The US Supreme Court recently ruled that just because the beneficiary of a trust lives in a certain state doesn’t necessarily mean that the state can impose income tax on the trust. It would violate the Due Process Clause of the 14th Amendment to the Constitution, the court ruled unanimously.
The trust at issue was created in 1992 by a New York resident for the benefit of his children. The trustee was also a New York resident, and the only connection the trust had with North Carolina was that one of the children had moved there. The state of North Carolina assessed a $1.3 million tax on the basis that the statute allowed the state to tax any income that benefits a state resident. In this instance, there were no distributions made to the beneficiary during the years in question and the trust did not make any direct investments in or hold any real property in North Carolina.
Under due process requirements, a state may impose income tax only if there are any minimum connections between the state and the trust. In the absence of distributions from the trust, the mere residence of a beneficiary in the state does not qualify as a minimum connection, especially when the beneficiary does not have the right to demand income from the trust, as was the case with this trust, the Supreme Court ruled.
In most states, a trust is deemed a resident trust if it is either created by a grantor (during lifetime) who is a resident of that state or by a resident decedent’s will. A resident trust is subject to that state’s income tax on all its income, regardless of the source. A nonresident trust, however, is subject to tax in that state only on the income sourced in that state (for example, rental income or income from business activities conducted in that state).
Some states tax trusts on the basis of other factors that the courts have found as having an adequate nexus to the state. These factors include the domicile of the trustee(s) and the situs of the trust administration.
For example, California taxes trust income on the basis of the trustee’s domicile and the residence of “noncontingent” beneficiaries. So if, for example, a New York resident creates a trust naming her two sisters, one of whom resides in California, as trustees, California will subject one-half of the trust’s income to income tax. Since the top tax rate in California is 13.3%, this could be quite significant over the life of the trust.
New York, on the other hand, categorizes trusts as either “resident” or “nonresident.” A resident trust is one that is funded by a New York resident either during that person’s lifetime or upon his death, whereas a nonresident trust is funded by someone who is not a New York resident. A nonresident trust is subject to New York tax only on its income sourced in New York regardless of where the beneficiaries or trustees reside. In contrast, a resident trust is subject to tax on all its income if a trustee is resident in New York—no matter where the income is sourced. It is therefore quite simple for a New York resident trust to avoid tax as long it has no resident trustee, no New York tangible property and no New York source income (not even $1).
Unlike an individual who must physically move to a low- or no-tax state to reduce his tax burden, a trust can avoid state income tax if it chooses its place of administration, investments and trustee residence with caution. There are many states that impose no state income tax on trusts created by nonresidents—including Delaware, Alaska, South Dakota and Nevada—and that offer other benefits, such as well-drafted trust laws. All one needs to do is choose an institutional trustee that has an office in any of these states. Although there will be some fee incurred, many of the trust companies offer reduced fees for directed trusts—those trusts in which they typically have only administrative duties. And these fees are likely to be more than offset by the state tax savings.
What if you currently are a beneficiary or trustee of a trust that is irrevocable and subject to state income tax? Through the process of either a decanting (distributing the assets of a trust into a new trust with different provisions) or a nonjudicial modification (depending on which state’s law the trust is governed under), you can “amend” the trust to remove the problematic connections that subject the trust to state income tax. In some cases, this might require a court proceeding. Or it might be as simple as asking the current trustee to resign in favor of a nonresident trustee. The resulting savings in state tax over the long term will more than offset the cost of remediation.