What Are the Worst States for Trusts?

A trust is a legal arrangement for managing assets on behalf of beneficiaries. The state laws governing a trust, known as its jurisdiction, are important for determining how effectively it can achieve its financial objectives. State legal frameworks differ widely, influencing everything from tax obligations to the level of protection assets receive from creditors. A trust established in one state might face tax burdens or legal challenges that would not exist in another, making the choice of jurisdiction a decision with long-term consequences.

The Impact of State Income Taxation on Trusts

State income tax laws can diminish the value of assets held in a non-grantor trust, which is treated as a separate taxable entity. The issue revolves around how a state defines a “resident trust” for tax purposes, as resident trusts are often taxed on their worldwide income, not just income from sources within that state.

States use several criteria to determine if a trust is a resident. Common factors include the state where the person who created the trust lived when it was established, where the trustee resides or conducts business, the location of the trust’s administration, or the residence of the beneficiaries. If a trust meets any of these conditions, it can be pulled into that state’s tax system, even if other elements are located elsewhere.

For example, New York considers any trust created by a resident to be a resident trust indefinitely, regardless of where the trustee or beneficiaries later move. California’s rules establish residency based on the location of the trustee and non-contingent beneficiaries. This can create complex situations where a trust might be considered a resident of multiple states, potentially leading to double taxation on the same income.

This impact is most pronounced in states with high income tax rates for trusts, such as California, New York, New Jersey, Minnesota, and Vermont. These states impose some of the highest top marginal rates on trust income in the country, and the rates often kick in at very low income thresholds. In states like California, high marginal tax rates apply to trust income at levels far below those for individuals, meaning even moderately successful trusts can face a significant tax liability.

Certain states offer specific safe harbor provisions that may allow a trust to avoid resident status. In New York and New Jersey, a trust may escape state income tax if the trustee is not a resident, the trust has no state-sourced income, and it does not own any real or tangible personal property within the state. However, navigating these exceptions requires careful planning to understand the rules that can subject a trust to a high-tax jurisdiction.

State Estate and Inheritance Tax Burdens

Beyond income taxes, some states impose estate or inheritance taxes on assets transferred at death. These taxes are separate from the federal estate tax and can reduce the wealth passed to the next generation through a trust. There are two primary types of state-level death taxes: estate taxes and inheritance taxes.

A state estate tax is levied on the total value of a decedent’s assets before they are distributed. If the estate’s value exceeds a specific state exemption amount, the estate itself is responsible for paying the tax. This shrinks the overall inheritance pool before beneficiaries receive their share.

In contrast, a state inheritance tax is paid by the beneficiaries who receive the assets. The tax rate often depends on the beneficiary’s relationship to the decedent. Close relatives typically pay a lower rate or are exempt, while distant relatives or unrelated individuals face higher rates.

Several states impose an estate tax, and their exemption amounts are generally much lower than the federal exemption. This means many estates not subject to federal tax may still face a state tax liability. These jurisdictions include:

• Connecticut
• Hawaii
• Illinois
• Maine
• Maryland
• Massachusetts
• Minnesota
• New York
• Oregon
• Rhode Island
• Vermont
• Washington

A smaller number of states levy an inheritance tax, including:

• Kentucky
• Maryland
• Nebraska
• New Jersey
• Pennsylvania

Notably, Maryland is the only state that imposes both an estate and an inheritance tax, creating a challenging environment for estate planning. The existence of these transfer taxes can complicate trust administration and diminish the intended financial legacy.

Limited Asset Protection Provisions

Shielding assets from the claims of creditors is a primary reason for creating a trust, but the level of protection varies dramatically by state. The most significant distinction lies in how state laws treat self-settled trusts and the rights of a beneficiary’s creditors.

Some states have unfavorable laws regarding self-settled asset protection trusts, also known as Domestic Asset Protection Trusts (DAPTs). These are irrevocable trusts where the creator can also be a beneficiary. In states without specific statutes authorizing DAPTs, a creditor of the trust’s creator can typically access as much of the trust property as the trustee has the discretion to distribute.

The strength of protections for beneficiaries against their own creditors also differs. In states with strong discretionary trust statutes, a beneficiary’s creditors cannot compel a trustee to make a distribution, and assets are only vulnerable once paid out. In contrast, states with weaker statutes may allow a creditor to obtain a court order attaching to future distributions, making it easier to seize trust funds.

States that have not enacted modern trust legislation often present a less secure environment for asset protection. These jurisdictions may lack clear statutory guidance on creditor rights, leading to uncertainty. This contrasts with states that have updated their laws to provide robust and clearly defined protections for assets held in trust.

Inflexible Trust Modification and Duration Rules

The legal framework governing a trust’s lifespan and adaptability is another area where states differ. Two concepts highlight these limitations: the Rule Against Perpetuities and the ability to “decant” a trust.

The Rule Against Perpetuities (RAP) is a legal principle designed to prevent assets from being tied up in trusts indefinitely. It traditionally limits a trust’s duration to a period measured by “a life in being plus 21 years.” While many states have modernized or abolished this rule, those that retain a shorter perpetuity period are less favorable for long-term planning, as they force the trust to terminate prematurely.

Decanting is a process that allows a trustee to “pour” the assets of an irrevocable trust into a new trust with more favorable terms. This is a tool for correcting administrative issues, updating tax provisions, or changing the trust’s governing law to a more advantageous state. States that lack a flexible decanting statute make it difficult to adapt an old trust to changing circumstances.

States with restrictive decanting laws may impose significant limitations, such as prohibiting changes to beneficial interests or requiring a court order for minor modifications. This lack of flexibility can prevent a trust from being administered efficiently. For families seeking to create a lasting legacy, the ability to modify a trust is an important consideration, making states with inflexible rules a poor choice.