Tax Duties of Trustees – Federal and State Compliance Issues Involving Complex Trusts & Fiduciary Income Tax

Trustees Have Tax Duties

Trustees must file complete and accurate tax returns and pay taxes when due. Generally, courts take a strict view when the trustee does not carry out these basic tax duties. Most states have found a trustee can be liable for interest and penalties where the trustee negligently or willfully falls below the standard. For this reason, a trustee must exercise due care and diligence.

Itemized Deduction Limit

The state and local tax deduction permits taxpayers who itemize when filing federal taxes to deduct certain taxes paid to state and local governments. However, the 2017 Tax Cuts and Jobs Act imposed a $10,000 itemized deduction limit. This affected California in particular because of the high-income tax rates in the state.

Pass-Through Entities

In the case of pass-through entities, such as partnerships and S corporations, the owner reports a share of the entity’s profits. The notice generally provided that for state tax payments made on or after November 9, 2020, the tax payment will reduce federal taxable income to that partner. Owners of eligible entities can deduct a more significant portion of their state income taxes paid against federal income.

The SALT Workaround

For the tax years ending before 2026, trustees should communicate the tax consequences to the income beneficiaries. Income beneficiaries may need to adjust their personal withholding taxes if the trustee and pass-through entity take advantage of the SALT workaround. 

Drawbacks of salt workaround. Sometimes there are drawbacks if a remainder beneficiary uses the SALT workaround. Assume a pass-through entity has $1 million of income. This would mean it could pay up to $93,000 of state income tax. The entity now has $93,000 less cash, which might arguably reduce what the beneficiaries receive one day.

Check out the next part of our series to learn about property taxes as they relate to trusts.

Are you a trustee that would like to learn more about tax planning? One of our expert tax attorneys can help. Call us today at (949) 501-4800.