Careful Planning Can Avoid Incurring Double Taxation of Trusts

Tax Nexus Trap

Only a minority of states—including Florida, Nevada, and Texas—don’t 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 trusts that presumably “reside” in those minority states can be subject to income taxes in other states 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.

Four Factors

States may claim the power to imposes taxes on trusts based on the following four questions:

1. Where did settlor create 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 does the beneficiary 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’s distributed or distributable to a state resident.

Such laws can cause complications if a beneficiary chooses to move. Keep in mind, also, that states can 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 doesn’t 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 doesn’t provide the minimum contacts necessary if the resident doesn’t have a right to receive the property — or at least some degree of possession, control or enjoyment of the trust property.

3. Where does the trustee reside?

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 is the trust administered?

States may tax a trust that’s administered in the state.

Taking Steps to Minimize Risks

Trust settlors need to pay attention to those four factors for both existing and new trusts. By knowing how they’re 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’s worthwhile to review a trust’s connections to high-tax states on an annual basis. Trustees, administrators, and beneficiaries could have moved, potentially creating or eliminating tax nexus with different states. In some cases, however, other priorities may outweigh tax considerations.

Proceed with Caution

With careful planning, a trust can avoid incurring significant income taxes in multiple states. Brady Ware’s tax advisors want to help you avoid unintended consequences for new and existing trusts.