particularly if the beneficiary also is a trustee of the trust. Additionally, a trust can include a “spendthrift” clause. A spendthrift clause is designed to limit or prevent access to trust assets by a beneficiary’s creditors, as long as the assets remain in the trust. This may enhance peace of mind for parents planning for their children who are in professions or occupations vulnerable to malpractice lawsuits (e.g., medical doctors, builders, attorneys, assisted-facility owners and operators, etc.) or for parents who are not confident in their children’s ability to manage their money responsibly, among other things. Some states have eroded the protection afforded by spendthrift clauses through laws providing exceptions for specified creditors (exception creditors).
- Ability to Modify (Decant) Trusts. Several states have enacted statutes allowing the modification or decanting of trusts, making it possible to respond to changes in circumstances. Modification or decanting may also be possible under the common law of a particular state. Decanting a trust involves paying its assets to another trust with more desirable terms. Where applicable law does not permit decanting, the governing law of the trust may be changed to that of a different jurisdiction that allows decanting. Decanting or modifying a trust may trigger adverse gift and income tax consequences and should be undertaken only after consulting with competent tax counsel.
- State Income Tax. For federal income-tax purposes, the income, gains, losses, deductions, and credits of the trust may be taxed to the trust itself as a separate taxpayer (a so-called nongrantor trust) or to the trust’s creator (settlor), or beneficiary (a so-called grantor trust). Most jurisdictions recognize grantor trusts for state income-tax purposes. For nongrantor trusts, state income taxation of the trust is often overlooked in choosing the situs of the trust. States that impose an income tax on trusts have their own rules to determine whether a trust is subject to tax in that state. State income-tax may be imposed based on: (a) where the trust is being administered; (b) where the beneficiaries reside; (c) where the trustee of the trust resides; and/or (d) the residence of the settlor of the trust. It is also possible for a trust to be subject to state income tax in more than one state. Settlors residing in a state imposing an income tax on trusts or considering appointing a trustee who lives in a state with state income taxes should consult with tax counsel to discuss how to minimize any potential state income tax exposure. In contrast, some states do not impose an income tax on trusts.
- Trustee Selection. The proper selection of trustees is important in choosing the situs of a trust. Trustee selection is also relevant to the status of a trust as a grantor or nongrantor trust for income-tax purposes. Substantial contact must exist between the trust and the selected situs as required by state law. Most state laws determine the situs of a trust based on (i) the location of the trustee, and (ii) the place of administration of the trust.