Edwin P. Morrow III, Geoff N. Germane, and David J. Bowen, J.
residents are patriotic and willing to pay taxes as a
necessary price of living in such a great state, but most
would feel just as proud paying half as much. This article
will focus on how Utah residents can legitimately avoid Utah
income tax using trusts during their lifetime by using either
incomplete and/or completed gift non-grantor trusts, and how
such trusts can, at the same time, lead to charitable
deductions superior to those produced by gifts made outside
of trust. Due to sharply increased applicable exclusion
amounts and dozens of recent private letter rulings from the
IRS, the benefits of these trusts are more appealing than
First, we will briefly summarize how trusts are taxed at the federal level before explaining Utah’s trust income tax scheme and the importance of being classified as a “resident” or “non-resident” trust. Then, we will address “source income” and situations where Utah may tax even non-residents and non-resident trusts that own Utah-sitused real estate, income, and businesses. More importantly, we’ll discuss how this may often be avoided. Once we’ve determined Utah income tax savings, we’ll revisit the two federal tax options available and distinguish between completed gift and incomplete gift options (a.k.a. DING trusts). Finally, we’ll explore when these same trusts may save federal income tax, despite the common wisdom that trusts pay higher rates of income tax.
Federal Trust Income Tax Scheme
Many trusts, including all revocable trusts and even many irrevocable ones, are “grantor trusts” for income tax purposes, meaning they are not considered separate taxpayers, and all gains, income, losses, and deductions in the trust are attributable to the grantor. See 26 U.S.C. § 671 (general rules); see also 26 U.S.C. §§ 672–769. Utah follows the federal grantor trust scheme. Utah Code Ann. §§ 59-10-103(1)(a), (w); -104(1).
Trusts and estates have similarities to pass-through entities, but are taxed quite differently from S corporations and partnerships. To sum up a complex subject: usually, capital gains are trapped and taxed to the trust and other income is taxed to the beneficiaries to the extent distributed and to the trust to the extent not distributed.
Federal trust income tax rates hit the higher income tax brackets at much lower levels to the extent that income is trapped in trust and not passed out to beneficiaries on a K-1. The top 39.6% federal income tax bracket is reached at only $12,500 for tax year 2017. 26 U.S.C. § 1; see also Rev. Proc. 2014–61 available at http://www.irs.gov/ pub/irs-drop/rp-14-61.pdf (inflation adjusted brackets). The 3.8% net investment income tax is triggered by investment income over this same low threshold. 26 U.S.C. § 1411(a)(2).
Utah’s Trust Income Tax Scheme: Differentiating Utah Resident and Non-Resident Trusts
Utah follows the lead of the federal scheme of trust taxation: if the trustee has to file a federal trust income tax return, it has to file a Utah trust income tax return. Utah Code Ann. § 59-10-504. Utah resident beneficiaries must report the income from the trust included in the beneficiary’s federal adjusted gross income via K-1 as though the beneficiary received the income directly. UT Instructions Form TC-41 at 3 (2017), available at http://tax.utah.gov/forms/current/ tc-41inst.pdf. The Utah fiduciary income tax has the same top tax rate as the individual income tax (5%). Utah Code Ann. § 59-10-201(1) (referencing § 59-10-104(2)(b)). Avoiding Utah trust income tax is essentially a two-step process: either (1) avoid being a resident trust or avoid appointment of disqualifying trustees of a resident trust, and (2) avoid Utah source income.
take the first step. Like most states, Utah tax law
differentiates between resident trusts and nonresident
trusts. See UT Form TC-41 (2017). Utah’s
definition of a resident trust is extremely taxpayer-friendly
and much narrower than in many other states. Utah statue
defines a “Resident Trust” in part as a
“trust administered in this state,” which in turn
means that “the fiduciary transacts a major portion of
its administration” in Utah.
Thus, unlike many states, the “residency” of a Utah trust is not triggered by the in-state residency of the settlor and/or beneficiaries, the state law that applies under the terms of the trust instrument, or even the location of trust assets (although the latter may matter for “source income,” which is explained later).
Nonresident trusts are defined as those that are not resident trusts. See id. Accordingly, to form a nonresident trust, Utah residents merely need to find an out-of-state trustee who will transact less than a major portion of the trust administration inside of Utah and whose usual place of business is outside Utah. Local trust companies with single purpose out-of-state sister companies, such as KeyBank and Key National Trust Company o f Delaware, have an edge because there can still be some local contact and incidental functions and meetings in Utah, while the major part of the trust administration is done out of state.
taxable income of a resident trust is simply its gross
federal income, modified by certain fiduciary adjustments.
Utah Code Ann. § 59-10-201.1. Utah adjustments that are
similar to those of other states, include adding back income
from municipal bonds issued by other states (unless there is
reciprocity) and subtracting U.S. savings bond income.
Id. § 59-10-202(1), (2). Surprisingly, Utah
does not start with federal taxable income
(e.g. after charitable deductions), while most states with a
separate trust income tax do. Thus, Utah is one of the least
friendly states when it comes to encouraging charitable
donations from trusts. Additionally, most states permit
attorney, accountant, and tax preparer fees. Utah does
There are a few subtractions from income that are truly unique to Utah law. Most notably, income of an irrevocable resident trust is subtracted from federal total income if: (i) the income would not be treated as state taxable income derived from Utah sources under Section 59-10-204 if received by a nonresident trust;
(ii) the trust first became a resident trust on or after January 1, 2004;
(iii) no assets of the trust were held, at any time after January 1, 2003, in another resident irrevocable trust created by the same settlor or the spouse of the same settlor;
(iv) the trustee of the trust is a trust company as defined in Subsection 7-5-1(1)(d).
Id. § 59-10-202(2)(b)(i)–(iv) (emphasis added).
This provides a significant tax incentive for Utah residents to either (1) name eligible trust companies as trustees for trusts, including garden-variety “AB” trusts, to enable the generous deduction noted above, or (2) use out-of-state trustees and avoid performing administration in state to avoid being a resident trust in the first place. Although this article primarily discusses inter-vivos planning, the concepts herein also apply to the administration of a testamentary trusts or irrevocable grantor trust after the death of the settlor. Under either scenario (lifetime or post-death trusts), naming a non-qualifying Utah resident individual trustee or co-trustee is the worst of all worlds tax-wise, because it would fail to qualify for either exemption from Utah income tax.
This does not mean just any trust company or out-of-state trustee should be used. It would be unwise to name a California resident as trustee to simply exchange a 5% tax for a 13.3% tax. However, many states, such as Wyoming, Washington, Alaska, Texas, Nevada, and Florida, have no income tax. Many other states that are considered leading jurisdictions for trusts, such as Delaware or Ohio, have an income tax for their own residents, but would not impose a state income tax on an out-of-state trust merely because the trust’s choice of law, trustees, advisors, or primary administration is in state. See, e.g., Ohio Department of Taxation Information Release, TRUST 2003-02: Trust Residency (Feb. 2003), available at, http://www.tax.ohio.gov/ohio_ individual/individual/information_releases/trust200302.aspx.
Understanding Utah Source Income – When Can and Cannot Be Avoided
As noted above, certain Utah “source” income cannot be avoided regardless of...