With the 2018 tax overhaul well behind us, many people who reside in high tax states such as California, Hawaii, New York, etc. are no longer able to fully deduct their high state taxes on their federal tax return. The 2018 Tax act limits the amount of federal income tax deduction for state income taxes paid, real property income taxes paid, to a cumulative $10,000 per year. This means if you paid $10,000 in real property taxes alone, you get no federal deduction for other categories such as state income taxes paid.
But what if there was a way to avoid or minimize state income taxes? There is, it’s a type of trust that has now become arguably the most important trust vehicle in the estate planning industry, and I’ll bet you have never heard about it from your CPA, attorney, or financial advisor.
So, what is this trust and how does it work? I am a fiduciary financial advisor and not an attorney, so I am going to describe the trust from a high-level perspective for you. The typical client for this type of trust is trying to save money on state income taxes, therefore the typical client is a resident of a state with a high income tax, they may be selling a business or other asset that will have a large capital gain, or they may have a large asset such as an investment portfolio with sizable gains and distributions that would be taxed by the clients home state if they hadn’t set up the trust. I should note that income earned by an asset such as a locally run business or local real estate, is considered sourced to the client’s home state and therefore cannot avoid state income taxes using this type of trust.
The trust is sitused in Nevada, this is because the trust must be in a jurisdiction that has Domestic Asset Protection trust statutes in order to avoid being what is called a grantor trust for income tax purposes. Nevada is generally considered the leading Domestic Asset Protection Trust jurisdiction which is why it is the leading state for these trusts. The trust is simply a non-grantor Domestic Asset Protection Trust. In addition, the chosen jurisdiction must not have a fiduciary state income tax, that alone excludes many states, leaving only Nevada and a small handful of other states where this technique is viable.
So, what about control you ask? This trust does require the client to give up some control, but not to worry – read on…
First, since the trust can’t have any trustees who live in the client’s home state, the client can’t be a trustee and therefore loses direct managerial control over the trust assets. However, the client can retain the power to remove and replace trustees, so this loss of control is merely indirect control with the presumption being that the selected trustees will invest based on the client’s wishes.
Second, the trust must have a power of appointment committee (also called a distribution committee) made up of adverse parties initially selected by the client from the potential distributees of the trust. This committee makes distribution decisions either (a) by unanimous vote or (b) by majority vote pus the vote of the client. The client cannot retain the power to remove and replace the committee members, so this technique does not work ideally for dysfunctional families.
This trust is not limited to residents of states with a high state income tax rate. Many estate planners overlook the federal income tax advantages that can be obtained using this trust. The federal income tax advantages are available to residents of states both with and without a state income tax.
For example, the Power of Appointment Committee can sprinkle up to $15,000 (the 2018 annual exclusion amount) of income each year to each of the client’s children and grandchildren who may be in a much lower federal and state income tax bracket. This can be increased to $30,000 each year if the client is married. This can be done without using any gift tax exemption.
In summary, a client can save taxes, have professional portfolio management of the trust assets in line with their wishes, and asset protection all at the same time, all while still having the ability to receive distributions from the trust via the committee.
This trust is ideally suited for clients with liquid assets which can be placed into the trust of at least $2 Million. If this sounds like something you’d like to know more about, simply schedule a call with me to discuss your particular financial details and goals. If from our conversation I think this vehicle can be helpful to you I am happy to set up a no cost initial consultation with the attorney who would be able to draft the trust for you, he also has a trust company that for a very reasonable fee can serve as the administrative trustee if desired, while we as your fiduciary advisor handle the investment of your funds.