Where does your trust reside? Does it reside in more than one state? Does it reside nowhere? What are the implications of a trust’s residence? One important implication is how the trust will be taxed for state income tax purposes. With a varied approach to the income taxation of trusts among the states, it is important for trust grantors, beneficiaries, and trustees to understand the relevant issues and planning considerations. Recent state court opinions show that this is an ever-changing area of the law, and one not without conflict.
State Taxation of Trusts
Although most states follow the federal grantor trust rules which would disregard the existence of a trust wholly taxable to the grantor for income tax purposes, that is not universal. Further, state sourced income is generally taxable in the state where the income is sourced (with a varied set of rules among the states determining the source of income). Therefore, the primary consideration for this article will be considerations regarding the state income taxation of non-source income of non-grantor trusts. Additionally, distributed income is generally taxable to the beneficiary meaning that the treatment of accumulated trust income is the primary concern in this analysis (as well as whether to accumulate vs. distribute). While this has always been an important planning issue, it has gained an increase in significance in the wake of the number of IRS private letter rulings respecting incomplete gift non-grantor trusts.1 Depending on where the state such a trust is formed, an incomplete gift non-grantor trust may be referred to as a NING (Nevada), DING (Delaware), WING (Wyoming), etc. This planning may be especially useful involving the sale of businesses, especially involving the sale of intangible business assets.
Eight states currently have no state income tax. Those states are Alaska, Florida, Nevada, New Hampshire, South Dakota, Washington, and Wyoming. Of the states with state income taxes, whether a trust is taxable is generally determined by one or a combination of the following criteria:
- Residence of the grantor, with these states diverging further regarding whether the trust is a lifetime trust, or one created by the Will of a resident decedent;
- Situs of trust administration of the trust and/or residence of the trustee; and
- Residency of trust beneficiaries (sometimes considering whether there are current distributions to the beneficiary and/or the beneficiary’s share of trust income).
Of course, the states applying these factors further have varied income tax rates. California, for example, taxes trust income at a rate up to 13.3%.2 Therefore, the analysis must not only consist of a question of what state(s) may tax a trust, but also what various income tax rates may apply. As indicated above, the state where the beneficiaries may be taxed also must be considered as well as their potential federal income tax rates. This must be compared against the benefits of accumulating versus distributing income to determine the overall state and federal tax which may be applied to a trust’s income.
A simple example can illustrate the importance of this question. A trust with a California trustee having $1,000,000 of capital gain income all taxable at the top rate of income tax in California will pay $133,000 in state income tax. This issue has been exacerbated even further due to the recent caps placed on deductibility of state and local taxes under the 2017 tax bill. However, if the grantor had named a trustee in another state, Texas for example, there could have been no state income tax on that income. As can be seen, planners anywhere in the country need to consider the state income tax implications of whom their clients appoint as trustees of their trusts. There can be very important tax consequences.
Relevant to the question is not only whether a state may attempt to tax a trust’s income, but also whether that state’s attempt to tax the trust is constitutional. As will be discussed below, just because a state attempts to tax a trust’s income does not mean the state has a constitutional basis to do so. A handful of recent court opinions illustrate a willingness of state appellate courts to find statutes unconstitutional when there is insufficient constitutional nexus to assert jurisdiction.
In analyzing the issues, Richard W. Nenno of Wilmington Trust Company suggests the following analysis:3
- Determine what state statutes, if any, apply;
- Determine whether each state in question has personal jurisdiction over the trustee or in rem jurisdiction over the trust assets;
- Determine whether imposition of the tax violates the state’s constitution or the U.S. Constitution; and
- Determine whether trust assets generate source income taxable by one or more states.
Recent Court Opinions Regarding Constitutionality
Most recently, on July 18, 2018, the Minnesota Supreme Court ruled their state’s attempt to tax a trust to be unconstitutional when the relevant statute attempted to tax a trust if the trustee was a resident of the state on the date the trust became irrevocable.4 The facts of this case are that 4 irrevocable trusts were formed with stock of a Minnesota S corporation. At the time, the trusts were grantor trusts created by a Minnesota resident. Eventually, the grantor relinquished the powers that caused the trust to be a grantor trust. During the year at issue, the trustee was a Texas resident and the trusts sold their interests in the S corporations. Three of the four trust beneficiaries resided outside of Minnesota.
The trust argued first that the only issue to be considered is whether statute only requiring a Minnesota grantor is constitutional. The trust further argued that, even looking beyond that limited questions, there are insufficient contacts with the state to give a constitutional right to tax the trust’s income. The state argued that the trusts were formed in Minnesota, by a Minnesota resident, using a Minnesota law firm, held stock in a Minnesota S corporation, were governed by Minnesota law, and had a Minnesota beneficiary. Ultimately, the Court disagreed with the trust’s desire to limit the inquiry to the face of the statute without looking into the other facts, but still found there to be insufficient contacts to create nexus for taxation. The Court did not allow the state to use the residence of a beneficiary as relevant for the residency of a trust as “a trust is its own legal entity, with a legal existence that is separate from the grantor and the beneficiary.” The trust is the taxpayer, not the beneficiary. Also, although the grantor was a Minnesota resident when the trust became irrevocable and a Minnesota law firm prepared the trust, that was years earlier. Such acts cannot bind the trust forever to be subject to state taxing jurisdiction. Further, the Court discussed the existence of a Minnesota S corporation holding Minnesota assets, but noted that corporate stock is an intangible asset and, in this case, was held solely by a trustee out of state. Merely governing a trust under state law provides no contacts with the state. Until or unless the courts of the state develop a relationship with the trust, that fact was of no consequence. In the end, the Court required the state to focus on contacts in the year at issue, not old, historical facts. There simply were insufficient contacts with the state in the relevant year to serve as a constitutional basis for taxation.
Also very recently, in the Kaestner case handed down by the Supreme Court of North Carolina on June 8, 2018, the state’s attempt to tax a trust based solely on the residency of a beneficiary was held to violate both the North Carolina constitution’s and the U.S. Constitution’s due process requirements.5 The relevant North Carolina statute allowed the state to tax income of a trust held for the benefit of a North Carolina beneficiary, regardless of whether any distributions were made for that beneficiary or any other factor such as situs of trust administration. The trust was sitused in New York and had assets in Massachusetts. Citing Quill, the Court referred to the requirement of some definite link, or minimum connection, with the state prior to a constitutional right to tax.6 Although the physical presence test of Quill has now been altered by the recent Wayfair opinion, the requirement for minimum contacts is still in effect.7 As in Fielding, the Court noted the “legally separate, taxable existence” between the trust and its beneficiaries and that “minimum contacts…cannot be established by a third party’s minimum contacts.” In essence, the beneficiary and the trust are two, separate tax entities. Actions by the beneficiary cannot be imputed to the trust.
These two very recent cases follow a number of other decisions in recent years where states’ attempts at taxing trusts have failed on constitutional grounds. Some of the additional cases are as follows:
- Residuary Trust A U/W/O Kassner: Like Minnesota, New Jersey attempted to tax a trust created by a resident-grantor. Like Fielding, the trust’s only connection to the state was that it held shares in a S corporation that owned New Jersey assets. The trust paid tax on the share of pass-through income attributable to New Jersey assets, but not its other income. Without addressing constitutional issues, the Court found that taxing all of the trust’s income on these facts would be fundamentally unfair.8
- Linn: This case also involved an attempt to tax a trust created by an in-state grantor. Here, Illinois attempted to tax the income of a trust administered in Texas. No beneficiaries were Illinois residents. The only contacts with the state were that grantor and original trustee were Illinois residents and Illinois law governed. The Court found there to be insufficient contacts for the state to constitutionally tax the trust.9
- McNeil: Once again, a state lost in court based on a statute attempting to tax the income of a trust created by a resident-grantor. In the year at issue, the trust had no Pennsylvania source income, had no assets in Pennsylvania, and was governed by Delaware law. Merely having discretionary beneficiaries in Pennsylvania was insufficient contacts to allow taxation of the trust on these facts. As with other cases cited in this article, the Court noted that a trust and its beneficiaries are different tax entities. They cannot be aggregated. Only to the extent trust distributions are actually made to the beneficiaries may Pennsylvania tax trust income.10
It is important to consider how to plan for both newly formed and preexisting trusts in determining how to minimize state income tax. Some of the important considerations are as follows:
- Newly formed trusts:
- Testamentary Trusts vs. Revocable or Lifetime Irrevocable Trusts: At least two jurisdictions’ appellate courts have upheld the ability to tax the income of a trust established under the Will of a decedent whose estate was probated in the state.11 The primary reasoning is that the state’s courts were involved. Other states seek to impose tax on this basis or at least use this as a basis for tax. Therefore, for decedents living in jurisdictions with state income taxes, it may be worthwhile to consider use of revocable trusts or lifetime irrevocable trusts. Note that elections to treat a qualified revocable trust as the decedent’s estate under IRC Section 645 could affect this treatment.
- Residence of Grantor: As seen above, states have been largely unwilling to base taxation solely on the residence of the grantor (at least inter-vivos trusts). Therefore, in the case of a mobile grantor, creating the trust while a resident of a jurisdiction which does not attempt to use this as a factor may be worthwhile planning.
- State of Administration and/or Residency of the Trustee: When selecting a trustee and/or the state where a trust will be administered, it will be important to consider how the relevant states might view that factor in seeking to assess tax. For example, where the preferred trustee is located in a state that taxes a trust administered in the state, perhaps appointing an administrative trustee in another jurisdiction may create planning benefits.
- Drafting Flexible Trusts: When drafting new trusts, flexibility should be considered. Examples which may serve to allow minimization of state income tax include movable situs provisions, specific inclusion of a decanting power, powers of appointment, granting the right of a trustee to delegate administrative duties, and granting someone the power to remove and replace the trustee.
- Preexisting trusts:
- Situs Change: To the extent state laws or the terms of the trust allow the situs of the trust to be moved to a more favorable income tax jurisdiction, this should be considered.
- Decanting: Where a situs change will not work to remedy the problem (i.e. a testamentary trust created under the probated Will of a decedent of the state) or when another method of changing situs may be problematic or less desirable, decanting to a trust formed in another state may be a planning solution.
- Change in Trustee: A simple change in the identity of the trustee, or the addition of an administrative trustee, may allow the trust to avoid state income tax.
Of course, the considerations outlined above are only a handful of the various considerations in how to handle trusts for state income tax purposes. Among other issues, is how to handle distributions of income. The trustee will need to consider the combined state and federal income tax which will apply to accumulated income versus distributed income. While that will only be one consideration in determining whether to make current distributions, it may serve to be an important one.
Attorneys arguably have a duty to their clients to consider these issues. Given the broad fiduciary duties of trustees, trustees generally are under a legal duty to minimize state income taxes. Failure to consider the state income tax implications of trust planning may create unintended liability on an attorney and/or a trustee. Therefore, these considerations are not mere suggestions or hypothetical issues, but rather issues that very well could create personal liability.
Anyone involved in trust planning and administration knows there are almost endless issues to consider. One of the important issues to consider is the state income tax consequences of decisions made in how a trust is formed and administered. Tax law can be complicated. Adding to that complexity is that there are multiple ways states seek to tax trust income. To minimize the effect of state income tax on a trust, there are opportunities at the drafting stage as well as during administration. One time when this planning can be especially useful is in the sale of a business, as illustrated in the Fielding case. Saving state income tax on large transactions can add significant value to the bottom line of a transaction.
Trust planners and trustees should evaluate new trusts and preexisting trusts to determine what may be done to reduce the imposition of state tax on the trust and its beneficiaries. There are several issues to consider. As described in this article, not only should planners consider relevant states’ statutory taxing scheme but also whether a challenge to a state’s attempt to assert income tax may be successful. That opportunity should not be forgotten. These considerations should take place periodically during administration as well as during planning for any large transaction involving trust assets. In summary, consideration of state income tax implications should be an important part of trust planning and administration. There are a number of opportunities to avoid unnecessary tax liabilities.
- Some of the more recent rulings include PLRs 201751001–003; 201744006–008; 201742006; 201738008–009; 201729009; 201718003‒010, 012; 201653001‒006; 201650005; 201636027‒032 (May 23, 2016); 201628010; 201614006‒008; 201613007.
- A summary of state income tax of non-grantor trusts has been prepared by Steve Oshins and can be found at https://www.oshins.com/state-rankings-charts.
- Nenno, Richard W., “Minimizing or Eliminating State Income Taxes on Trusts,” On the Road Again: Situs and the Resident Trust, 2018 American College of Trusts and Estates Counsel, March 10, 2018.
- Fielding for McDonald v. Commissioner of Revenue, 2018 WL 3447690 (Minn. 2018)
- The Kimberly Rice Kaestner 1992 Family Tr. v. North Carolina Dep’t of Revenue, 814 S.E. 43 (N.C. 2018).
- Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
- South Dakota v. Wayfair, Inc., 585 U.S. ____ (2018).
- Residuary Trust A U/W/O Kassner vs. Dir. Div. of Taxation, 28 N.J. 541 (N.J. 2015).
- Linn v. Department of Revenue, 2 N.E. 3d 1203 (Ill. 2013).
- Robert L. McNeil, Jr. Trust ex rel. McNeil v. Com., 67 A.3d 185 (Pa. 2013).
- See District of Columbia vs. Chase Manhattan Bank, 689 A.2d 539 (D.C. 1997) and Chase Manhattan Bank v. Gavin, 733 A.2d 782 (Conn. 1999).