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Trust and estate issues are always complex. While fiduciary and individual income tax matters in the past have generally been dissimilar, the new tax law compounds the differences.
In contrast to individuals, trusts and estates can still claim certain deductions between now and 2025 that will save on taxes. At the state level, trusts and estates remain subject to the same ongoing rules, but here, too, proactive planning can still pay off.
A review of old and new fiduciary income tax laws is essential to maximize savings on both the federal and state levels. Here’s a rundown.
Miscellaneous Itemized Deductions
Much has been written about the tax law’s elimination of miscellaneous itemized deductions for individuals. Yet trusts and estates can still deduct many fees, dollar for dollar, against their income.
As with individuals, the main exception is investment advisory fees. Many other professional fees tied to trusts (e.g., trustee commissions and legal or accounting fees) still qualify for a deduction, and without having to exceed the 2% adjusted gross income floor that previously governed individual income tax.
To ensure they take advantage of these tax savings, trusts and estates should closely monitor how invoices for professional services are prepared. At the outset, they should separate and pay invoices through the trust.
Bundled fees are a common trap where trusts and estates rely on institutional trustees, who typically charge a single fee.
Costs associated with fiduciary fees and tax preparation services are fully deductible, but investment advisory services are not. Unbundling these fees will help ensure a trust deducts the fees it can rightfully claim.
Trust Definitions Vary by State
State definitions of a resident trust vary widely, and that can present some traps.
Some state definitions are based on the trustee’s location, others on that of the grantor (e.g., creator of the trust) or of the beneficiary. This lack of uniformity could lead a trust to be simultaneously taxed as a resident of two separate states. On the other hand, it’s also possible for a trust to not be taxed as a resident in any state and avoid a state level income tax altogether.
Before establishing a trust, consider the respective locations of the trust, the trustee, and the beneficiary or beneficiaries. The potential to reduce or avoid state income tax on an annual basis could yield far greater tax savings than the one-time cost of professional services needed to determine the optimal arrangement to reduce or eliminate potential state income tax imposed on the trust.
Let’s say that a trust was formed by an individual in Florida. The state defines the income tax residence of a trust by referring to the trustee’s location. Perhaps the trustees, for their part, are located in New York. New York, meanwhile, generally defines the residency of a trust by the location of the grantor at the time he/she formed the trust. In this particular example, because of varying state laws defining the residency of a trust, the income of the trust, where tied to intangibles, is sheltered from state taxes. Notably, income from intangible assets (such as real estate) will be taxed by the state in which the real estate is situated, regardless of the location of the grantor, trustee or beneficiary.
Limited Escape for State Trust Residency
There’s another reason to review the location of various parties to a trust at the outset. Being able to later change a trust’s state income tax profile is not a given.
While an individual taxpayer can relocate and cause a change in his/her state of residence for income tax purposes, the same is not always true for a trust. For example, New Jersey and New York both stipulate that if a grantor creates a trust as a state resident, then relocates to Florida, the trust will remain a resident of state in which the grantor resided before he/she relocated to Florida.
There may also be favorable rules when a trust generates income solely from intangibles. For instance, New York law provides for an Exempt Resident Trust; a resident trust with no assets or trustee physically located in the state, and no income sourced to the state, will not be taxed. Naming a trustee who’s not a New York resident is important. So is reviewing the trust’s income sources.
A trust cannot take advantage of this statutory exception where it has even $1 of New York source income from physical assets such as in-state real property. Trusts can avoid this trap by separating into two trusts—one to hold real property, the other to hold brokerage accounts.
If a trust with real estate is created, there’s a further trap to avoid. Like individuals, trusts with real estate face the $10,000 federal cap on the state income tax deduction. While some tax practitioners suggest splitting these trusts into smaller entities to maximize the $10,000 limit, this workaround is costly and potentially impractical, especially given the law’s expiration in 2025.
Look for Fiduciary Experience
As these issues illustrate, trusts and estates face unique challenges and opportunities. Unlike a pass-through entity, which flows income to the partners or shareholders, a trust faces its own rules and exceptions that could leave it and the beneficiary on the hook for taxes.
A trust may pay all the tax in one year, for instance, or the beneficiary may assume the obligation, or they may share the responsibility, depending on the level of distributions from the trust to the beneficiary.
In all cases, hiring a professional based solely on cost considerations may be tempting, yet potentially shortsighted. Because the beneficiary holds the right to sue a trustee who may not have taken steps to minimize tax exposure or otherwise has not acted in the beneficiary’s best interest, the trustee should exercise particular care in the selection of an adviser.
Start by reviewing an adviser’s knowledge of fiduciary matters. The right adviser will focus on trusts and estates on a regular, continual basis. This experience maximizes the chances of tax savings for any trust or estate—minus the traps.