With state income taxes on a constant increase, many taxpayers are looking for ways to protect themselves from double (federal and state) taxation. With the combination of federal and state income taxes, in states like California and New York, individuals could be subject to taxes as high as 50% to 60%. The same rates would apply to trusts and beneficiaries of trusts. One of the options gaining popularity is creating trusts in states that do not impose an income tax.
In a grantor trust, the individual who creates the trust maintains certain powers over the trust and continues to pay income tax on the assets of the trust. In the event that the trust becomes a non-grantor trust, i.e. the grantor relinquishes power over the trust, the tax responsibility will shift to the beneficiaries of the trust.
However, another option is available for grantors who wish to maintain some power and responsibility over the trust yet reduce or eliminate the burden of double taxation. The No State Income Tax trust (NSIT) offers the grantor the opportunity to maintain some power over the trust, which prevents the transfer to the trust from being treated like a completed gift, yet relieves the grantor of complete control, which changes the income tax treatment of the trust to non-grantor. (As an aside, don’t get bogged down with the name of this trust. We are simply using a descriptive name, and others have slapped various marketing terms on this type of trust. Names carry no substance.)
With an NSIT, the state income tax on the trust, especially for high tax states, can be reduced or completely avoided by establishing the trust as a separate taxpayer and moving the trust to a no-income-tax state such as Delaware, Florida, or Nevada.
By establishing the trust as a separate taxpayer in a no or low income-tax state, the grantor is no longer viewed as the owner of the trust and is no longer liable for the state income tax on the trust.
However, for this strategy to work, the grantor must make sure that the trust is recognized not only as a separate taxpayer but also as a resident of the desired state, and not a resident of the grantor’s home state. There are several factors that affect the recognition of a trust as a resident in the desired state.
- The residence of the grantor/trustee when the trust was created or became irrevocable
- Where the trust was administered
- Where the trust or the assets associated with the trust operate
Here is a common example of how the trusts may be used.
Jones is planning on selling his business in a few years for $20 million. Jones is a California taxpayer and has zero basis in the business. On the sale, he will have a California income tax liability of approximately $2.5 million. Assume that today, when the business is worth only $10 million, Jones sells the business to a non-grantor trust established by a family member in Delaware. The sale is for a promissory note and a down-payment, so the vast majority of the tax liability is deferred. The California tax liability on this sale is approximately $1.25 million and will be due when the promissory note is paid off. In a couple of years the business is sold for $20 million. The Delaware trust, as the new owner of the business, will be taxed on the gain on the sale (the difference between $20 million sale price and the trust’s purchase price of $10 million). No state income tax is due when the business is sold. Jones saved himself $1.25 million in state income taxes. As the assets of the trust continue to generate taxable income, that income will only be subject to the federal income tax, and not the state income tax.
Like most structures of this kind there are lots of nuances, and this type of planning does not work for everyone. If you are interested, call us and we can explore whether you too can be like Jones and avoid state income taxes.