Cocktails & Estate Planning are Not Necessarily Good Mixers

Oh, the things you hear at cocktail parties: “Everyone should have a revocable trust,” “It’s easy to change your residence to Florida for tax purposes – just count days and get a Florida license,” “Make all your trusts Delaware trusts to avoid state income taxes.” The efficacy of any of these pronouncements depends on each person’s particular circumstances. One size does not fit all.

In previous articles, I have addressed the need for revocable trusts and changing residency for tax purposes. So, what about creating a trust in Delaware (or another state with no state income tax) to avoid paying state income tax on the trust’s income?

Here, I only address state income taxes and will refer to Delaware trusts for ease of reading. If you are a New York resident and gift property to an irrevocable trust for the benefit of your children, your trust is considered a New York Resident. Trust, even if the trustee and/or the beneficiary are non-New York residents and even if the trust is governed by Delaware law. This means that the Delaware trust is subject to New York income tax. However, a New York Resident Trust can be exempt from New York income tax if it meets certain requirements.

To qualify as a tax-exempt New York Resident Trust, the trust must meet the following requirements:

• The trust cannot be a grantor trust for income tax purposes. (Many irrevocable trusts give the Grantor certain powers so that the trust income is taxed to the grantor where he/she resides (a “grantor trust”), which may be considered additional tax free gifts to the trust.)
• The trustee must not be domiciled in New York. (Frequently, you must consider a Delaware corporate Trustee, such as a bank.)
• The Trust cannot hold any New York assets. (If the trust owns New York real property, it cannot be an exempt trust.)
• The trust cannot have any New York income or gain from New York sources, such as flow through income from a New York partnership or S corporation.

If all of these conditions are met, a New York grantor can create a New York Resident Trust exempt from New York income tax. Note, however, if the exempt trust makes a distribution to a New York beneficiary, that income will be taxed in New York. This rule can also be applied to income that was accumulated in the exempt trust in prior years on which no New York income tax was paid and is later distributed to a New York beneficiary!

So, is it better to create a Delaware trust instead of a New York Trust? As with every estate planning technique, it depends upon your circumstances.

This article appeared in the April 2023 issue of Stroll Lloyd Harbor.