Using Trusts to Minimize your State Tax Burden

John McCabe, Senior Trust Officer, First Republic Trust Company of Delaware LLC

Don’t Forget about State Taxes When Planning for the Future

Federal taxes receive the lion’s share of attention from the mainstream and financial press. During the past year, that attention has been particularly acute due to changes in the tax rates for income and capital gains (on high-income taxpayers) as well as gift, estate and generation-skipping transfers; a new net investment income tax; and an increase in the Medicare tax on wages above set thresholds. By focusing only on federal taxes, however, you may miss out on ways to reduce state tax liabilities. One tool that can be helpful in state tax planning, a trust, may offer the
opportunity for significant state tax savings.

One tool that can be helpful in state tax planning, a trust, may offer the opportunity for significant state tax savings.

State Taxes: The Current Landscape

Awareness of the impact of state taxes on wealth planning has grown steadily as state tax rates have risen, sometimes substantially. Consider California, where the current income tax rate for the highest bracket is 13.3%. In New York City, the combined city and state top income tax rate is almost 12.7%. Oregon taxpayers face a top income tax rate of almost 10%.

State income taxes are just one part of the state tax picture; state estate taxes also must be considered. Certain states, such as New York, Connecticut and Oregon, have estate tax filing thresholds ($1 million, $2 million and $1 million, respectively) that are lower than the federal estate tax exemption amount (currently $5.25 million). In states such as these, an estate may be subject to state estate tax even in situations where no federal estate tax would be due.

Use of Trusts: State Income Tax Planning

High state tax rates raise an important question: What can a resident of a high-tax state do to minimize the impact of state income taxes on investment income? For some, the answer may be to set up a trust in such a way that it is not subject to state income tax. The structure required to avoid state income tax on the trust’s income varies from state to state and depends on how that state taxes trust income. The varied approaches adopted by the 50 state legislatures and revenue authorities have not made this type of planning simple. Nonetheless, in certain states there are fairly clear methods for saving state income tax on trust income. With certain trust structures, it is a matter of establishing the trust in a state that does not impose a tax on trust income. Delaware is such a state, provided the trust does not have Delaware resident beneficiaries.
To put this in context, consider the following hypothetical situation involving the sale of a stock:

  • Sale Proceeds: $2 million
  • Tax (Cost) Basis: $200,000
  • Capital Gain: $1.8 million

A California taxpayer in the highest tax bracket would owe $239,400 in taxes on this transaction. Under certain circumstances, in a properly structured trust, this same transaction would result in no California (or any other state) income tax.

Use of Trusts: State Estate Tax Planning

In addition to reducing the state income tax burden, trusts also can be used to reduce state estate taxes. Certain types of trusts can be structured so the assets are not included in a decedent’s taxable estate for estate tax purposes. With proper guidance and administration, a trust can help
reduce overall wealth transfer taxes, both for current and future generations.

These types of tax savings are not available in all situations. As an initial consideration, the settlor must be willing to transfer the property to an irrevocable trust.

When planning for state tax savings, it is essential to keep in mind how the strategy fits in with your overall financial and estate plan. Frequently, state tax considerations can be incorporated into a plan that accomplishes multiple goals.  

The views of the authors of these articles do not necessarily represent the views of First Republic Bank. First Republic Private Wealth Management encompasses First Republic Investment Management ("FRIM"), the Luminous Capital division of First Republic Investment Management, First Republic Trust Company ("FRTC"), First Republic Trust Company of Delaware LLC and First Republic Securities Company, LLC ("FRSC"), Member FINRA/SIPC. FRIM, FRSC and First Republic Trust Company of Delaware LLC are subsidiaries of First Republic Bank. FRTC is a separate division of First Republic Bank.

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