Will Appointment of Trustee Cause Taxation of Trust in Their State?

 In Revocable Trusts
taxation of trust income

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Question:

The online trust services I have contacted (LegalZoom, Trust & Will) include standard recitations that the overseas grantor lives in a US state with no option not to select one. I could include one of the adult children of the grantor who lives in California as a co-trustee but I am concerned that this would subject the trust to California’s punitive taxes.

Does the domicile of the trustee matter for state tax purposes or am I concerned about a non-issue from a capital gain tax standpoint.

Response:

State taxation of trusts is extremely complicated in large part because each state has its own rules. They may or may not tax a trust based on the residence of the grantor, the residence of trustees, the residence of beneficiaries, or where the trust is administered. California, which you mention, taxes trusts based on the residence of beneficiaries, but this ground for taxation was recently challenged in a U.S. Supreme Court case. Here’s a comprehensive article on state taxation of trusts: https://www.thetaxadviser.com/issues/2021/may/trust-state-tax.html.

But all this said, taxation of trusts is usually is not a huge concern. Revocable trusts are taxed to the grantor and do not have to file tax returns. Irrevocable trusts (and revocable trusts become irrevocable upon the death of the grantor) must obtain their own tax identification numbers and file 1041 tax returns. However, they may deduct income distributed to beneficiaries, passing it on to the beneficiaries, to whom they issue K-1s reporting the income. The IRS calls this “distributable net income” or “DNI.”

Capital gains, which you specifically ask about, are treated differently and are usually taxed to the trust. However, they may also pass through to the beneficiaries “to the extent they are, pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of discretion by the” trustee, to quote the governing regulation. In other words, the trust can trump the presumption that capital gains will be taxed to the trust. Many trusts contain provisions empowering the trust to make reasonable allocations between income and principal, which should allow them to determine whether capital gain should be treated as distributable income for tax purposes.

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