The Kiddie Tax can apply to the unearned income of children. Read on to learn if this tax applies to you or your children. Also, learn ways to avoid the Kiddie Tax.
Trusts can be drafted to be quite flexible. This article examines several ways you can add flexibility to your trust. This added flexibility will increase the usefulness of your trust.
Where you die matters. While you’ll pay the same federal estate tax no matter where you die, 1/3 of the states have a separate estate or inheritance tax. The most populous state, California, is the latest state to consider adding a state estate tax. Read on to learn more.
When and Where You Die Matters
Trusts can be drafted to be quite flexible. This article examines how Trust Protectors can add flexibility to your trust. This added flexibility can increase the usefulness of your trust.
Trust Protectors Add Flexibility
Irrevocable trusts often can be modified. They can be modified under the Uniform Trust Code or a state law decanting. Read on to learn more about how a modification of a trust can help.
Modifying an Irrevocable Trust
States are all over the board on their income taxation. An individual in a state with a high state tax rate could use a nongrantor trust to hold some of their income-producing assets and thereby avoid state income taxation on the income from those assets.
Briefly, trusts may be taxed as grantor trusts or nongrantor trusts. A grantor trust is taxed directly to the grantor, so this type of trust doesn’t help if you’re trying to avoid your state of residence’s income tax. However, a nongrantor trust is a separate taxpayer. As such, a nongrantor trust could be a resident of a different state than its grantor.
Let’s look at a quick example: Mary sets up an irrevocable nongrantor trust in Nevada, a state without any state income tax. She avoids any triggers for the trust being a resident in any other state. The trust has no income that would be deemed sourced from another state. Thus, the income of the trust would face no state income taxation.
However, states have complicated rules on when they will try to tax a nongrantor trust as a resident. States tax based on where the trust is administered / trustee is resident, where the beneficiary is resident, where the grantor was resident when the trust became irrevocable, etc.
Each state has a different set of rules. Here’s a link to a helpful chart of those rules for nongrantor trusts.
Just because a trust is administered in a state without an income tax does not mean that other states might not try to claim the trust as a resident of their states. Let’s look again at the example of Mary’s trust set up in Nevada. If Mary were a resident of Maine when she set up the trust, Maine would consider the trust a resident of Maine. If the beneficiaries of the trust were residents of California, California would consider the trust a resident of California. When a state considers a nongrantor trust to be a resident, it will tax it on all its income, not just the income derived from sources within that state.
Kaestner v. North Carolina examines the constitutionality of a state taxing a trust as a resident when the trust is not administered in the state and the trustee doesn’t live in the state. The North Carolina Supreme Court held it was unconstitutional for the state to tax the trust under those circumstances because there weren’t sufficient contacts with the state. Here’s a link to that case. The U.S. Supreme Court decided to hear the appeal in the case, so we could see new developments in this area before too long.
If you set up an irrevocable nongrantor trust in a state without a state income tax and you scrupulously avoid triggers which would consider the trust to be a resident of any other state, you can avoid state income taxation on the assets you put in the trust. Kaestner could simplify this process.
Often, the smallest things have the most sentimental value. Your grandmother’s silverware or your grandfather’s railroad watch could connect you to them in a special way. Your mother’s ring or your father’s Boyscout bugle could hold a special place in your heart. Your sports memorabilia could connect you to one of your children in a unique way. You may want those items to go to particular beneficiaries who will cherish their sentimental value as you have. There’s an easy and flexible way to do that.
When your will or trust is drafted, it can include a disposition of “tangible personal property” through a list external to the document. Tangible personal property includes things you can touch, like the items listed in the paragraph above. It does not include real estate or intangible assets like bank accounts, cash, etc.
In most (if not all) states, if your will or trust references a tangible personal property list external to the will or trust, the list is valid to transfer the items detailed on that list to the beneficiary identified. The list would reference your will or trust and would provide for the disposition of the specific item of tangible personal property with a description of the item and to whom it should go. The list must be signed and dated every time you update it.
The unique thing about the tangible personal property list is that it does not need to be executed with the formalities of a will or trust. For example, the list does not need to be witnessed or notarized, even though the document referencing the list needed additional formalities. If you change your mind, you can simply update the list and sign it and date it again.
The list is an easy and flexible way to earmark items to your desired beneficiary. The flexibility can be important. Let’s say that you have an athletic daughter and you were leaving all your sports memorabilia to her. Then, your grandson earns an award in a swimming event. You may want to decide to give your diving trophy to your grandson since it’s a way for him to remember the special bond you share. You can simply update the list with the new disposition and sign it and date it.
Trusts are incredibly useful tools. But, not ever trust will fit every circumstance. Trusts must be used appropriately. Here are two common mistakes with trusts and how they can be easily avoided.
The first mistake with the use of trusts is not using the right type of trust. There are many different types of trusts. By far the most common type of trust is a Revocable Living Trust, often just called a "Living Trust" or “RLT.” A Living Trust is a great solution for most estate planning situations. It can provide for management of your estate during incapacity, avoid probate at death, and protect your beneficiaries' inheritances from divorce, creditors, and taxes. But, it may not be the right solution for every situation.
Additional estate planning must be done if one wishes to do more than address incapacity and death. Some clients are at higher risk for lawsuits (e.g. doctors, lawyers, etc.) and want to do additional planning to protect their estate from potential lawsuits. Even more often, clients own rental properties where a slip-and-fall accident could take everything away from them and they want to protect their investment. For the few clients that may be subject to the estate tax, planning needs to be done to minimize the estate tax burden, or potentially to eliminate taxes altogether!
Such additional planning is often done through the use of an irrevocable trust and/or limited liability companies (LLCs). An Asset Protection Trust can limit a creditor's rights to certain assets when done properly. In order to protect part of the estate from such creditors, the irrevocable trust must be set up years before the potential creditor has a claim against the estate; an Asset Protection Trust cannot hide assets from current creditors. For landlords, an LLC can be an extremely effective way to protect an accident on a rental property from taking away personal assets (e.g. your home, bank accounts, etc.). For estate tax planning, attorneys will often use myriad trusts to minimize or eliminate the tax impact of someone's death, whether through an Irrevocable Life Insurance Trust ("ILIT"), a Charitable Trust, or Gifting Trusts, to name a few.
Whether you are the attorney or the client, consider what type of trust is appropriate. Each type of trust has its strengths and challenges. The key is choosing the right type of trust for the situation.
The second mistake with the use of trusts is not funding the trust properly. A Living Trust is a great tool, but only if it is has legal ownership of the assets it is designed to manage (a.k.a. "funding," or the process of transferring legal title of the estate into the Trust). If a Living Trust is not properly funded, your successors will have twice the amount of work to deal with upon your death. If there is a Pour-Over Will (and there should be!), the assets that were not funded into the Trust would be subject to probate and only then would be distributed to the Living Trust. Once funded by the Probate Court, the assets must then be distributed according to the terms of the Living Trust. This is doing similar work TWICE! Worse yet, if there is no Will the unfunded assets would pass pursuant to "intestacy” laws, under which the remaining assets will pass to your next closest living heirs according to state law, irrespective of anything you've done in your estate plan. A Living Trust should be funded appropriately to maximize its usefulness during incapacity (to avoid needing a conservatorship) and death (to avoid a probate).
If you have questions regarding Living Trusts, asset protection, tax planning, or any other estate planning matters, please contact the experienced attorneys at Anderson, Dorn & Rader, Ltd. for a consultation. You can contact us either online or by calling us at (775) 823-9455. We are here to help!