Similar to individuals, trusts normally pay federal and state income taxes. In 2018, the highest federal rate of 37 percent only applies to single individuals if they have more than $500,000 of income and to married couples filing jointly if they have more than $600,000 of income. However, a trust will be in the highest federal tax bracket if it has more than $12,500 of income. (The maximum long-term capital gains and qualified dividends rate is now 20 percent for trusts with more than $12,700 of income.)

The combination of this 37 percent tax and the 3.8 percent Net Investment Income Tax (on interest, dividends, rents, royalties, capital gains, and passive trade or business income) means that most trusts will effectively have rates of 40.8 percent for ordinary income and 23.8 percent for long-term capital gains. Therefore, federal taxes take a big bite out of the investment returns of trusts before even considering state income taxes.

Trusts are only taxed on ordinary income that is not distributed to a beneficiary. Distributed income passes out to the beneficiary on a K-1 and must be reported on the beneficiary's personal individual income tax return. Capital gains are almost always taxed to the trust, even if they are distributed to a beneficiary.

State income tax rates

There are seven states with no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Of the remaining states, the highest tax rate is California's 13.3 percent and the lowest is Pennsylvania's 3.07 percent.

State taxation of trust income

Unless a trust is a resident of the state, the state can only tax the trust on “source income” that is connected to the state (such as rental income from real estate located in the state or income from a business located in the state). An individual is deemed to be a resident of a state if he or she is domiciled in that state.

Trusts are more complicated. A state can tax a trust based on the location of the creator of the trust, the trustee and/or the beneficiary. If the trust is a resident of the state, then the state can tax all of the trust income, not just the income connected to the state. Each state has its own definition of what is a resident trust. Due to these different definitions, it is possible for a trust to fall within more than one state resident trust definition and be subject to state income taxes in multiple states. It is also possible for a trust to not be a resident trust of any state and thereby avoid paying any state income taxes.

For example, a trust will be an Illinois resident trust if the trust is created by an individual domiciled in Illinois (thereby subjecting the trust to Illinois taxes forever). A trust will be a Missouri resident trust if the trust was created by an individual domiciled in Missouri and the trust had at least one income beneficiary who was a resident of Missouri on the last day of the taxable year. Kansas only treats a trust as a resident if the trust is administered in Kansas.

States where you can avoid income taxes

In states such as Kansas you can avoid state income taxes by moving the location of the trustee and administration of the trust to another state. Other states with similar resident trust definitions are Arizona, Colorado, Hawaii, Idaho, Indiana, Kentucky, Louisiana, Massachusetts, Mississippi, Montana, New Jersey, New Mexico, Oregon, South Carolina, and Utah.

Therefore, if a trust is paying income taxes as a resident trust in one of these states, you may be able to avoid it with proper planning.

Incomplete Non-Grantor (ING) trusts

This same type of planning (avoiding a trust being treated as a state resident) can also be used to avoid state income taxes on an individual's income. This works by an individual transferring income-producing property to an irrevocable trust that is designed to avoid being a resident trust in all 50 states. In most cases, this planning also only works for individuals living in the states mentioned above.