QUARTERLY INSIGHTS FOR CLIENTS: Reducing California Income Tax on TrustsJuly 2014
The California Tax Problem
As many California residents know, we have the dubious distinction of living with the highest state income tax in the country. Our top marginal income tax rate reaches 13.3%, given the additional 1% tax on income over $1 million. The California income tax brackets that apply to irrevocable trusts are the same as those for single taxpayers. The result is that high tax brackets are reached with surprisingly modest trust income. For example, a 9.3% tax rate applies to taxable income between $49,774 and $254,249.
If the California income tax on accumulated income could be reduced or avoided altogether, this would reduce a significant drag on the trust’s investment performance. Over time, the trust investments would grow at a higher after-tax rate.
The Opportunity in Non-Tax States
Several different systems are used by the states to impose income tax on trusts. Some states have no income tax at all, some have no income tax on trusts, and some present the chance to design trusts to avoid their income tax. States without an income tax on trusts include Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Delaware is a popular state for trusts with no resident Delaware beneficiaries, since its state income tax does not apply to trust income set aside for non-Delaware beneficiaries.
Existing irrevocable trusts that pay California income tax on accumulated trust income may have the opportunity to move to a more favorable state in order to reduce or eliminate the California tax. Irrevocable trusts being created may be designed to avoid California income tax by establishing them in states without income tax. Irrevocable trusts to be established in the future, for example, a trust for children under one’s revocable living trust created when the revocable trust ends at death, can be formed in a non-tax state when that future date arrives.
What Kind of California Trusts Can Benefit?
To benefit, the trust must accumulate income for future distribution to a beneficiary, and not pay it out each year. This is because trust income paid to a beneficiary typically is taxed to the beneficiary in the state of the beneficiary’s residence. Most trusts provide that taxable capital gains are accumulated, and others may also accumulate ordinary income such as dividends, interest, rents and royalties. For example, an irrevocable trust created for children and grandchildren, where a trustee has discretion over how much income might be paid out to these beneficiaries, may be a candidate for a move to a non-tax state.
The revocable living trust used by Californians in their estate plans cannot benefit, as all trust income is taxed to the California resident who created the trust. The same rule applies to grantor retained annuity trusts (GRATs) created by Californians as a way to give future appreciation in an asset to family members. The income of these and other “grantor trusts” is never taxed to the trust itself, but always to the “grantor” who created the trust, in the state where the grantor lives.
With irrevocable non-grantor trusts, the residence of the trustee and the beneficiaries matters when seeking to avoid California trust income tax. California taxes accumulated trust income if the trustee is a California resident, or if the beneficiary is a California resident with a non-contingent interest in the trust (as described below). Also, even if there are no resident California trustees or beneficiaries, California taxes California “source income.” A common example of source income is rent or capital gain from California real estate held in an irrevocable trust.
Moving a Trust out of California
Irrevocable trusts with a California trustee that accumulate income for California beneficiaries have successfully been moved to non-tax states in order to escape future California income tax. This requires changing from a California trustee to a trustee resident in a non-tax state. While the new trustee could be an individual who resides in the non-tax state, most commonly the trustee is a bank or trust company incorporated and administering trusts in the non-tax state. Not surprisingly, there are many corporate trustees in Delaware, Nevada, South Dakota and other non-tax states who regularly take on trusts from other states.
In order to make a move, the trust must have provisions for the California trustee to resign, and provisions that allow appointing a trustee in a non-tax state. If there are no such provisions, it may be possible to make the move with the informed written consent of the person who created the trust and all the beneficiaries. Ultimately, a California probate court could be petitioned to allow the move, although that would involve additional time and expense.
California law taxing trusts based on the residence of the trustee has a few complexities. First, if there is more than one trustee, the income tax on accumulated trust income is prorated based on the number of California resident trustees. For example, if one trustee resides in Nevada and one in California, one-half of the accumulated trust income will be taxed in California. Second, the California statutes technically refer to the residence of the “fiduciary” rather than to the residence of the “trustee.” Some irrevocable trusts have “advisors” or “protectors” with roles more limited than a trustee’s, but they may still be treated as fiduciaries and California residence could be enough to trigger California income tax.
If the trust has more than one trustee, and eliminating the California trustee is not feasible, using one or more co-trustees resident in a non-tax state would save California tax on a prorata portion of the trust’s income. The same approach could be taken if it is critical to keep a California trust protector or advisor in place, who would then work with trustees who are residents of non-tax states.
Before moving an irrevocable trust to a non-tax state, the trust must be examined to see whether the interest of any California resident beneficiary is “non-contingent.” If a beneficiary has the right to take trust income at any time, the income would be taxed to the trust by California, even if the beneficiary declined to withdraw it. However, if income distributions can be made only by the trustee in the trustee’s discretion, or if income distributions are delayed until a future date dependent on some contingency, such as reaching a stated age, getting married, or finishing college, California should not be able to tax accumulated income until the contingency is met.
Some non-California trusts holding California real estate that produces taxable California source income have taken steps to avoid the tax. It may be possible to transfer the real estate into an entity such as an LLC or limited partnership, and convert the real estate into an “intangible” property interest. By so doing, the location of the real estate could be moved from California, since the location of an intangible asset is the same as the residence of the trustee. If the trustee is resident in a non-tax state, this could avoid the California tax on source income.
Planning a New Trust To Avoid California Tax
A factor to consider when creating a new irrevocable trust to benefit children, grandchildren or other beneficiaries is whether to avoid California tax on the trust’s income. If the trust will not pay out all income as it is earned, and particularly if there could be a large taxable capital gain in the future, this could be worth considering. For example, if the trustee is given discretion whether to pay out any income to trust beneficiaries, or if income is to be accumulated for a number of years until a beneficiary reaches a mature age such as 35 or 40, avoiding the annual California income tax can allow the trust to grow at a higher after tax rate. If a trust holds an asset with significant capital gain upside, such as a real estate project or stock in a company that may be acquired or go public, avoiding the loss of a significant part of the gain to tax could be important to the beneficiaries.
Such a trust can appoint a trustee resident in a non-tax state to handle the trust from inception. The interests of California resident beneficiaries can be designed to avoid classification as non-contingent interests. Entities might be created to hold California real estate or operating businesses to avoid the tax on California source income.
Even in the case of a trust that cannot avoid California tax because it is a grantor trust, the income of which is taxed to a resident Californian who created the trust, planning can be done to avoid California income tax in the future. It is common for new irrevocable “subtrusts” to be created under one’s revocable living trust upon the grantor’s death. These typically are for a spouse, children, grandchildren, or other beneficiaries. To the extent that these trusts will accumulate some or all trust income, there may be a savings worth preserving by naming a trustee in a non-tax state to handle those trusts in the future. An alternative is to allow the appointment of a trustee in a non-tax state at any future date if it is determined that state income tax (whether in California or some other state) can be saved.
A similar approach can be taken with a GRAT. If, as often happens, assets in the GRAT pass to an irrevocable trust for children when the GRAT terminates, that irrevocable trust can be designed to use a non-tax state resident trustee, beginning on the date that the GRAT ends and the assets pass to the trust for the children. Since the goal of a GRAT is often to pass on highly appreciated stock (or other assets), such use of a non-tax state trustee can produce significant savings of California capital gains tax on a future sale by the children’s trust of the stock received from the GRAT.
If you are the trustee or beneficiary of a trust that pays California income tax, feel free to get in touch to discuss whether your trust might be a candidate for a move to a non-tax state. You also may get in touch with us if you are considering a new trust, and want to discuss a trust design that could avoid California income tax. Finally, bear in mind that there are a number of non-tax factors to weigh in thinking about a non-California trust, including convenience for the beneficiaries, expertise of trustees in the new state, cost of trust administration, and how the new state defines the rights and obligations of beneficiaries and trustees.