Picking the right location is the key to success in real estate. Now it's also a crucial decision in the sleepy world of trust funds. To lure a piece of the trust business, some states have recently enacted laws designed to make it attractive to establish trusts within their borders. As a result, it's possible to improve your trust's return, life span, and defenses against creditors simply by locating it in a particular state. "Shopping for a trust locale has become de rigueur in the industry," says Michael Smith, managing director at Deutsche Bank. (DB )
Which state you choose -- you don't have to use your home state -- will depend on your goals. For example, to maximize your trust's returns, you might pick a state with no income tax -- or at least none on trusts. Meanwhile, those intent on a lasting legacy can choose a state that allows trusts to live forever instead of for just a few generations. If legal liability is a concern, you might look at the few states that permit "domestic asset-protection trusts" -- or trusts designed to benefit you, while still protecting the assets from others. A word of caution: Since these trusts are irrevocable, you can't change your mind once you set one up.
While investment decisions will dictate your trust's financial success, you can lend a helping hand by selecting a tax-friendly jurisdiction. Trusts must pay federal taxes on their capital gains and any income they don't pass along to beneficiaries. They're also subject to federal estate, gift, and generation-skipping taxes. But you can select a host state that either has no state income tax or exempts trusts from paying it.
Be forewarned that this area of the law can be complex. Delaware, for example, exempts trusts with in-state trustees from paying its income tax -- but only if the beneficiaries live in other states. And no matter where your trust is, it may be liable for Illinois' income tax if the person who establishes it lives there, says Ed Orazem, managing director at Citigroup Trust. (C ) In contrast, New York and New Jersey generally impose no income tax on residents' trusts as long as the trustee is based in another state and the trust holds no state-based property or investments that generate income. To figure out your trust's tax exposure, check the laws of each state in which a trustee, grantor, and beneficiary live, says Catherine Keating, managing director at JPMorgan (JPM ) Private Bank.
Where your trust is located can also make a big difference in its longevity. Most states require trusts to dissolve after about 90 years, a feature inherited from English common law. But 22 states plus the District of Columbia have changed their laws to permit irrevocable trusts with in-state trustees to endure for generations. That's a big deal, since a trust worth $1 million today that grows 8% a year and makes a 3% annual payout to heirs will have $131 million in 100 years, according to Richard Nenno, managing director at Wilmington Trust (WL ).
Another reason to shop for a trust locale is to better protect your money from legal action, including shielding your assets from creditors should you file for bankruptcy. Money put into an irrevocable trust for someone else -- say, your children -- is generally off-limits to creditors. But seven states, including Alaska, Delaware, and Nevada, have recently enacted laws that let you name yourself the beneficiary of a protected trust. Until recently, you could get this type of trust only by moving your money offshore to places including the Cook Islands in the South Pacific.
Still, because these new trusts have yet to be tested in court, they're not bulletproof. You also have to be willing to give your trustee control over distributions. And the trust can be ruled invalid if established after a legal claim arises. "I wouldn't use them to replace other asset protection techniques, such as liability insurance," says James Kronenberg, principal at Bessemer Trust.
If you already have a trust, can you move it to another state to take advantage of these new laws? Success is more likely if your trust document lets you change trustees and doesn't require a specific state to govern it. But while switching to an out-of-state trustee might help your trust reap income-tax benefits, it's unlikely to result in a longer life span. Why? Many trusts set an expiration date in the time frame allowed by their home state. A donor can go to court to request a change. But that can be expensive and time-consuming -- and there's no assurance of success. That's why it's key to choose the right state for your trust from the start.
By Anne Tergesen