By Steven J. Oshins, Esq., AEP (Distinguished)
Estate planners are constantly looking for additional ways to save taxes for their clients. One often-overlooked concept is to use trusts to save state income taxes, especially for those clients who reside in a state with a high state income tax. Ironically, income tax savings is generally the most appreciated work we do for our clients given that they can personally enjoy the savings, but yet the planning opportunities are frequently missed.
Different states have different rules as to what creates a “resident trust” that is subject to taxation in that state. States may tax a trust based on the residency of the settlor or testator, based on whether there is a resident trustee or beneficiary or whether there is administration in that state, or for a combination of these factors and/or other similar factors.
No trust should ever be created without the advisor knowing the residency of the settlor, the proposed trustees and the beneficiaries. This information is invaluable in the planning process since it can have a substantial influence on certain decision points.
So it isn’t as easy as simply situsing a trust in a state with no state income tax. You have to look at the state taxing statutes that may apply.
North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust
The U.S. Supreme Court decided unanimously on June 21, 2019 in favor of the taxpayer in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, holding that North Carolina violated the Due Process Clause of the Constitution by taxing a trust based solely on the residency of a beneficiary.
North Carolina imposes a tax on any trust income that “is for the benefit of” a North Carolina resident. Thus, North Carolina’s statute, as written, says that a trust owes income tax to North Carolina whenever the trust’s beneficiaries live in the State, “even if those beneficiaries received no income from the trust in the relevant tax year, had no right to demand income from the trust in that year, and could not count on ever receiving income from the trust,” as noted by the U.S. Supreme Court.
The North Carolina courts held the tax to be unconstitutional when assessed in such a case because the State lacks the minimum connection with the object of its tax that the Constitution requires. In this highly-anticipated U.S. Supreme Court decision, the Supreme Court agreed with the North Carolina courts and ruled that the State’s tax violates the Due Process Clause of the Fourteenth Amendment.
Which States this Affects
There are three states that tax a non-grantor trust based solely on the residency of a beneficiary: Georgia, North Carolina and Tennessee. Tennessee will be phasing out its income tax entirely by 2021.
The Tax Drag
The “tax drag” is the amount by which investment returns are reduced due to taxes. The opportunity to move a non-grantor trust to a jurisdiction where state income tax can be avoided often makes a substantial impact on the value of the trust’s underlying assets. By avoiding the tax drag inherent in a trust that is subject to state income tax, the trust grows in value much faster.
This planning opportunity is very well-known to many advisors, but yet it appears to be underused by most and should be considered whenever any trust is being planned and created and whenever an advisor is reviewing an existing trust to look for opportunities to help the client.
$10,000 State and Local Tax Deduction (“SALT Deduction”)
The 2017 Tax Cuts and Jobs Act created a new $10,000 limitation on the federal income tax deduction for state and local taxes paid. This hits residents of states with a high state income tax especially hard, thereby making it that much more important for estate planners to understand how and why a non-grantor trust is subjected to a state income tax and how to design new trusts and modify old trusts to avoid or reduce the state income tax hit.
The biggest immediate opportunities will be obtained by CPAs who will be busy amending prior-year tax returns to assist their clients in obtaining tax refunds for trusts with Georgia, North Carolina or Tennessee beneficiaries.
The next opportunities will be for trust attorneys to set up tons of Incomplete Gift Non-Grantor Trusts (“INGs”) and Completed Gift Non-Grantor Trusts for their clients who live or have families in Georgia and North Carolina to take advantage of this new opportunity. Given the number of residents of states such as California, New Jersey, Hawaii and Oregon (among many others) who have successfully used these types of trusts for so many years, there must be countless North Carolina and Georgia residents who are chomping at the bits to be able to do the same type of planning.
These opportunities will be magnified by either renouncing grantor trust powers in grantor trusts or by taking advantage of decanting opportunities where the trustee can distribute trust assets from grantor trusts into non-grantor trusts that are designed to avoid state income taxes.
At the same time, the trust companies and banks in the top-tier trust states will be the recipients of a lot of new trusts and should be staffing up.
Moving an Existing Trust to Save State Income Taxes
In addition to planning for a newly-created irrevocable trust, there are a number of existing trusts that can be moved to a new jurisdiction to achieve the state income tax savings described in this article. The trustee or trust protector might have the power under the trust agreement to move the trust to another jurisdiction. This is done in writing with a new co-trustee in the new jurisdiction accepting the co-trusteeship.
If there is no provision allowing the trustee or trust protector to move the trust to another jurisdiction, then the trustee might be able to “decant” the trust by distributing the trust assets into a second trust that is established in the new jurisdiction. Decanting has become extremely popular and can often be used to fix inflexible trusts.
Yet another option would be for the trustee to petition the local court for approval to move the trust or for approval to modify the trust to allow the trustee or trust protector to move the trust.
The Kaestner decision, at a minimum, is a wake-up call for all estate planners who haven’t been doing any state income tax planning for their clients.
This new case’s application is limited to those states that tax a non-grantor trust solely on the basis of there being a resident beneficiary. However, given the national attention that this case has received, it is clear that the underlying message is that state income tax planning is big business and those who have failed to take advantage of these opportunities are leaving money on the table, not only for their clients, but also for themselves. If you haven’t already done so, it’s time to exchange business cards with someone from a trust company or bank in a top-tier trust state with no state income tax.
Advisors should be taking advantage of the opportunity to avoid the tax drag inherent in many trusts that accumulate income that is subject to state income tax even if not sourced to that state. In fact, it is somewhat shocking that this concept isn’t the most talked about concept among the financial planners whose assets under management are ratably affected by this tax drag.
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ABOUT THE AUTHOR
Steven J. Oshins, Esq., AEP (Distinguished) is an attorney at the Law Offices of Oshins & Associates, LLC in Las Vegas, Nevada, with clients throughout the United States. He is listed in The Best Lawyers in America®. He was inducted into the NAEPC Estate Planning Hall of Fame® in 2011 and was named one of the 24 Elite Estate Planning Attorneys in America by the Trust Advisor. He has authored many of the most valuable estate planning and asset protection laws that have been enacted in Nevada. He can be reached at 702-341-6000, ext. 2, at email@example.com or at his firm’s website, www.oshins.com.
Excellent summary and ideas. Thanks.