State Income Taxation of Non-Grantor Trusts: An Important Area for Tax Planning

Journal of Financial Planning: December 2019

I. Richard Ploss, Esq., CPA, CFP^®, TEP, is counsel to Porzio, Bromberg & Newman P.C. and a member of the firm’s trusts and estates department. He serves as an adjunct professor, teaching trusts and estates at the University of Maine Law School.

Non-grantor trusts¹ have become a staple item in many clients’ estate plans. While financial planners have traditionally focused on the estate and gift tax planning associated with the creation of such trusts, the income taxation of trusts and beneficiaries of trusts (sometimes referred to as “fiduciary income taxation”) has not garnered as much attention.

As is the case with individual and business entities, U.S. domestic non-grantor trusts and their beneficiaries are subject to the federal income tax under the Internal Revenue Code (IRC) and, depending upon the residency of the trust, state income taxation as well. While the rules associated with fiduciary income taxation are uniform with regard to federal income tax, whether a trust and its beneficiaries are subject to state income taxation will depend upon individual state law, which is not uniform in its application and scope.

The cost of state income taxation can be high. While some states (such as Florida and Texas) impose no income tax on a resident trust and its beneficiaries, other states (such as New Jersey, New York, and California) have fiduciary income tax systems with rates as high as 13.2 percent (in California). In many instances, with proper planning and trust administration state fiduciary income taxes can be minimized or in certain instances eliminated.

To better advise clients, planners need to understand the following: the basics of fiduciary income taxation; how states determine whether a trust is a “resident trust” that together with its beneficiaries is subject to state income taxation; and, what planning should be considered to minimize the impact of state income taxes on a trust and its beneficiaries.

This article will be divided into three parts. In Part I, I will provide a brief overview of the mechanics of fiduciary income taxation and how a trust and its beneficiaries are taxed for income tax purposes. In Part II, I will discuss the three current types of state fiduciary income tax regimes among the U.S. states, and the impact of the recently decided U.S. Supreme Court decision North Carolina Department of Revenue v. Kimberley Rice Kaestner² (“Kaestner”) on these existing regimes. The focus will be on how states determine whether a trust should be subject to fiduciary income taxation in that jurisdiction. In Part III, I will discuss some planning opportunities that planners and their clients may wish to consider to minimize state fiduciary income tax liability.

Part I: Overview of Trust Income Taxation

Federal income tax. Like most taxable entities and individuals, non-grantor trusts generally recognize gross income on all worldwide income. The trust may claim certain deductions³and an exemption⁴ in order to compute its taxable income. For income tax purposes, taxable income is taxed only once, either at the trust level (which theoretically is assessed against taxable income that the trust recognizes but does not distribute to the trust beneficiaries during the tax year), or, at the beneficiary level (for taxable income that the trust recognizes but distributes to the trust beneficiaries during the tax year). As such, a trust is a “hybrid entity” in that it retains the characteristics of both a Subchapter C Corporation (which pays income tax at the entity level on all income it recognizes during its tax year) and a partnership or Subchapter S Corporation (in which all items of income regardless of whether such income is distributed, is taxed to the partners or shareholders) under the Internal Revenue Code of 1986, as amended.

As part of this regime, trusts that recognize income and distribute the same to the beneficiaries in the same year will deduct such distributed income on the trust’s fiduciary income tax return by claiming an “income distribution deduction.” Beneficiaries who receive such distributed income will be issued a Schedule K-1 reflecting the type of income that was distributed to them (e.g., portfolio or business income) and will report the same on their individual tax returns in the same year in which trust claimed the distribution deduction.⁵

Unlike Subchapter C Corporations or individual taxpayers, a trust’s federal income tax rates are “compressed” with all trust ordinary taxable income in excess of $12,500 (for tax year 2018) being taxed at the highest federal marginal income tax rate.⁶ Computation of the distribution is dependent upon the computation of a trust’s “distributable net income” (sometimes referred to as “DNI”). A discussion of how to compute DNI is beyond the scope of this article.⁷

State income tax. Most state fiduciary income tax regimes “piggyback” on the federal system by employing the same “hybrid entity” approach to trust income taxation. However, some states’ systems do not totally “mimic” the federal law, and the income tax consequences for trusts and beneficiaries in these jurisdictions will vary.⁸

Part II: State Fiduciary Income Tax Regimes and the Kaestner Decision

Types of state tax regimes. As discussed above, some states do not impose state income tax on resident trusts, while other states impose significant tax burdens on trusts that have a connection (nexus) to the state. Complicating the issue even further are the systems that states utilize in determining there is sufficient nexus to cause the entire trust to be subject to the taxing state’s income tax system.

Some states (such as Maine) view the domicile of the grantor (trust creator) at the time that the trust was created as the determining factor for state taxation (“grantor focused”). Other states (such as California) take the position that the domicile of a trustee is the determining factor (“trustee focused”). Other states (such as Louisiana) will base the imposition of tax on the governing law as contained in the trust instrument. Still, other states (such as Illinois and Missouri) weigh a series of factors, such as residency of the trustee, residency of the beneficiaries, location (situs) of trust property, place of administration (i.e., where meetings with beneficiaries are held), and governing law as contained in the trust instrument (“factors focused”). Finally, a few states (such as Georgia and North Carolina) have taken the position that the residency of the beneficiary is the sole determinative factor for imposing state income tax on the trust (“beneficiary focused”).⁹

The application of these various systems can sometimes produce very onerous and unfair results:

Example 1: Under Maine’s current regime, an irrevocable trust that is created by a Maine resident grantor for the benefit of Florida resident beneficiaries, has a New York resident serving as trustee, and solely owns liquid assets that are held by a Massachusetts custodian will be subject to Maine income tax, even though there is no continuing nexus to Maine.

Example 2: Likewise, an irrevocable trust created by a Florida resident grantor for the sole benefit of Florida resident beneficiaries and funds the same with Florida situs (location) assets will be subject to California fiduciary income tax if one of the serving trustees of the trust is a California resident.¹⁰

The constitutional challenge to state tax regimes. Tax practitioners have consistently claimed that a state’s ability to tax the income of a trust which has no ongoing nexus to that state violates the U.S. Constitution. They have raised the argument these systems violate the Due Process Clause of the 14th Amendment. Unfortunately for taxpayers and their advisers, the U.S. Supreme Court has not ruled on a case that would bring certainty to this area of taxation. During its last term, in a highly anticipated case, the U.S. Supreme Court addressed this issue in the case North Carolina Department of Revenue v. Kimberley Rice Kaestner.

The Kaestner decision. The facts in this case are relatively straightforward. In 1989, a New York domiciled grantor created an irrevocable trust for the benefit of his children. The trust-governing instrument granted the independent trustee the “absolute discretion” to distribute trust income to the beneficiaries in “such amounts and proportions” as the trustee might from “time to time” decide.

At the time that the trust was created, none of the grantor’s children resided in North Carolina, the trustee did not reside in North Carolina, nor did the trust own any North Carolina situs property. The trust-governing instrument specifically stated that all trusts were to be governed under the laws of New York. In 1992, the trust divided into separate trusts for the benefit of each of the grantor’s children and their children (grantor’s grandchildren). Each trust was to terminate upon a child’s attaining the age of 40, and the remaining assets were to be distributed to the child who was a beneficiary of such trust.

In 1997, one of the grantor’s children, Kimberley, for whom a share was held in one such trust, permanently moved to North Carolina. With Kimberley’s consent, the trustee, utilizing New York’s decanting statute, transferred the assets in the trust for her benefit into a new trust which, while retaining the trustee’s absolute discretionary authority over distributions, eliminated the termination provision, which would have mandated the distribution of principal to Kimberley upon her attaining age 40.

During the tax years from 2005 to 2008, the trustee made no distributions of income or principal to Kimberley or her children. Furthermore, the trustee was a New York resident, the trust corpus was held in a Massachusetts investment account, and the trustee never met with Kimberley in North Carolina to discuss the administration of the trust. However, the North Carolina Department of Revenue, relying on a North Carolina statute which authorizes the state to impose an income tax on any trust income that “is for the benefit of a state resident,” asserted that all of the income recognized by the trustee was subject to North Carolina income tax. The North Carolina Department of Revenue claimed that the trust owed a tax liability of more than $1.3 million. The trustee paid the tax and sued the North Carolina Department of Revenue in state court asserting that the state’s tax system violated the 14th Amendment. The North Carolina Supreme Court, affirming a lower court decision, ruled in favor of the taxpayer. Not to be denied, the North Carolina Department of Revenue appealed the decision to the U.S. Supreme Court, which granted certiorari and heard oral arguments in April 2019.

In writing for a unanimous court, Justice Sotomayor held that in order for a state’s taxing system to not violate the 14th Amendment’s Due Process Clause, there must be some definite link between a state and the person, property, or transaction it seeks to tax; and that the income attributed to the state for tax purposes must be rationally related to the values connected with the taxing state. In the trust beneficiary context, this link and rational relationship focuses on the beneficiary’s right to control, possess, or enjoy trust assets. As applied to the facts in Kaestner, since Kimberley did not receive any income from the trust for the years in question, had no right to demand trust income or otherwise control, possess, or enjoy trust assets, and could not count on receiving any specific amount of income from the trust in the future, the court found that North Carolina’s statute violated the 14th Amendment.

Consequences of Kaestner. The Kaestner decision provides that a beneficiary-focused state income tax system will not survive the Due Process Clause. However, the court specifically limited the applicability of its opinion to the facts in the case. The Kaestner decision clearly stands for the proposition that, in the case of a purely discretionary trust, a beneficiary-focused tax system will not satisfy the scrutiny of the Due Process Clause if the following factors are present:

1. The trustee is not a resident of the taxing state;

2. The trust is not administered under the laws of the taxing state;

3. The trust does not own any assets in the taxing jurisdiction;

4. No aspects of trust administration occur in the taxing state;

5. The beneficiary who resides in the taxing state has no unilateral right to compel the trustee to make distributions to the beneficiary; and

6. The beneficiary who resides in the taxing state will not receive a terminating distribution from the trust during his/her lifetime.

However, the court did not provide the hoped for determinative final answer to the question as to what factors are most important in determining whether a state’s fiduciary income tax regime violates the 14th Amendment. Thus, while the beneficiary focused systems in North Carolina (and potentially Georgia) are now resolved, we still do not have an answer as to whether grantor-focused, trustee-focused, factor-focused systems, or the law contained in the governing instrument are constitutional.

Part III: Planning

Despite the lack of final judicial guidance with regard to state fiduciary income tax regimes, there are strategies that planners and their clients should consider in order to minimize the impact of state fiduciary income taxes.

The planning phase. At the outset of the trust planning, planners should consider designing a trust that will qualify as a resident trust in a state that does not impose any income tax. For clients who are considering creating irrevocable trusts, planners should consider selecting a state jurisdiction that does not impose a fiduciary income tax such as Florida, Texas, or Nevada (“tax free states”).¹¹

In designing the trust instrument, the following factors will need to be considered by both the planner and legal counsel:

(a) The governing instrument should clearly state that the situs and governing law of the trust is the tax-free state. Make sure that the governing instrument also authorizes the trustee to change the situs and governing law of the trust.

(b) At least one trustee must be a resident of the tax-free state. No serving trustee should be a resident of state that has a trustee-focused income tax system (such as California).

(c) To the extent possible, do not insert any income-producing real property that is located in a state with high fiduciary income tax rate system (such as California).

For existing trusts. For existing trusts that are currently subject to tax in states with high state income tax rates, planners should first determine whether the state regime is grantor focused, trustee focused, or factor focused in its approach to income taxation. Once this determination is made, consider one of the following alternative strategies:

(a) Check with legal counsel and the client’s tax adviser to determine whether specific changes to the trust administration will result in the severing of the trust’s nexus to the current jurisdiction. This could be accomplished by changing the trustee or moving the custody of the trust and selecting a state that does not impose an income tax. This strategy will not be viable in states that have a grantor-focused tax regime.¹²

(b) Check with legal counsel to see if state law and the governing instrument will allow the trustee the right to decant¹³ into a new trust that will qualify as a resident trust in a state that does not impose an income tax. Although a full discussion of decanting is beyond the scope of this article, it should be noted that certain states have statutes authorizing trust decanting (“statutory decanting”),¹⁴while other jurisdictions’ courts have authorized trustees to decant trusts if the trustee has sole and absolute discretion to make discretionary distributions (“common law decanting”).¹⁵

(c) If decanting is not an option, check with legal counsel to determine if the trust is currently administered in a jurisdiction that has adopted the Uniform Trust Code (UTC). If the UTC is the law, consider having legal counsel draft an exact duplicate of the existing trust agreement in a jurisdiction that has no state income tax and arrange to merge the existing trust into the newly created trust under UTC Section 417.

In evaluating any the foregoing potential strategies, planners should seek the input and advice of competent legal counsel.

Conclusion

As private non-grantor trusts continue to proliferate as part of their clients’ estate plans, financial planners will need to become more familiar with the income taxation of trusts. While the federal income taxation of trusts will remain uniform for all such trusts, the state fiduciary income tax systems are not uniform and savings may result from ensuring that a trust has sufficient nexus with a U.S. state that does not impose a fiduciary income tax. Many tax advisers had hoped that the recent U.S. Supreme court decision in Kaestner would have provided more certainty as to the constitutionality of various state income tax regimes. However, the court provided only limited guidance.

While the best time to address state income taxation issues is during the planning process, for existing trusts there may be techniques to minimize or eliminate state income taxes. This article has endeavored to provide planners with an overview of the types of state income tax regimes in current use and potential strategies for minimizing state income tax liability.

Endnotes

1. ​​This article focuses solely on the income consequences of non-grantor trusts. When used in this article, the term “trust” refers to non-grantor trusts.

2. Slip Opinion No. 18-457, decided June 8, 2019 and published June 21, 2019.

3. It should be noted that trusts may claim almost the same deductions that most taxpayers may claim, except that a trust may claim a deduction for attorney and accounting fees and trustee compensation, which individual taxpayers are ineligible to deduct.

4. While individuals are currently prohibited from claiming any personal exemptions, a trust is granted a $100 or $300 exemption depending upon whether it is classified as a “simple trust” or “complex trust.” See IRC §642(b)(2) and Treas. Reg. §1.651(a)-1 for the definition of simple and complex trusts.

5. Individual taxpayers will report such income on Schedule E of their individual income tax returns. For purposes of this article, I ignored the “65-day rule” under IRC §663(b), which would allow a trust that makes a distribution to a beneficiary in a given year to elect to claim the distribution deduction on its prior year tax return, which would result in the beneficiary recognizing the income in the prior tax year.

6. Currently 37 percent. See Instructions to 2018 IRS Form 1041 (page 30) and IRC §1(j)(2)(E). It should be noted that capital gains, qualified business income, and qualified dividends recognized by the trust will be taxed at the same rates as an individual taxpayer. In this article I excluded the impact of the Alternative Minimum Tax (AMT) and Net Investment Tax on fiduciary income taxation.

7. See IRC §643(a) and the instructions to IRS Form 1041.

8. By way of example, some states such as New Jersey and Pennsylvania have a “gross income tax,” which will only permit deductions for trustee compensation and distributions to beneficiaries but not for attorney fees. New York follows federal income tax law in effect before the enactment of the Tax Cuts and Jobs Act of 2017.

9. For an excellent summary of each state’s fiduciary income tax systems, see Richard W. Nenno’s “Bases of State Income Taxation of NonGrantor Trusts for 2018,” at actec.org/assets/1/6/Nenno_state_nongrantor_tax_survey.pdf.

10. Please note that in both examples, if the trustee were to own income-producing rental real property in either Maine (in the first example) or California (in the second example), there would be sufficient nexus and the analysis would not apply.

11. Delaware is also a potential choice provided that there is no beneficiary who is a Delaware resident.

12. It should also be noted that this technique may not work if the trustee, trust property, or one or more trust beneficiaries has nexus to the original trust jurisdiction (factor focused).

13. Decanting is derived from the world of wine and generally refers to moving wine from one wine bottle to a new wine bottle. In a private trust setting, decanting refers to transferring property that is currently owned by the trustees of one trust (“Trust A”) to a newly created trust (“Trust B”), which may have different terms and provisions than Trust A but generally has the same beneficiaries.

14. For examples, see New York’s statute (EPTL §10-6.6) and Nevada §163.556. For a complete listing of states that have statutory decanting regimes see premiertrust.com/wp-content/uploads/2019/02/6th-Annual-Trust-Deanting-State-Rankings-Chart.pdf.

15. See Phipps v. Palm Beach Trust Co., 196 So. 299 (Fla. 1949), which is often cited as the seminal case in common law trust decanting (Florida now has a statute). Also see Wiedenmayer v. Johnson, 106 N.J. Super. 161(1969).