People set up trusts to preserve their assets and ensure their easy transfer to the designated beneficiaries. For example, you can create a trust in New York State to bypass probate. Thanks to the existence of the trust, your beneficiaries will likely receive the assets you want them to have faster.
So, are there any obstacles that a trust can bypass? For instance, could you create a trust and eliminate the need to pay taxes?
Trusts can be complicated arrangements on their own. However, when you add tax considerations into the mix, they can become especially complex.
Let’s take the time to discuss taxation on trusts in greater detail throughout this article.
Factors That Affect Taxation on Trusts
To figure out if the trust you are planning to create will be taxed in New York State, there are key considerations we need to identify. Those considerations include the party in control of the trust and its residency status.
You should already be mindful of the things we mentioned before you even take the first step to create your trust. Otherwise, you could be taking on substantial taxes and responsibilities without fully understanding what you are getting into.
We have only given a brief overview of how New York treats trusts from a taxation perspective. To fully grasp your responsibilities as the trust creator, we must understand its specific characteristics.
How Control Structure Affects Trust Taxation in New York State
Whether a trust is subject to taxation largely depends on who controls it. There are two distinct types of control structures for trusts.
A trust can be controlled by the person that creates it. For example, the grantor could serve as both the trustee and the beneficiary of the arrangement. In that case, the arrangement would be a grantor trust.
If a trust has a trustee and different beneficiaries, it would be considered a non-grantor arrangement.
Let’s focus first on grantor trusts. We have already detailed the control structure of grantor trusts, so let’s take the time to discuss why people may consider setting these up.
You may be more interested in setting up a grantor trust rather than its alternative because you want to maintain control over it. Since you are going through the trouble of creating a living trust, you may decide that you want to fully manage it until the time comes to distribute its assets.
During the lifetime of your grantor trust, you can change the trustee name and its beneficiaries. However, you also retain some control over the assets contained within this revocable trust.
Notably, grantor trusts can also be irrevocable. You can make your grantor trust irrevocable to claim additional protection from taxation, but you will sacrifice flexibility in the process. Consult with an estate planning attorney to determine if that trade-off will be worth it for you.
For most creators, the main appeal of a grantor trust is not necessarily the control it provides. Instead, they want to create this type of trust because it makes dealing with taxes significantly easier.
The grantor trust itself is not taxed. The courts subject only the grantor to taxation, allowing the trust assets to grow significantly.
Grantor trusts are also easier to manage in terms of convenience. However, as the grantor, you must pay taxes on the trust’s income.
From an estate planning perspective, there are key advantages inherent to grantor trusts. Those advantages may be enough to sell you on the idea of creating one.
If you do not want to set up a grantor trust, you can go with a non-grantor trust.
A non-grantor trust is an irrevocable trust. Once you create it, you lose the ability to control it. Grantors do not even retain the ability to change the beneficiaries in a non-grantor trust.
Hearing that you will lose all control over a non-grantor trust may make it less appealing in your eyes. However, some individuals may see that as a selling point.
An individual who wants to set up a trust without maintaining any obligation to manage it should seriously consider creating a non-grantor trust. For example, this would be an ideal arrangement if you are looking to set aside assets for a former spouse as part of your divorce agreement.
Even taxation is handled differently for non-grantor trusts. The law recognizes non-grantor trusts as separate entities, so their grantors are not obligated to pay their taxes.
Creating a non-grantor trust also makes sense in other ways.
If the grantor and the trust beneficiaries are in separate tax brackets, then having the trust taxed directly may lead to some cost savings. Entrepreneurs can also use non-grantor trusts to claim certain business incentives.
Understand how taxation works for non-grantor trusts before you create one. Enlist the help of an estate planning attorney to determine if it is the right option for you and your specific situation.
How Residency Status Affects Trust Taxation in New York State
Now that we have detailed how control structure affects trust taxation let’s shift our focus to residency status. That is right. The residency status of your trust will also affect whether it is taxed or not.
Trusts are in four categories in terms of their residency status. They can be resident trusts, non-resident trusts, part-year resident trusts, or exempt. Understanding which category your trust falls under will help you avoid headaches when tax season arrives.
You can learn more about the specific qualities of those trusts below.
First off, we have the resident trusts.
A resident trust becomes created when a testamentary trust becomes established when the New York State-based grantor dies. In addition, irrevocable trusts established by New York State residents are also resident trusts.
If a trust qualifies as a resident trust, its income will become subject to New York State taxation laws. This is because they will treat the trust essentially like a resident of the state.
The assets in a resident trust may be more exposed than assets held within other arrangements. That means your beneficiaries could miss out on receiving a larger inheritance due to how the trust is taxed.
Then again, you may have no option but to create this trust. Unless you are receptive to moving to secure better tax protection for your beneficiaries, a resident trust is still preferable to having no plan in place.
To qualify as a non-resident trust, your arrangement must not qualify as a New York State resident for any part of the year. Therefore, you must work carefully to maintain that status for your trust unless you want to open it to greater taxation.
Of course, New York State will still take taxes from your non-resident trust. More specifically, the state will take taxes from your New York source income.
Examples of your New York source income that will be taxed include any real or tangible property you have in the state. Any business income you generate in New York State will also be taxed. The state government may also tax profits you make from selling certain stocks.
New York State estate or trust income is also taxed. Taxes will also be on your New York State lottery winnings if you win more than $5,000.
Crucially, income from certain pension plans, annuities, and sales of personal property not based in New York State will not be taxed. You may also avoid taxes on your income if you are an active member of the US military or a military spouse.
Figuring out the taxes your non-resident trust will have to pay can be tricky. Hire a lawyer who can examine your trust’s tax situation to avoid potentially costly mistakes.
Part-Year Resident Trusts
A part-year resident trust could be a resident or non-resident trust, depending on when they examine it. As long as the trust does not fall into one of the mentioned categories for the entirety of the year, then the state will see it as a part-year resident.
Clarifying the status of your trust is important for taxation purposes. You may end up paying the incorrect amount of taxes if you do not clear things up first.
Any income you indicated in your federal return as a New York State resident is taxable on your part-year resident trust. On top of that, they still handle the taxable sources of income we mentioned in the non-resident trust section the same way.
Given how they handle taxes for part-year resident trusts, grantors have reason to avoid establishing it. Instead, carefully plan how you want to handle your trust at the start of the year so you can avoid the obligations of managing a part-year resident trust.
Finally, we have the trusts that are exempt from taxation in New York State. A trust may only receive tax-exempt status if it meets three distinct conditions.
The first of those conditions is related to where the trustees live. For a trust to qualify for exempt status, all its trustees must reside in a state other than New York.
Next, the property status in the trust also affects its residency. The trust can receive exempt status if all its real and tangible properties are outside of New York State. The state notes that intangibles in the state but not used in any business conducted in the state are not regarded as based in New York.
Lastly, a trust can only be exempt from taxation in the state if it has no New York source income.
As you can see, there are high bars you need to clear if you want your trust to gain tax-exempt status. Whether those incentives are worth the potential sacrifices you need to make will ultimately be your call. Again, seek feedback from your attorney to make the best decision in that scenario.
What Happens if the Residency Status of Your Trust Changes?
Over the course of a year, certain changes that you make in your daily life could affect the status of your trust. Among those impactful changes is your place of residence.
You may have moved away from New York State to accept a job opportunity elsewhere. Alternatively, you may have moved to New York State to start living there as a regular resident. In either case, the status of your trust will change.
If the status of your trust changes within the same year, then it will become a part-year resident trust. Therefore, moving forward, you will handle your trust’s taxes under the assumption that it will receive part-year resident status.
Changing your place of residence is already quite a complex ordeal. It will become even harder to manage if you also need to worry about your trust. Ask your attorney to handle your trust so you can focus on more pressing concerns.
Can You Get an Extension When Filing Taxes for Your Trust?
Setting up a working trust does not take a lot of time. If you work with an experienced estate attorney, you can get the trust in order after a few days or weeks.
Of course, other aspects of managing your trust could take more time than you initially expected. After you finish them, you may need more time to properly calculate and pay your trust’s taxes.
Do not worry if you are running short on time. New York State will grant an extension for filing your trust’s taxes if you request it.
File the Application for Automatic Extension of Time to File for Partnerships and Fiduciaries to receive an extension period of five and a half months. You can also file that extension request online if you wish.
Reach out to us at the Alber Law Group if you have questions regarding the set up, transfer, or dissolution of a trust. For all other tax matters, please refer to a licensed CPA.