Q: Doug recently wrote me to ask, “is there anything I can do to ensure that my beneficiaries who reside in states with high state income tax rates avoid paying state income tax on my IRA/401k savings?
A: YES! Currently, some income-tax rates within many states ranged from the lowest top rate of 2.90% in North Dakota and 3.07% in Pennsylvania to the highest top rate of 9.90% in Oregon, 12.696% in New York City, and 13.3% in California. With proper planning, this tax may be minimized or eliminated in many instances. Conversely, without proper planning, the income of a trust might be subject to tax by more than one state.
Even where only one state is involved, trustees pay a good deal of state income taxes. For example, in 2014 (the latest year for which figures have been released), 59,685 resident fiduciaries paid $342,062,000 of New York income tax. Given that the rules for exempting trusts from taxation are straightforward, one wonders how much of that tax could have been avoided.
In many situations, the potential benefits of eliminating state income tax by trustees are clear. For example, if a non-grantor trust, which had a California trustee but no California beneficiaries, incurred a $1 million long-term capital gain, had no other income, and paid its California income tax by the end of the year, the trustee would have paid $108,775 of California income tax and $232,860 of federal income tax. However, if the trust had a non-California trustee, the trust would have owed $0 of state income tax and $236,514 of federal income tax—a difference of $105,121, or over 30% less!
Similarly, if a non-grantor trust, which was created by a New York City resident and was subject to New York State and City tax, incurred a $1 million long-term capital gain in 2019, had no other income, and paid its New York State and City income tax by year-end, the trustee would have owed $107,124 of New York State and New York City tax on December 29, 2019, and $232,922 of federal income tax on April 15, 2020. If the trust had been structured so that the New York taxes were not payable, however, the trustee would have owed no state or city tax and $236,514 of federal income tax—again, over 30% less.
Under the Internal Revenue Code of 1986 (‘‘IRC’’), state income tax was fully deductible for federal purposes in 2017, but the deduction was essentially worthless in the above examples, due to the alternative minimum tax (‘‘AMT’’). Even if the AMT did not apply, the state income-tax deduction would have been of limited value, because it was a deduction—not a credit—and because, in 2017, the maximum tax rate on long-term capital gains was 23.8%, therefore providing only a 23.8% federal tax offset for the state income taxes paid.
Federal vs. State Tax Savings.
The federal income tax brackets for trusts are more compressed than those for individuals. Hence, as a result of the regular income tax and the net investment income tax, trusts reached the top 43.4% bracket for short-term capital gains and ordinary income in 2017 at only $12,500 of taxable income, whereas single and joint filers didn’t do so until $418,400 and $470,700 of such income, respectively.
Similarly, in 2019, trusts reached the top 23.8% bracket for long-term capital gains and qualified dividends (the sources of income on which many trusts largely will be taxed) at just $12,500 of taxable income, but single and joint filers didn’t do so until the levels described in the preceding sentence.
In light of this increased disparity between the federal income taxation of trusts and individuals, attorneys and trustees are considering increasing distributions to beneficiaries and including capital gains in distributable net income (‘‘DNI’’) to take advantage of the beneficiaries’ lower tax burden. Federal income tax is only part of the picture, however, so that practitioners must analyze nontax and other tax factors as well. From a non-tax standpoint, advisers should evaluate the trust’s purposes, the loss of protection from creditor claims, and fairness among beneficiaries. From a tax standpoint, they should factor in potential federal transfer-tax and state death-tax costs, as well as the state income-tax impact on the beneficiaries.
And, the savings from structuring a trust to minimize state income tax as described in this article often can offset much—if not all—of the added federal tax costs. For example, if a non-grantor trust, which was created by a California resident but was not subject to California income tax because it had no California fiduciary or noncontingent beneficiary, incurred a $1 million long-term capital gain in 2019 and had no other income, the trustee would have owed $0 of California income tax on December 29, 2019, and $236,514 of federal income tax on April 15, 2020. Conversely, if the trustee distributed $1 million to a California resident beneficiary (who had no other income) in 2017, the West, a Thomson Reuters business 4 trustee caused the $1 million of long-term capital gain to be included in DNI, and the beneficiary paid the California income tax on the distribution by year-end, the beneficiary would have owed $108,255 of California income tax on December 29, 2017, and $203,788 of federal income tax on April 15, 2020. Thus, $108,255 of California income tax would have been incurred to achieve a $32,726 federal tax reduction, a $75,529 added tax cost.
In 2008, Professor Sitkoff of Harvard Law School and Professor Schanzenbach of Northwestern University School of Law reported that: In the timeframe of our data [1987-2003], seventeen states abolished the Rule [Against Perpetuities], implying that through 2003 roughly $100 billion—10% of total reported trust assets—moved as a result of the Rule’s abolition. In addition, our findings highlight the importance of state fiduciary income taxes. Abolishing states only experienced an increase in trust business if the state also did not levy an income tax on trust funds attracted from out of state.
The Risks of Inaction Are Real.
Attorneys who do not discuss the state income taxation of trusts with individual clients and trustees face potential malpractice claims for subjecting trusts to the needless expense. In addition, trustees in more than half the states have a statutory duty to ensure that trusts are placed in suitable jurisdictions. In the other states, that duty might exist under common law.
Implications of the 2017 Tax Act.
On December 22, 2017, President Trump signed An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for the Fiscal Year 2018, formerly known as the Tax Cuts and Jobs Act (the ‘‘2017 Tax Act’’). Passage of the 2017 Tax Act magnifies the importance of this series’s subject. This is because, among other things, that Act limits an individual’s deduction for state and local taxes to $10,000 per year. Structuring a non-grantor trust to eliminate the state income tax entirely can help an individual to preserve that deduction. In addition, given that the 2017 Tax Act increases the federal gift, estate, and GST tax exemptions to $11,180,000, far fewer individuals must concern themselves with federal transfer tax planning. Such individuals should analyze whether creating grantor trusts continues to make sense, or whether non-grantor trusts designed to minimize state income tax now are the preferable alternative.
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