It’s not uncommon for people who live in states with high income taxes to relocate to states with more favorable tax climates. Did you know that you can use a similar strategy for certain trusts? Indeed, if a trust is subject to high state income tax, you may be able to change its residence — or “situs” — to a state with low or no income taxes.
How different trust types are taxed
The taxation of a trust depends on the trust type. 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. Instead, 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.
Therefore, relocating a trust may offer a tax advantage 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 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 if the trust is movable
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 a trust in another state owns those assets.
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’s assets to a new trust in the destination state. A situs change may also require the consent of the trust’s beneficiaries or court approval.
For tax purposes, a final return should be filed in the current jurisdiction. The return should explain the reasons why the trust is no longer taxable in that state. Before taking action, discuss with us the pros and cons of moving your trust. We can help you determine whether it’s worth your while.
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