Trust Situs

When the tax season comes around, you will often see people crossing their fingers and whispering a silent prayer that they will receive a refund. The sad truth is few are doing so.

We can all relate to the feeling though. The tax code (and IRS customer service) are intimidating, so most people leave the status of their taxes up to luck.

No one can deny the immense relief that comes when you save on taxes. Though the intimidation may always linger, some simple planning can both increase your tax savings and return your fingers to a nimbler state.

That’s right, no more crossing your fingers hoping for the best. Don’t rely on luck when it comes to your financial future.

State income tax is one of the most demanding and invasive taxes (the State of New York imposes an income tax rate of up to 8.82%, California is 13.3%).

However, it’s good to remember that the higher the tax rate, the higher your savings could be.

An effective method of saving on state income taxes is placing your income in a trust.

There are various types of trusts and they are each used for vastly different purposes. If you want to save on state income taxes, you should consider setting up what the IRS refers to as a “non-grantor trust.”

A “non-grantor trust” is irrevocable, which means the terms of the trust agreement cannot be amended and the trust itself cannot be revoked. Basically, once you’re in, there’s no going back.

Unlike a grantor trust, which directs all state income taxes to the creator of the trust, a non-grantor trust is taxed directly.

If any assets of the non-grantor trust are distributed to the named beneficiaries than the beneficiaries must pay taxes on the distributions they receive.

The “situs” of a trust typically determines the tax jurisdiction of a trust. For example, though you may reside in New York, you can create a trust with a situs in Alaska. Alaska does not impose any state income tax, so any proceeds received by the trust would be exempt from state income tax.

Pretty cool, I know.

Be sure to review the income tax laws of any relevant states with your tax advisor. If you reside in New York and set up a non-grantor trust in Alaska to store the income you receive from California, you should read up on the income tax laws for all three states.

Make sure you’re knowledgeable as to what every states’ laws include. Though the income is not residing within the jurisdiction of California or New York, these states may still consider themselves parties to the transaction.

Some estate planners are wary about creating a trust with a situs that’s outside of the creator’s home state. The fear is there could be unanticipated expenses and complications.

However, the process is typically quite simple.

The situs of a trust is determined by the residence of the trustee. Though you may have a reliable trustee that is local to you, you can easily appoint a co-trustee that resides in a different state.

This co-trustee, likely a trust company or bank, can have limited responsibilities and primarily serve as a jurisdictional trustee. A trust company or bank will often charge a minimal fee for their services because their roles and responsibilities are minimal.

Remember how I said an irrevocable trust cannot be revoked? You may be wondering if it is possible to alter the situs of a trust you already have in place. I’m here to tell you in this day and age, anything is possible!

Here’s what you got to do:

  1. Make sure you review the terms of your trust agreement. There may be a clause that allows the trustee to amend the jurisdiction of the trust.
  2. If no such clause is found, the trustee can “decant” the trust and place all of the assets in a new trust within your preferred jurisdiction.
  3. A final option is to petition the local court that has governance over the trust for a change of situs.

Though the federal income tax brackets for a non-grantor trust are compressed, this can provide an advantage when distributing the assets to the named beneficiaries. Particularly if a wealthy relative is providing financial assistance to a young family member.

The reason being is because the young family member is almost certainly in a lower income tax bracket than both the trust and their wealthy relative and the distributions the young family member receives from the non-grantor trust will be taxed at a lower rate.

As we’ve stated, there are various types of trusts. Charitable trusts can provide a similar defense against state income taxes, but the timeline of the distributions and the structure of the trust agreement bears some differences to a non-grantor trust.

“Charitable trusts” are typically structured as “split interest-trusts”. Half of the assets within the trust are distributed to a charity and the remaining proceeds are distributed to the named beneficiaries.

The trust agreement will specify a time period identifying how long the trust shall exist.

During the trust’s existence, either the charity or the named beneficiaries shall receive an income interest. Once the time period has come to a close and the trust has effectively expired, the remaining interest shall be given to the party that did not receive interest during the trust’s term.

It is up to the discretion of the trust creator to determine the intervals of these distributions

If the assets within the trust were to grow in value and the creator decided to sell those assets, the trust would be considered the recipient of the additional income. Charitable trusts are not typically subject to an income tax, so the entirety of the profits would be kept safe within the trust.

Make sure you speak with your estate planner when constructing your charitable trust. This way you can ensure the IRS will deem the trust as qualifying for an exclusion from income taxes.

Do not let intimidation be the voice in your head. There are tax saving opportunities right under your nose! Some simple planning and you will no longer wonder if you will save money on taxes this year. You will be saving money on taxes every year.