By Jennifer A. Mendel, JD, and Michael H. Israel, MA, JD, LL.M.
The U.S. Supreme Court recently issued its opinion on North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, which addressed “….the limits of a State’s power to tax a trust.” This is the first time in decades the Supreme Court has addressed this issue, and its decision could have significant implications for the private client.
Planning with trusts is a central component to any comprehensive wealth plan, and in addition to leveraging the estate, gift, and GST exemptions, consideration should be given to a trust’s income tax treatment. And when a trust is structured as a “non-grantor” trust - meaning it is responsible for its own income tax burden - state law governs the state where a trust may be taxed.
Trust Must Have Minimum Contacts
Due Process principles require that a trust must be sufficiently connected to a state before that state can assess tax on the trust’s income – a premise known as “minimum contacts.” The analysis is complicated, however, by the fact that each state is permitted to define what it considers suitable contact. For example, the residence of the grantor, the Trustee, or the beneficiaries, the location of the assets, the place of administration, or a combination of these factors, can all determine which state a trust “resides” in. The variance in laws from state to state can produce unlikely results and can thwart certain planning strategies.
Planning for State Income Tax with Trusts
Individuals who live in high income tax states, or who face increasing state income taxes, may look to utilize trust planning to move some assets out of their home state. For instance, an individual may have certain assets that will produce significant income, such as from the sale of a business, or have assets they intend to accumulate in trust for a considerable amount of time. Being able to establish a trust to hold these assets in a state with no income tax can result in significant tax savings. One planning method is the use of the “DING, WING, or NING” trust – an incomplete non-grantor trust domiciled typically in Delaware, Wyoming or Nevada. The basic premise is for the grantor to transfer assets to an irrevocable trust that is administered in a favorable state with a third-party resident Trustee. However, the transfer is not deemed a completed gift – and therefore, no gift tax is due. Further, the provisions of the trust ensure that the grantor is not responsible for the income tax; instead, the trust itself must pay. The idea, of course, is that the trust will be deemed to reside in the “no income tax” state, rather than the grantor’s own high-income tax state. It’s worthwhile to note that this approach, or any approach, to trust planning should occur well in advance of the intended transaction to avoid application of the “step transaction doctrine,” which can negate the tax benefits of a structure if the steps occur too close together in time.
Trust residence is also a planning issue with the prevalence of trust “decanting” (the process of transferring trust assets to another trust, which can involve moving the trust’s place of administration), or when, multiple generations later, many of the original factors used to tax a certain trust no longer exist.
In states that tax trusts based on the location of the assets, the Trustee, and/or the beneficiaries (California is a notable example), trust planning can be successful at reducing the state income tax burden, since the grantor’s “home” state will not consider the trust a resident for tax purposes.
On the other hand, in states that tax a trust based on the grantor’s state of residence, such as Illinois, income tax planning is of greater concern, as “ING”-type trusts do not produce the intended results. While it’s fairly easy to establish a trust in a state that has no income tax, unless the grantor moves, the trust will not avoid the “home” state’s income tax. Clients who undertake trust planning in these states to reduce income taxes may face opposition from the state’s Department of Revenue.
The Linn Case – Taxation Based on Grantor’s Residence
Illinois’ definition of trust residency under 35 ILCS 5/1501(a)(D)(20) was challenged in Linn v. Department of Revenue, a 2013 case which concerns an irrevocable trust established in 1961, while the grantor was a resident of Illinois. Illinois taxes trusts based on the residence of the grantor at the time the trust became irrevocable, and it properly assessed tax on the trust in Linn. Fast forward several decades later, and some of the subtrusts created under the original trust agreement had been properly “decanted,” or transferred, to new trusts, governed by new trust agreements, in Texas. Additionally, the Trustee, the beneficiaries, the assets, and the place of administration now all existed outside of Illinois. Nonetheless, Illinois continued to tax the new Texas trusts, since the trusts originated from the Illinois trust. The Trustee disagreed and filed suit.
The Illinois court agreed with the Trustee and found “insufficient contacts exist between Illinois and the [trust] to satisfy the due process clause, and thus the income tax imposed on the [trust] for the tax year 2006 was unconstitutional.” While the ruling found the statute unconstitutional as applied to the facts in this case, it did not find the statute itself unconstitutional, and it is still applicable to trusts created in Illinois. All the same, it was a successful challenge to a state’s power to tax a trust when the trust’s connection was tenuous, at best.
The Kaestner Decision
Since then, there have been several cases regarding the taxation of trusts at the state level, but Kaestner is the first state tax case to be heard by the U.S. Supreme Court in some time. Kaestner involves a trust that was established in New York, in part for the benefit of Kimberley Kaestner. The Trustee was in New York (later in Connecticut), and the assets were under management by a Boston-based firm. Kimberley eventually moved to North Carolina, but the trust’s domicile stayed the same.
Even so, based on North Carolina’s statute, which taxes trusts based on the residence of the beneficiary, North Carolina claimed that all of the trust’s income, whether distributed to Kimberley or not, should be taxable by North Carolina. It should be noted that, for the period in question, Kimberley did not receive any trust distributions, nor did she have the discretion to compel any distributions. Not surprisingly, the Trustee argued that the state did not have the authority to tax the trust based solely on the residence of a beneficiary, and the case worked its way up to the North Carolina Supreme Court, which agreed with the Trustee’s assertion. Eventually, the case was chosen to be heard by the U.S. Supreme Court, and many practitioners hoped that the Supreme Court’s opinion would provide more definitive and broad guidance on the constitutionality of state income taxation of trusts, beyond the facts of the case.
The Supreme Court opinion confirmed what most were thinking – North Carolina cannot assess income tax on an entire trust’s income based solely on the residence of the beneficiary, as that connection alone is too weak and does not meet “minimum contacts.” Central to the Supreme Court’s analysis was the amount of control, possession or enjoyment the beneficiary had over the trust’s assets. As noted above, Kimberley did not control the timing of distributions, did not receive any distributions, nor did she control or manage the trust’s assets.
The Supreme Court was clear, however, that it was only reviewing the application of North Carolina’s statute to Kimberley’s trust, and concluded that the “….presence of in-state beneficiaries alone does not empower a State to tax trust income that has not been distributed to the beneficiaries…..” The Supreme Court declined to expand its analysis further, thereby providing little of the hoped-for guidance on the factors used to tax trusts in other states.
Kaestner’s Impact on Trust Income Tax Planning
Nonetheless, Kaestner is still a significant case. Although the Supreme Court declined to directly opine on state systems that tax based on the residency of the grantor or Trustee, or the place of administration, the Supreme Court’s opinion references several state cases that indicate what combination of factors the Court likely considers sufficient to justify state income taxation of trusts. Notably, for grantor-residency tax states, the Supreme Court states that there must be an analysis of what the grantor controls or possesses, and how it relates to the state’s right to taxation. This is in line with a recent trend of cases (Linn being one) at the state level that suggest that taxation of a trust based solely on the residence of the grantor, without further connections, is not sufficient.
One of these recent cases, Fielding v. Commissioner of Revenue, also rejected the residence of the grantor as the basis for taxation by the State of Minnesota. The state filed a petition with the Supreme Court late last year, but the Supreme Court recently declined to hear the case.
While we wait for further decisions that more clearly define the limits of state taxation, income tax planning can occur in states with similar overreaching statutes with proper planning and a careful analysis of all the factors involved, but the client should be willing to incur significant expense in potentially defending its position.