Insight on Estate Planning - June/July 2013: Shipping your trust over the state line to realize tax savings

by Adler Pollock & Sheehan P.C.

It’s not uncommon for families to relocate to another state to enjoy lower state income taxes. If trusts make up a big portion of your estate plan, and they’re subject to high state income taxes, you can institute a similar strategy. Thankfully, only your trusts need to cross state lines, not your entire family. Let’s take a closer look at how to change a trust’s residence, or “situs,” to a state with lower (or no) income taxes.

Trusts and taxes

The taxation of a trust depends on the type of trust. Revocable trusts and irrevocable “grantor” trusts — those over which the grantor retains enough control to be considered the owner for tax purposes — aren’t taxed at the trust level. Rather, trust income is included on the grantor’s tax return and taxed at the grantor’s personal income tax rate.

Irrevocable nongrantor trusts generally are subject to federal and state tax at the trust level on any undistributed ordinary income or capital gains, often at higher rates than personal income taxes. Income distributed to beneficiaries is deductible by the trust and taxable to beneficiaries.

Advantages of relocation

Relocating a trust may offer a tax advantage, therefore, if the trust is an irrevocable nongrantor trust, accumulates (rather than distributes) substantial amounts of ordinary income or capital gains, and can be moved to a state with low or no taxes on accumulated trust income.

There may also be other advantages to moving a trust. For example, the laws in some states allow you or the trustee to obtain greater protection against creditor claims, reduce the trust’s administrative expenses or create a “dynasty” trust that lasts for decades or even centuries.

Determining whether situs can be changed

For an irrevocable trust, the ability to change its situs depends on several factors, including the language of the trust document (does it authorize a change in situs?) and the laws of the current and destination states.

In determining a trust’s state of “residence” for tax purposes, states generally consider one or more of the following factors: the trust creator’s state of residence or domicile, the state in which the trust is administered (for example, the state where the trustees reside or where the trust’s records are maintained), and the state or states in which the trust’s beneficiaries reside.

Some states apply a formula based on these factors to tax a portion of the trust’s income. Also, some states tax all income derived from sources within their borders — such as businesses, real estate or other assets located in the state — even if those assets are owned by a trust in another state.

Depending on state law and the language of the trust document, moving a trust may involve appointing a replacement trustee in the new state and moving the trust’s assets and records to that state. In some cases it may be necessary to amend the trust document or to transfer the trust assets to a new trust in the destination state.

For tax purposes, a final return should be filed in the current jurisdiction. The return should explain the reasons that the trust is no longer taxable in that state.

Research the trust’s destination

If you reside in a state with high income taxes, the ability to move a trust to another state offers great flexibility. However, it’s important that you understand the tax and nontax consequences. Before taking action, discuss this strategy with your estate planning advisor.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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