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Advisors and wealth management firms often turn to trusts – both grantor and n n-grantor – as prime estate planning options with aim of reducing tax burdens for clients’ beneficiaries.
Trusts are good starting points for that effort, but they’re not the finish line because as advisors know, taxes are complex and there is little in the way of state-by-state uniformity. Still, trusts are solid tax-reducing ideas, but it’s also a matter of blocking and tackling. That includes pinning down the basic differences between the two forms of trusts.
In a grantor trust, the creator or the spouse holds power of the trust and is considered the owner of the held assets. That means that person is liable for taxes on the trust’s income and realized gains. An important point for advisors to mention to clients is all of that remains true even if the trust’s creator relinquishes rights of benefit from the trust’s assets.
When it comes non-grantor trusts, the trust is considered the owner of the held assets, meaning it pays the taxes. Typical deployment of non-grantor trusts occurs when the grantor passes away. So those are the basics of the two trusts. From there, advisors can explore avenues for trimming or eliminating related tax exposures – both of which are possible.
Geography Matters
Advisors also know that there’s a prominent intersection shared by retirement planning and geography. The same is true of trusts. Said differently, where a trust “lives” is an important issue when it comes to mitigating tax liabilities.
“Even if a trust ‘lives’ in a state that does not tax income at all, the trust might still owe taxes to another state, one that does tax income,” observes Jordan Sprechman of J.P. Morgan Private Bank. “Some states, such as California, look at the beneficiaries’ residence when determining whether, and to what extent, to tax trust income. Meanwhile, New York has a ‘throwback’ tax that, in certain circumstances, can subject New York resident beneficiaries to tax on income earned by some non-grantor trusts in earlier years.”
As Sprechman points out, one avenue for eliminating or lowering state income taxes on non-grantor trusts is finding trustees that live in no income tax states. So in a hypothetical situation, let’s say a non-grantor trust is created in California by a family and one of the trustees is an heir that lives in that state. To lower tax exposure, that heir could be replaced by a sibling that lives in Florida.
Another option and perhaps one more practical many clients, is to have the trust held by an established bank or financial services firm – many of which have dedicated trust units set up in tax-favorable jurisdictions such as Delaware.
Change Is Easy
When it comes to lowering tax tabs, clients are sure to love it regardless of the situation and that’s true with trusts. Trusts are prime value add opportunities and that point is proven on multiple fronts.
Remember that even the most astute clients view taxes and trusts as complicated subject matter. That can create mental barriers to altering trusts for the better, but advisors can ameliorate that situation with ease.
“And if you already have a trust in a high-tax state, that condition almost certainly can be changed. The trustee’s lawyers usually handle the process of changing trustees, which modern trust agreements generally streamline,” notes Sprechman. “Of course, the cooperation of the existing trustees in any transition helps. So too would be the cooperation of courts, which would almost always be involved in the succession process for trusts created under the terms of a decedent’s Will.”