By Timothy Barrett, Argent Trust Company
Most estate planning attorneys will agree that a thoughtful determination of the state law to invoke in a trust is essential to thorough estate planning. In fact, most estate planning discussions now include at least a brief comparison of your home state trust laws to one or more other state trust laws. Establishing which trust “situs” (the place of administration and the state law that applies to that function) to choose is an essential issue.
A trust established under a state law outside the grantor’s home state is often called a nonresident trust. But even a nonresident trust should be construed under the resident state law for:
- validity (was it properly established and funded by a competent grantor?)
- construction (are the trust’s terms proper, unambiguous and effective?)
- public policy (is the trust’s purpose legal and legitimate?)
Your last will must be construed under the laws of the state in which you reside at the time of your death, regardless of where you lived when you signed it and which state law it invokes. If you die owning property over which another state has a greater interest, such as real estate located in that state, your last will must also be probated in that state relative to that property only. The court in that state should still apply your resident state law for most purposes, but a trust is different.
A trust, whether you include it in your last will or establish it as grantor or settlor under a separate trust agreement, can invoke any state law. That choice will likely be respected if certain trust administration rules are followed: the trustee appointed to administer the trust qualifies as a trustee in that state, substantial assets are custodied or located in that state, and the trustee substantially administers the trust in that state.
For example, I am domiciled in Kentucky. If I die here, my last will, which invokes Kentucky law, must be administered, likely by formal probate, in a Kentucky court. But I could name Argent Trust Company as the successor trustee of my trust at my death or incapacity with authority to change the trust situs to Tennessee. Even if my private residence in Kentucky is held in the trust for my beneficiaries’ use, Tennessee law will apply to the trust if the qualified trustee meets those administrative rules governing situs.
The choice of state law can greatly influence a trust’s functions because a host of states differ in a few important respects from the rest. Many states allow or empower highly advantageous terms:
- The trust may last through many generations or even forever,
- The trust provides extra protections to shield trust assets from creditors,
- The trustee and beneficiaries may modify an otherwise irrevocable trust without the approval of a state court,
- The trustee may appoint the assets to a completely new trust,
- The trust may limit the trustee’s liability so the trust can hold concentrations in certain assets, like a family business, a farm or vacation home, an art collection, etc.,
- The trust may allow family members to direct the trustee relative to certain assets,
- The trust may create different trust advisors and committees, even with the grantor and beneficiaries as members, that can direct the trustee to make distributions, and
- The trust may be structured so the trust pays no state income taxes.
If you live in a state that prohibits asset protection trusts, requires a court order to modify a trust, voids any trust language that seeks to limit the trustee’s liability, and/or requires that a trust pay state income taxes even if the only connection to that state is the grantor’s domicile, then you may have good reason to consider a nonresident trust. You won’t necessarily overcome your home state’s limitations. A reviewing court may determine that your home state’s laws must apply to invalidate trust terms or purposes because they violate its public policies.
Trust taxation is a particularly sticky issue. A trust that is required to pay income tax on its undistributed net income is called a nongrantor trust. A trust that passes that income tax liability to the grantor or some other person is called a grantor trust. If you live in a state with no state income tax, and reducing taxes is the primary purpose for the trust, then a nonresident trust may not interest you. Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington, and Wyoming levy no income tax.
Additionally, 20 states that do levy state income tax exempt a nonresident irrevocable nongrantor trust established by a living grantor. If you live in one of these 28 states, your trust may invoke a trust situs, like Tennessee, that essentially eliminates state income tax for your trust. There are several situations where such a trust can be highly beneficial.
For instance, a pre-transactional trust strategy can be used to sell highly appreciated assets, i.e., closely held company stock, and eliminate state level income tax on the taxable gain. If the business owner funds a nongrantor Tennessee trust with that closely held company stock, the trust can participate in the sale of the stock, or company assets, and recognize the long-term capital gain from the sale at the trust tax level. Although federal income taxes must be paid, and the trust pays the same federal capital gain income tax rate as an individual, state level capital gain income tax may be eliminated.
This information is for illustration only, is by no means the only options and won’t be suitable to your needs without expert legal advice. Consult your estate planning attorney to review your nonresident trust options and, especially, before selling a highly appreciated asset to consider valuable pre-transactional trust strategies.