State Taxation of Trusts

Take-Away: Several state income tax statutes are now being successfully attacked in courts across the nation on the grounds that the imposition of the state income tax is a violation of the Constitution’s Due Process Clause. As such, there exists the need to spend a bit more time selecting the administrative situs of an irrevocable dynasty-type of trust that is intended to accumulate income over the years.

Background: This past summer the Minnesota Supreme Court held as unconstitutional its state income tax  law that taxed irrevocable trusts on the basis of the settlor’s residence. Fielding, Trustee of the Reid and Ann MacDonald Irrevocable GST Trust vs. Commissioner of Revenue (July 18, 2018.) This decision came on the heels of an earlier North Carolina Supreme Court decision that found its state income tax statute that taxed accumulated income of a North Carolina trust unconstitutional as a violation of the Due Process Clause of state and federal constitutions, where the basis for the imposition of the North Carolina tax was solely the trust beneficiary’s residence. Kimberly Rice Kaestner Trust vs. North Carolina Department of Revenue (2018).

• Nexus: These decisions each found that there was an insufficient nexus, or connection, between the irrevocable trust and the state’s power to impose an income tax on the trust’s accumulated income. The trust in Fielding had several connections with Minnesota: (i) the settlor was a Minnesota resident when the trust was created and at the time of the tax year in question; (ii) the trust instrument applied Minnesota as the source of its governing law; (iii) the trust was drafted by a Minnesota attorney; (iv) trust records were maintained in Minnesota; (v) one of the trust beneficiaries was a Minnesota resident; and (vi) the primary asset held in the trust was an S corporation that was incorporated in Minnesota. Fielding held that the settlor’s residency as the basis for the application of Minnesota’s income tax statute was unconstitutional, and that the state lacked subject matter jurisdiction over intangible personal property that was located outside of Minnesota that generated part of the trust’s income. In essence the Court in Fielding found that the statute’s focus was solely on the settlor residence at a single point in time (when the trust was created) rather than on the trust’s activities and when, how and where the trust’s income was actually earned for the tax year under audit.
• Beneficiary Residence: Eleven states, including Michigan, use the beneficiary’s residence as a critical factor under their trust income taxing regime.
• Settlor Residence: Several more states also focus on the settlor’s residence as an important factor when to impose its state income tax, again including Michigan. The Court in Fielding expressly rejected the settlor’s residence as insufficient to create an income tax nexus for the state to impose its income tax.

Blue vs Department of Treasury: Michigan court decisions are not normally a source of a national law, sad to admit. But there is one noteworthy Michigan court decision that is often cited on the topic of state income taxation of irrevocable trusts. That case is Blue v. Department of Treasury, 185 Mich. App. 406 (1990).

• Statute: The Michigan statute that was challenged was MCL 206.18. That statute defined any trust created by, or consisting of property of, a person domiciled in Michigan at the time the trust became irrevocable as a resident trust, and thus subject to Michigan’s income taxation. The resident trust  in Michigan is subject to taxation from ‘receiving, earning or otherwise acquiring income from any source whatsoever’ which is pretty sweeping in its scope of what income will be exposed to Michigan’s income tax.
• Facts: The settlor died one year after creating the trust; her death caused the trust to become irrevocable. The settlor was a Michigan resident at the time of her death. The lifetime beneficiary of the trust was the settlor’s daughter, a resident of Florida. The trustee of the trust was a Florida resident. With the exception of one parcel of non-income producing property which was located in Michigan, all other trust assets were located in Florida. For the following 5 years after the settlor’s death, the trustee accumulated income in the trust. Michigan then filed an action to recover Michigan income taxes imposed on that accumulated trust income.
• Trial Court: The trial court found that there were insufficient contacts between the trust and Michigan to justify the imposition of the Michigan income tax on that trust.
• Appellate Court: The Court of Appeals also found the application of Michigan’s resident trust statute a violation of Due Process with regard to the facts before it.
• The Court of Appeals cited favorably from a Missouri case on when state income taxation of an irrevocable trust is justified: An income tax is justified only when contemporary benefits and protections are provided the subject property or entity during the relevant taxing period in determining whether this state has sufficient nexus to support the imposition of an income tax on trust income; we consider six points of contact: (1) the domicile of the settlor, (2) the statute under which the trust is created, (3) the location of the trust property, (4) the domicile of the beneficiaries, (5) the domicile of the trustees, and (6) the location of the administration of the trust. For purposes of supporting an income tax, the first two of these factors require the ongoing protection or benefits of state law only to the extent that one or more of the other four factors is present.
• In finding ‘insufficient connections between the trust and the State of Michigan’ the Court noted that both the income beneficiary and the trustee were domiciled in Florida and ‘most importantly, the trust is administered and registered in Florida.’
• Accordingly the Court of Appeals found that MCL 206.18 that defined the Blue trust as a resident trust subject to Michigan income taxation violated the Due Process clause of the Fourteenth Amendment.
• The key point made in the Blue decision is that a state cannot pick and choose among historical facts unrelated to the tax year in question to support its efforts to impose an income tax- each tax year should be reviewed on its own merits before a state income tax is imposed.

ING Trusts: Sophisticated estate planning now attempts to exploit what are called ING-trusts: Incomplete (for federal gift tax purposes) Non-Grantor Trusts. Nevada and Delaware are popular destinations in which to situs an ING-trust, since those states do not impose a state income tax on accumulated income in the trust unless there are state-resident beneficiaries of the trust.

• A DING is a Delaware-Incomplete-Non-Grantor-Trust.
• An ING-trust usually has the following features: (i) The ING-trust is irrevocably established in a jurisdiction without state income taxation on the trust; (ii) the settlor retains sufficient control such that the ING-trust is treated as an incomplete gift for federal gift tax purposes, and thus the transfer of assets to the ING-trust does not trigger gift tax on its creation; and (iii) the settlor does not retain any power that would cause the ING-trust to be treated as a grantor trust for income tax reporting purposes, and the settlor is therefore not taxed on the ING- trust’s income. As such, income can be accumulated inside the irrevocable ING-trust (yet not taxed to the settlor) free from any state income taxation.
• Obviously, the ING-trust offers no savings from federal income tax, because the ING-trust must still pay federal income tax on any undistributed income. But in high income tax states, e.g. New York, Minnesota, considerable state income taxes can be avoided through the use of an ING-trust, especially if the trust is set up as a dynasty-type trust which is intended to accumulate income for an extended period of time.

Conclusion: As trusts become more sophisticated and flexible to adapt to ever-changing tax laws and the needs of beneficiaries, more thought needs to be given to where an irrevocable trust will be situs-ed, especially if there is a good chance that income will be accumulated for long periods of time in the trust, like a dynasty-trust. Consider adding a trust protector to a trust instrument with the power to unilaterally change the situs of the trust and thus its administration to a jurisdiction where the trust can escape state income taxation on its accumulated income.