You have successfully moved into Florida’s rewarding tax structure. You have retired, sold your home and otherwise disassociated yourself from your former state. With this move, you have also left that state’s income tax behind you, right? Not necessarily.
If you established a trust as a grantor when you resided in another state, or your trustees or beneficiaries reside in another state, your trust may be pulled into that state and taxed as a resident trust. This depends on the individual states involved and the type of trust you created.
Grantor vs. Non-Grantor Trusts
If your trust is taxed as a “grantor trust,” you pay tax on its income until you are deceased or release grantor status. Therefore, the tax obligation is based on the grantor’s residence. A grantor who resides in Florida, which has no state income tax, would not be taxed at the state level for any non-business income the trust generates.
This is not the case for “non-grantor trusts,” which are taxed as separate entities. Generally, income will be taxed at the trust level if not distributed. Like individual taxpayers, resident trusts are taxed on income from every source, regardless of where the income is generated.
Therefore, the question becomes, “What state does the trust reside in?”
Beware of Worst-Case Scenarios
Each state is different in how they classify “resident trusts.” Grantors in certain states need to be particularly mindful of taxation rules that will affect their trusts even after moving to another state.
New York, for example, treats all non-grantor trusts created by residents as resident trusts. If you lived in New York when you created the trust, it is subject to the state’s income tax, even if you move out of state or change the trust’s legal situs.
California bases trust residency on the residence of the trustee and/or beneficiaries. Regardless of where you as the grantor resided when the trust was created or where you reside now, if the trustee or any non-contingent beneficiaries of your non-grantor trust are California residents, the trust is treated as a resident trust.
Given the wide variation of rules nationwide, it is conceivable that a trust could be subject to income tax in more than one state. For example, a New York resident creates a trust in New York and names a trustee in California. Income tax obligations in both states will remain with the trust even after the grantor moves.
A recent Supreme Court case decision (Kaestner) has challenged North Carolina on its definition of resident trust. This is moving in the right direction for change in certain state tax laws; however, Kaestner dealt with very specific issues and cannot be relied upon in all situations.
Strategies to Avoid Out-of-State Trust Income Tax
In addition to the warmer climate, affordable living and lifestyle changes, one of the greatest motivators for retiring to Florida is to save state income tax dollars on certain income.
Although you, as the grantor, are not personally liable for income tax on a non-grantor trust, your hard-earned wealth can be significantly reduced by taxes, especially given the higher trust tax rates. Fortunately, there are strategies to circumvent state rules and minimize the tax burden on your trust and heirs, including:
- Read between the lines. As with any tax law, do not take the state rules at face value without consulting your tax advisor. Some states offer safe harbors that provide relief for out-of-state taxpayers. For example, New York and New Jersey will waive the tax obligation for grantors who meet three criteria: (1) trustee is not a state resident; (2) trust earns no state-sourced income, and (3) trust does not own any “real property or tangible personal property” in the state. (Keep in mind that NY has a throwback tax on accumulated trust income when a distribution is made, which can also be minimized through strategic tax planning.)
- Reconsider your trustee. To use the loophole above or avoid taxation in a state that bases its rules on trustee residency, you will need to change your trustee to someone who lives in a more taxpayer-friendly state. Consider relatives, trusted advisors (e.g. attorney, accountant) or professional trustees in your new state.
- Get the timing right. If you have not yet created your non-grantor trust and are anticipating a move to Florida from a high-tax state, consider waiting until after your new residency has been established. Creating the trust under Florida’s rules will mean that no state income tax is imposed as the trust continues to grow, as long as your trustee is chosen strategically.
Trusts are created to maximize the wealth you transfer to your heirs. Before and after a move, review your trusts carefully with your estate planner to ensure no out-of-state tax obligations will keep you from reaching that goal to the fullest.
Lisa Rispoli, CPA, AEP, TEP is the Trust & Estate Services Leader at Grassi and a Partner in the firm’s Private Client Services Group. For more than 30 years, she has helped high-net-worth individuals reach their wealth preservation, gifting, tax savings and philanthropic goals. Lisa can be reached at firstname.lastname@example.org.
This article originally appeared in the January 3, 2021 issue of Palm Beach Daily News.