Minimizing State Income Taxation of a Trust

Take-Away: The Supreme Court’s decision in Kaestner this past June held that a state could not impose an income tax on accumulated income in an irrevocable trust if the sole basis to impose the state’s income tax was the state residence of a trust beneficiary. While that was good news, the Supreme Court made it clear that its decision was limited to the facts and circumstances of that case. The Court focused on several different facts in Kaestner that led to its decision to prohibit North Carolina from taxing the accumulated income in the trust. Consequently, the Kaestner decision provides a roadmap if the trustee of an irrevocable trust is concerned that it may not have enough ‘good facts’ that were emphasized by the Supreme Court.

Kaestner: Instead of providing a ‘bright-line’ test to guide trustees when they deal with a state’s assessment state income tax on accumulated trust income, the Supreme Court limited its decision to the facts and circumstances before it. The Supreme Court merely identified the facts that would not allow a state to tax a trust based on the beneficiary’s residence due to a lack of specific ‘contacts’ with the taxing jurisdiction required by the Due Process Clause of the U.S. Constitution. Specifically, the Court focused on the fact that the beneficiary in Kaestner had no control over the trust assets, nor could she demand any trust income, and she did not actually receive any income from the trust during the challenged years. In light of the Court’s emphasis on these facts, trustees might consider some changes to a trust that they administer to avoid exposing any accumulated income to the assessment of state income taxes, which can be extremely important if the trust beneficiary lives in a high income tax state like California, New York, or one of the East Coast states.

Decant Trusts to Eliminate Mandatory Distributions and Control:  The trust in Kaestner had been previously decanted from a trust that was supposed to terminate upon the beneficiary’s specific attained age. Given the Court’s fixation on the beneficiary’s inability to demand distributions in Kaestner, the trustee should consider decanting the assets of a trust when either the terms of the trust permit, or if permitted by Michigan’s decanting statute [MCL 556.115a], to make the trust wholly discretionary by eliminating some problematic trust provisions.

• 5+5 Power: If the beneficiary can annually demand the distribution of 5% or $5,000 of the trust’s corpus [IRC 2515(e)] that withdrawal right might be eliminated by a decanting.
• HEMS Standard: If the trustee is required to make distributions for the beneficiary’s health, education, support and maintenance (HEMS) some states might treat that as the beneficiary’s right to distributions consistent with that standard. Accordingly, a trustee’s decision to decant assets to shift them from an HEMS standard to a purely discretionary distribution standard would eliminate any perceived right held by the beneficiary.
• Distribution Milestones: Many trusts are drafted give the beneficiary the right to withdraw assets at specific ages or when other milestones are reached, e.g. earning a college degree. A trust decanting to remove those milestones would eliminate any right held by the trust beneficiary to demand distributions when those milestones are met.

Obtain Judicial Modification of the Trust without Beneficiary Approval: A judicial modification of the trust to curtail the beneficiary’s control or rights over the trust might work to avoid the imposition of state income tax. However, a non-judicial modification of the trust [MCL 700.7111] probably would not work since an interested person [MCL 700.1105(c)] whose consent is required would include the trust beneficiary. As such,  that beneficiary would be viewed as actively participating in, or controlling, that non-judicial modification agreement. If the trust instrument is modified with no beneficiary involvement, then a judicial modification to eliminate or narrow the beneficiary’s control rights might work. [MCL 700.7410; MCL 700.7412(2); MCL 700.7416.]

Avoid Making Distributions to Beneficiary:  A trustee might avoid making a distribution to a beneficiary who resides in a state where such a distribution would trigger the assessment of a state income tax. Instead of making a distribution,  the trustee might periodically (but not regularly) make loans to the beneficiary, if the trust instrument permits loans, in order to address short-term cash needs of the beneficiary. [The power of the trustee to make loans to a beneficiary is authorized under the Michigan Trust Code. MCL 700.7817(kk).] However, in order to avoid the appearance of a disguised trust distribution, any loan by the trustee should carry fair-market interest, be adequately secured, and fully documented to show an actual intent by the beneficiary to actually repay the loan.

Permit Use of Trust Property by the Beneficiary: On occasion, if the trustee is asked for a distribution to the beneficiary in order for the beneficiary to acquire a residence, like a Colorado ski chalet or Florida condominium, (but not in the state where the trustee hopes to avoid being taxed), if the trustee acquires that asset and permits the beneficiary to use the asset, the use of a trust asset would not cause the trust to be taxed by the state in which the trustee wants to avoid being taxed, i.e. the use is not the same thing as a distribution.

Exploit Powers of Appointment: If an individual in a non-fiduciary capacity directs the trustee to transfer assets from the trust to a named person pursuant to a power of appointment, that payment by the trustee may not be treated as a distribution, and its recipient might not be treated as a beneficiary, because only a fiduciary can make distributions to a beneficiary. While this admittedly is ‘splitting hairs,’ it may work to convince a state that it cannot tax the trust if the donee of the exercise of that power of appointment is a resident of the taxing state. If the exercise of the power of appointment can achieve the same effect as a trust distribution, then consider the power of appointment first before making a distribution.

Think Twice About Naming an Individual Co-trustee: The residence of an individual trustee is a critical factor used to determine a state’s ability to tax trust income. In Kaestner, no trustee lived in North Carolina, a fact that the Supreme Court stressed on multiple occasions. If the goal is to have an individual participate in the trust’s administration, consider giving that person a power of appointment to act in a non-fiduciary capacity, but not as co-trustee with some element of control over the trust’s assets. Another option would be to create an LLC in a tax-friendly jurisdiction, name the LLC as a trust director [MCL 700.7703a (24) (f)] and then name the desired individual to serve as manager of the LLC. The LLC, not its manager, would be a fiduciary under Michigan law. The LLC manager’s residence would not be a reason for the state to claim a right to tax the trust’s income.

Be Mindful of How the Trust is Administered: The Court in Kaestner stressed that the trust records were physically located in New York, not North Carolina. How this factor plays out in our digital age admittedly is not very clear. In addition, the custody of all of the Kaestner assets were located in another state. Consequently, a trustee will want to make sure that the trust being administered does not own real property or tangible personal property that is located in the taxing state, nor should it have any direct investments in the taxing state. If there does exist assets in the taxing state that will attract a state income tax, the trustee should exercise its power to divide the trust into separate trusts, one that holds the in-state asset that will attract the state income tax, and another trust that holds all of out-of-state assets, the income from which can be accumulated without exposure to state income tax.

Conclusion: As states scramble in their search for revenues, and as trust beneficiaries continue their mobility moving from job to job throughout the country, the issue of state income taxation of irrevocable trust is going to continue to be a hot topic. How a trust is drafted and administered by the trustee can go a long way to minimize disputes over a state’s power to impose its income tax on accumulated trust income just because a trust beneficiary lives in that state.