Tuesday, July 29, 2014

Trusts and Taxes

Taxation on trusts warrants consideration. Trust income is subject to income taxation at one of two levels: 1) at the trust level if the income is retained in the trust, or 2) at the individual level if the income is distributed from the trust to the individual trust beneficiary. Since trust income is taxed at the maximum federal tax rate at relatively low levels of Income (39.6% at $11,950 in 2013), income is usually distributed to individual beneficiaries. 

 
Texas does not have a state income tax at this time; therefore, federal income tax rules are the primary consideration for Texas trusts. That is not the case everywhere. It is no secret that some individual states are facing significant challenges in financing their state operations. Those states are frequently turning to trusts for tax revenues.

 
The first consideration is state income taxes on trust income. Forty three states have a state income tax and thus tax income the trust earns. Seven (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) do not have state income taxes. The old rule was taxation by the state in which a trust has its “principal place of administration.” States are now attempting to tax trusts when there are other, minimal jurisdictional contacts.

 
In almost all cases, income earned by the trust in the state is taxed according to the state income tax rates. Income earned outside the state is not taxed at the state level. However, there are more attempts to tax the entire trust income at the state rate if some jurisdictional conditions apply. Some of these conditions include the following:

  1. The deceased creator of the trust lived in the state at the time of death.
  2. The grantor of a lifetime trust lived in the state at the time the trust was created.
  3. The trust was administered according to the state’s trust laws.
  4. One of the trustees lives or does business in the state.
  5. One of the beneficiaries of the trust lives in the state.
Thus, consider a trust that became irrevocable under the following conditions:
  1. The grantor lived in one state when the trust became irrevocable.
  2. Two individual trustees reside in separate states from the grantor’s state.
  3. Two trust beneficiaries reside in two separate, different states.
The trust could then be subject to state income taxes in five different states; the amount subject to state taxation could vary depending on allocation methods used by the state’s taxing authority.

Trusts created in Texas, administered in Texas, with Texas trustees and beneficiaries face federal taxation problems. However, with an increasingly mobile population, a review of wills creating trusts and existing trusts warrant a review of conditions.

We, at Paragon Financial Advisors, assist our clients in reviewing their estate/trust planning.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.



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