Different states have different rules for determining whether a trust is a “resident” for income tax purposes. State tax liability can depend on the location of settlors, trustees, or beneficiaries. In some situations, a trust could be liable for taxes in multiple states. Fortunately, you may be able to take certain steps to reduce the taxation of new trusts and existing trusts.
Tax Nexus Trap
Several states do not impose any income taxes on nongrantor trusts (trusts that are separate taxable entities from the settlor, who retains no control or interest in it). But those states — including Florida, Nevada, and Texas — are in the minority.
Moreover, trusts that ostensibly “reside” in those states may be subject to income taxes in other states. That is because many states find ways to establish tax nexus with trusts that appear to have minimal connection to the state. The term “tax nexus” generally refers to the minimum contacts with a state that are required to subject an entity to taxation in that state.
States may claim the power to impose taxes on trusts based on the following four factors:
1. Where the settlor created the trust. Several states impose a tax if the testator (a settlor who created a testamentary trust in a will) or the trustor (a settlor who created an “inter vivos” or “living” trust) resided in that state when the trust was created. In other words, according to these states, a person could draft a will or establish a trust while briefly residing in the state and the trust will be taxed there even if the person died after living elsewhere for decades.
Some courts have disagreed with states that base taxation solely on testator or trustor residency. For example, in 2013, the Pennsylvania Commonwealth Court found that such a tax scheme violated the U.S. Constitution (McNeil, Jr. Trust v. Pennsylvania, 67 A.3d 185, Pa. Commw. Ct. 2013). In that case, the state had assessed income tax and interest against two inter vivos trusts that were located and administered in Delaware and governed by the laws of that state. The trusts had no Pennsylvania income or assets, but their trustor had lived in Pennsylvania when he established them in 1959.
2. Where the beneficiaries reside. A handful of states will tax a trust that has one or more beneficiaries residing within their borders. For instance, California taxes trust income that is distributed or distributable to a state resident.
These laws can complicate things, as beneficiaries might move at any time. Bear in mind, too, that states may have broad definitions for the term “beneficiary” in this context. They could ensnare not only mandatory beneficiaries but also discretionary or contingent remainder beneficiaries living there.
However, in 2019, the U.S. Supreme Court dealt a blow to trust taxation based entirely on the residence of beneficiaries. In North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust (139 S. Ct. 2213, 2019), the Court unanimously held that the presence of in-state beneficiaries alone does not empower a state to tax undistributed trust income if the beneficiaries have no right to demand the income and may not even receive it. According to the Court, the residence of the beneficiaries does not provide the minimum contacts necessary if the resident does not have a right to receive the property — or at least some degree of possession, control, or enjoyment of the trust property.
3. Where the trustee resides. Some states will tax a trust if a trustee resides in the state. States also may consider the residence of co-trustees, including trust advisors and other non-trustee fiduciaries. For example, a trustee could reside in Nevada, but, if the trust also has a fiduciary living in California, California treats the trust as subject to its income tax.
4. Where the trust is administered. States may tax a trust that is administered in the state.
Steps to Minimize the Risks
Trust settlors need to pay attention to those four factors for both existing and new trusts. By knowing how they are affected by the relevant laws, it may be possible to reduce the related taxes.
For example, the Supreme Court in Kaestner acknowledged that, in states that tax based on a beneficiary’s residence, the beneficiary could delay taking distributions until after relocating to a state with a more favorable tax regime. Trusts can avoid taxation in states that tax based on trustee residence by appointing nonresident trustees or replacing resident trustees. A similar approach could be taken to avoid taxation based on where a trust is administered. Another alternative is removing certain nondiscretionary powers and rights from settlors or beneficiaries.
It is worthwhile to review a trust’s connections to high-tax states on an annual basis. Trustees, administrators, and beneficiaries may have moved, potentially creating or eliminating tax nexus with different states. In some cases, however, other priorities may outweigh tax considerations.
Proceed with Caution
Without careful planning, a trust can end up on the hook for significant income taxes in more than one state. Contact our estate planning team to help avoid unintended consequences for existing and future trusts.
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