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Trust, but Verify Your Estate Tax Planning

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March 20, 2013

In the world of trust and estate administration, where tax planning typically involves special attention to federal tax law compliance, it’s easy to lose focus on state income taxation issues.

And while some states do not tax income related to trusts, states that do tax trust income have a variety of rules and criteria for which trusts are subject to tax.

Since CPAs can enter the picture both as trust advisors and as trustees, and as preparers of the trust income tax return, they need to be aware of what characteristics may result in a trust being subject to a state’s income tax, according to Christine Albright, a partner with Holland & Knight.

“Part of the problem we’re faced with is that the 51 jurisdictions that we’re dealing with don’t play by the same rules,” she said.

“Some have no income tax at all, some base their tax on where the person who created the trust resided at the time the trust was created or at the time it became irrevocable, others look to the state where the trust is being administered, or where a trustee resides, or where a beneficiary reside,” said Albright. “Depending on the answer to these types of questions, different states take the position that they have nexus over the trust, and if they have that, then they can tax some portion or all of the income.”

An example of the complexity of the issue is when a trustee changes residency to a different state, Albright noted. “In some situations a trustee’s move has the potential to trigger state income tax on the trust in the new state in which the trustee now resides,” she said. “But often the impact of such a move may not be understood and therefore go unreported for a number of years. This in turn could result not just in unpaid taxes, but the resulting interest and penalties.”

And things can change over time, creating a trap for the unwary, Albright observed. “For example, I live in Florida and set up a trust in Florida for my children, who also live in Florida. But I name my brother-in-law or best friend who happens to reside in Georgia, California, Arizona, Kentucky, New Mexico, North Dakota, Oregon or Virginia as the trustee. And based on the fact that the trustee lives in one of those states, all of a sudden the trust is subject to tax in one of those states.”

To complicate matters further, the state where a trust is taxable can move based on where the trustee resides, where the beneficiaries reside, or where the trust is administered. “There could be a trustee in Georgia and one in Arizona, and you may be taxed in both states,” she said. “The existence of a credit [for taxes paid to another state] is determined on a state by state basis, and very often, even with the credit, you might end up paying more than if you weren’t taxed in multiple states.”

Albright believes that many states are not aware that a trustee resides in the state, making the trust taxable in the state.

“How would, say, California or Arizona know that someone who moves to their state is a trustee?” she said. “The trustees don’t know they have to file, and the state has no reason to know.”

There could be a problem for successor trustees who take over for someone who rendered the trust liable for tax but did not file. “They have to understand that they may be getting the trust in further trouble with interest and penalties if they find out and do nothing,” she cautioned. “Clients, beneficiaries and trustees don’t stay where we put them. For accountants preparing income tax returns, every year, I worry whether they realize that a trustee might have retired and moved to Arizona.”

“Even with a small trust, if a beneficiary moves to the wrong state, it can trigger tax liability that the accountant just doesn’t think of,” she said. “They have blinders and are focused on their own state rules rather than tracking where all the other possible triggers are located.”

Albright recommends that a trustee should arrange for periodic reviews of the trust regarding various state income tax laws, and develop a system for tracking state requirements as well as other factors that could trigger state income taxes.

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