State Income Taxation of Trusts: How to Navigate the Maze
May 17, 2017
By: Edward B. Becker
The federal income tax brackets for nongrantor trusts are markedly compressed as compared to those that apply to individuals. The top marginal rate of 39.6% applies to trusts upon reaching $12,500 in taxable income. The net investment income tax (3.8%) is imposed on the lesser of net investment income or taxable income above the $12,500 threshold. Finally, the top rate of 20% for net long-term capital gains and qualified dividends goes into effect when a trust's taxable income exceeds $12,500. In addition, trusts may also face taxation at the state level, where tax rates sometimes reach double digits. Fortunately, with the right planning, opportunities may be available to reduce or eliminate the tax burden levied at the state level.
Trusts can be classified for income tax purposes as either a grantor trust or nongrantor trust. Taxes are of no independent consequence to grantor trusts as all income tax items (gains, losses, deductions, credits, etc.) are reportable on the grantor's personal income tax return. With nongrantor trusts, taxes can be of great independent significance as all of its accumulated income (income not distributed to beneficiaries) is taxed at the trust level. States may tax nongrantor trusts on (i) accumulated income that is generated from source income (i.e., real estate or business activities located in that state); and (ii) nonsource income such as interest, dividends or gains on intangible property. The taxation of nonsource income by a state typically hinges upon whether that state deems a trust to be a resident trust or a nonresident trust.
The factors that states use to determine trust residency include one or more of the following factors:
· the residence of the grantor when the trust is formed;
· if the trust is established under a Will, the residence of the decedent at death;
· the residence of the trustee(s) and other fiduciaries;
· the residence of the trust beneficiaries; and
· the state in which the trust is administered.
The relevant factors that classify a trust as a resident trust vary from state to state. In most states a combination of factors is typically required. The states that rely solely on the grantor's residence at the time the trust was created continue to invite challenges to this method under the Due Process and Commerce clauses of the U.S. Constitution. Thus far, lower courts have reached differing conclusions and the U.S. Supreme Court has yet to directly address the issue.
Tax planning may not be of singular importance when a trust is setup. State creditor protection laws, perpetual trust provisions and investment rules typically have some role to play for many clients establishing trusts. Nevertheless, given the lack of uniformity at the state level, planning professionals, fiduciaries, as well as those that utilize their services, should, and may even have a duty to, investigate opportunities to alleviate a trust's state income tax burden. If you would like to explore such opportunities, please contact one of our attorneys.