Introduction
NOTE: If your estate (or combined estate with your spouse) is over $5 to $7 million dollars, this might especially interest you.
In 2023, Pennsylvania Governor Josh Shapiro signed Senate Bill 815 (S.B. 815) into law, marking a significant shift in the state's treatment of grantor trusts for income tax purposes. If that sounds boring, you may want to keep reading as this opens an even better estate tax planning techniques for Pennsylvania citizens.
Effective for taxable years beginning on or after January 1, 2025, this legislation aligns Pennsylvania's tax code with federal provisions, recognizing irrevocable grantor trusts and altering the tax responsibilities of grantors, trustees, and beneficiaries.
This article explores the nuances of the new law, its practical implications, and provides illustrative examples to show its impact on estate planning in Pennsylvania, and to help you know if this type of trust might be for you.
Background: Grantor Trusts and Previous Pennsylvania Tax Treatment
Federal Perspective on Grantor Trusts
Under federal tax law, a grantor trust is one in which the grantor (the trust “creator”) retains certain powers or interests, causing them to be treated as the owner of the trust's assets for income tax purposes. In many cases, these trusts are “out” of their estate, for estate tax purposes but they income tax liability remains for the grantors. Consequently, all income, deductions, and credits of the trust are reported on the grantor's individual tax return, regardless of whether the income is distributed to beneficiaries. This treatment allows the trust's assets to grow without the burden of income taxes, as the grantor pays these taxes personally. It simultaneously shrinks the taxable estate of the grantor.
Pennsylvania's Previous Stance
Prior to the enactment of S.B. 815, Pennsylvania did not conform to the federal treatment of irrevocable grantor trusts. Instead, the state taxed these trusts as separate entities. Trustees were required to file a Pennsylvania Fiduciary Income Tax Return (Form PA-41), and the trust itself was liable for taxes on undistributed income, while beneficiaries were taxed on any distributed income. This discrepancy between federal and state tax treatments led to administrative complexities and potential double taxation issues, especially when grantors moved to states recognizing federal grantor trust rules.
Key Provisions of Senate Bill 815
Senate Bill 815 amends the Pennsylvania tax code to recognize irrevocable grantor trusts in alignment with federal tax provisions. The key aspects of the new law include:
- Taxation of Trust Income: Income received by a resident or nonresident trust, where the grantor is treated as the owner under Internal Revenue Code (IRC) Sections 671 to 679, will now be taxable to the grantor for Pennsylvania personal income tax purposes. This applies irrespective of whether the income is distributed to beneficiaries or retained within the trust. So, the growth of the trust can remain in the trust or be distributed.
- Relief for Trust Entities: Such trusts are no longer subject to Pennsylvania personal income tax on income or gains not distributed or credited to beneficiaries. This shifts the tax liability entirely to the grantor, simplifying the tax reporting process for trustees.
- Effective Date: The new provisions take effect for taxable years beginning on or after January 1, 2025.
Implications for Grantors, Trustees, and Beneficiaries
For Grantors
Grantors of irrevocable grantor trusts will now be responsible for reporting all trust income on their personal Pennsylvania tax returns. This change necessitates careful planning, as grantors must account for the additional income in their tax calculations and estimated payments. While this may increase the grantor's immediate tax liability, it offers the advantage of allowing trust assets to grow unencumbered by income taxes, effectively reducing the taxable estate.
NOTE: Your attorney can still draft a trust that is liable for its own taxes. Be sure to get help deciding what’s best for you.
For Trustees
Trustees of grantor trusts will experience a shift in their administrative responsibilities. Previously, trustees were required to file Form PA-41 and handle tax payments on behalf of the trust. With the new law, the obligation to report and pay taxes on trust income transfers to the grantor. Trustees will no longer need to make estimated tax payments for the trust or issue tax documents to beneficiaries for income distributions, streamlining trust administration.
For Beneficiaries
Beneficiaries of grantor trusts will also see changes in their tax obligations. Under the previous system, beneficiaries were almost always taxed on income distributed to them from the trust. With the enactment of S.B. 815, the grantor assumes tax liability for all trust income, regardless of distribution. Consequently, beneficiaries will receive distributions free of Pennsylvania income tax, as the income has already been taxed at the grantor's level.
Estate Planning Considerations
The recognition of grantor trusts in Pennsylvania presents several estate planning opportunities and considerations:
- Income Tax Planning: Grantors should assess the impact of additional taxable income on their personal tax situation. Strategies such as adjusting withholding or making estimated tax payments may be necessary to avoid underpayment penalties. Speak to your lawyer and accountant.
- Interstate Tax Implications: For grantors residing in or moving to states other than Pennsylvania, it's crucial to understand how different states' tax laws interact with Pennsylvania's new provisions to prevent unintended tax consequences or overpaying taxes.
- Review of Existing Trusts: Trusts established prior to 2025 should be reviewed to determine if modifications are beneficial under the new law. This may involve amending trust documents or decanting existing trusts into new ones that align with the grantor's objectives and the current tax landscape.
Addendum: Illustrative Case Studies
The following examples might help to reduce any confusion about how the new law will work.
Case Study 1: The Business Owner’s Legacy Plan
Scenario: John, a successful business owner in Pennsylvania, sets up an irrevocable grantor trust in 2025 to transfer ownership of his closely held company to his children while maintaining some control over income distribution. Under the new law, all income generated by the business inside the trust is now taxable to John personally. His children, as beneficiaries, receive distributions free of Pennsylvania income tax.
Outcome:
- John pays the trust’s income tax liability, reducing his taxable estate over time.
- The trust assets grow without erosion from tax payments, benefiting future generations.
- Trustees are relieved of filing Pennsylvania tax returns for the trust, simplifying administration.
Case Study 2: Real Estate Investor’s Dilemma
Scenario: Susan, a Pennsylvania resident, owns multiple rental properties and places them in a newly created irrevocable grantor trust for asset protection and estate planning benefits to her heirs. Under the new law, all rental income is reported on Susan’s personal Pennsylvania tax return, rather than being taxed at the trust level.
Outcome:
- Susan’s taxable income increases, requiring adjustments to her estimated tax payments.
- The trust's principal grows without tax leakage, preserving real estate assets for her heirs.
- Beneficiaries can receive distributions without Pennsylvania tax liability, improving their net inheritance.
Conclusion
Pennsylvania’s new law recognizing grantor trusts represents a major shift in state taxation, aligning it with federal law and simplifying tax compliance for estate planners, trustees, and beneficiaries. While this change presents opportunities for wealth preservation and transfer, it also requires careful tax planning to mitigate increased grantor tax liabilities. Reviewing and adapting estate plans to accommodate this legislative update is crucial for maximizing tax efficiency and ensuring smooth wealth transitions for future generations.
What To Do Next:
If you are a grantor, trustee or beneficiary of an irrevocable grantor trust that was established prior to 2025, reach out to your estate planning attorney to review the document to determine if modifications are beneficial under the new law. Our clients can reach the office at 610-933-8069 to set up a consultation.
If your estate exceeds $5 million dollars and you’re interested in passing assets to your heirs in this way, be sure to consult legal counsel and your income tax advisors.
