Sometimes people try to settle their financial matters themselves before passing away. Although this do-it-yourself estate planning is performed dutifully and with the best of intentions, it may actually lead to complications for the fiduciaries or beneficiaries later if not done right. One major cause for concern is where to establish trusts, because each state treats fiduciary income taxes on certain trusts differently.
In general, most states incorporate federal rules when taxing trust income, which taxes either the grantor or beneficiary depending on the type of trust. Certain trusts controlled by fiduciaries or trustees, also called nongrantor trusts, do not distribute ordinary income earned or capital gains realized. For tax purposes, these trusts are considered standalone taxable entities and are subject to both federal and state fiduciary income taxes. If set up incorrectly or without consideration, however, a trust could be taxed under multiple state fiduciary income tax laws.
To ensure that people look before leaping and avoid establishing a trust in a state that may have strict or severe fiduciary income tax laws, they should consider setting up a trust in another state with no fiduciary income tax, reviewing the facts that the tax law may apply to and looking at states with lower fiduciary income tax rates.
Only seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) do not tax trust income. In all other states, income earned from trusts is subject to taxation. Most state income taxes are triggered by resident trusts like testamentary or inter vivos trusts, which are trusts that may be subject to a particular state’s laws because a testator or grantor lives in a state at the time of death, trust property is located in a state, the trustee or beneficiary lives in a state or a trust’s administration occurs in a state.
A state may use fixed facts to apply to a trust and make it subject to fiduciary income tax. Some states tax testamentary trusts established by a state resident’s will or inter vivos trusts set up by grantors who were state residents at the time of creation. For other states, a trust’s interest and dividends are the basis for fiduciary income taxes. States may also use one or more criteria to ensure a trust’s income is taxed. Virginia applies a rate of almost six percent to any trust “created by a Virginia resident, established under the will of a Virginia decedent or administered in Virginia.” This makes it difficult for any trust to escape fiduciary income tax.
Some states have lower fiduciary income tax rates, which make them important to consider before establishing trusts. The tax rates for both Illinois and Pennsylvania are around three percent, which makes them advantageous destinations for preserving more principal for beneficiaries to receive in payouts.
When it comes to establishing trusts, it pays to look before leaping. If you are thinking about creating a trust in your state, you should contact an experienced estate planning lawyer for advice about which state’s fiduciary income tax laws would be best for the type of trust you want to set up. Trusts can provide income and stability for your loved ones after you are gone, so make sure you consult an attorney to ensure your trust will do this in the most efficient and effective way possible for all involved.
Source: ALI “Planning Techniques For Large Estates,”