Originally published on Forbes.com.
“Put not your trust in money, but put your money in trust” comes from the Autocrat of the Breakfast Table by Oliver Wendell Holmes Sr. The context was advice to young women about to be married and is probably reflective of the legal concept of coverture which put the property and earnings of a married woman under the control of her husband. The law was changing in that regard even in 1858 when Holmes penned the advice, but the advantages of putting your money in trust have multiplied since then.
We now have a new social group -trustafarians- that is created by the forethought of previous generations putting their money in trust. The Urban Dictionary defines them as :
privileged white kids who subscribe to the hippie lifestyle (because they can) since they have no worries about money, a job etc. They can then devote their lives to eating organic, following Phish, and wearing dreadlocks (no need for job interviews).
A Victory For The Trustafarians
And the Supreme Court just handed a victory to tomorrow’s trustafarians in North Carolina Department of Revenue v Kimberly Rice Kaestner 1992 Family Trust. For the very wealthy, trust arrangements can make the payment of state income taxes largely optional. As an individual, it can be extremely challenging to establish domicile in a tax-free state and avoid being a statutory resident. Accomplishing that with a trust requires professional expertise, but that can be hired and won’t affect your day to day life.
I got some great feedback about the decision from people at the international law firm Withers. Withers had filed an amicus brief on behalf of organizations representing professional trustees, bankers, and attornies in South Dakota, New Hampshire, Delaware, Nevada, and Tennesse.
The lawyers at Withers like the decision, which of course went the way they recommended and have some pro tips that I will share, but the overall practical takeaway is that you need really sharp legal work with a national, if not international perspective to take advantage of the favorable state income tax treatment of trusts. And you will need to be alert or more likely to pay somebody to be alert to avoid nasty surprises.
Why This Is Not Such A Great Thing
The state income tax treatment of trusts that can afford and benefit from the counsel of firms like Withers is one of those things that fuel inequality. One of the biggest differences between the very wealthy and even the quite prosperous is that the very wealthy don’t spend all or even most of their income to live. Another big difference is that most of the income of the non-wealthy comes from working. If you have income being generated by wealth that you don’t need to spend to live on, sharp trust legal work can avoid state income tax on that income regardless of where you live.
The benefit goes not to today’s trustafarians who are living in Williamsburg. They might end up paying through the nose on their distributions if they come out of trust income. It is their children and grandchildren who will be supported by the state tax-free accumulations. Regardless, that is why I don’t see this decision as not such a great thing, but rather as one more brick in the wall that the new American gentry is building.
How Does It Work?
Now that I have gotten my inner anarchist out of my system, let’s look at the practical points.
To grossly oversimplify trusts don’t get a really good deal for federal income tax purposes. If they have certain attributes, they are considered “grantor trusts”. They are disregarded and what they do hits an individual’s return like a single-member LLC or they may be mere title holding devices that are altogether ignored. And some things called trusts are taxed as corporations.
There are however entities called trusts that are taxed as entities. They are required to file Form 1041. Doing Form 1041 correctly for a trust that has a decent amount of stuff going on is beyond most tax preparers. Fortunately, nobody seems to care much that a large percentage, perhaps the majority of 1041s are done wrong. It usually does not matter that much.
Again oversimplifying for federal tax purposes a trust is taxed much as an individual is with a less generous rate table and smaller exemptions. That’s the whole deal if the trust is just accumulating income. If the trust makes distributions, it can, with all sorts of limitations and special rules, deduct those distributions from its taxable income. Then the beneficiary who received the distribution has taxable income which is reported on a K-1, much like a partnership or an S corporation.
The Trust Triad
The Withers amicus brief refers to the trust triad – settlor, trustee and beneficiary. Let’s say the Tommy Atkins Fantasy Family Trust has a million in interest income. Tom is the settlor. His friend Richard is the trustee. And Tom’s son Harry is the beneficiary. Depending on the terms of the trust and actions taken by Dick, that whole million dollars will be reported for federal income tax purposes by some combination of Tom, Dick (in his capacity as trustee) and Harry.
When it comes to state income taxes, it is a different story. Assume that Tom, Dick and Harry all live in states with state income taxes – three different states. Let’s also assume that Tom has made the trust irrevocable and has not retained any of the powers that would make it a grantor trust. If Dick distributes to Harry and deducts the distribution, Harry will have state taxable income on the distribution (There might be an exception to that, but I don’t know of any.)
The interesting question is what happens if Dick does not make a distribution. If the million is the only thing going on, Dick will pay, out of trust assets, federal income tax. And what about state income taxes?
State Income Tax – Who Pays? If Anybody
North Carolina wanted to tax the trust merely because the beneficiaries lived there. The Supreme Court has now ruled that that is not enough at least in the case of a trust that is wholly discretionary. What about the state where the trustee is? Well, you will probably be able to find a state that will not tax on that basis, because the states are competing for trustee business. That was the biggest takeaway from my discussion with William Kambas. Then there is the state where Tom was living when the trust became irrevocable.
In 2014, I wrote about a trust that traced to an Illinois trust that was funded by A.N. Pritzker in 1961. The trust in question had A.N.’s grandaughter Linda as its primary beneficiary. The trustee relocated it in Texas (That’s a simplification). The remaining tenuous connection to Illinois was not enough to allow Illinois to tax the trust.
Mr. Kambas had something to say on that:
For those looking for what will happen for taxing regimes not addressed by Kaestner, the focus should now be on the case of Bauerly v. Fielding, which has a pending petition as of today. This is a case where the state is seeking to levy an income tax on trusts based primarily on the fact that the settlor was domiciled in Minnesota when the trusts became irrevocable. This is a second case where there is potentially only a “single factor” that could establish nexus between the state and the trust.
Let The Games Continue
How to tax trusts for income tax purposes is a matter that screams out for a simple uniform rule. (I have no idea what that rule would be.) Mr. Kambas does not see that happening anytime soon.
Instead, states have rules based on the trust triad in various degrees. Massachusetts will consider a trust resident if it has a Massachusetts settlor and a Massachusetts trustee. So switch to a Connecticut trustee. Connecticut does not consider the residence of either trustees or beneficiaries.
Thanks to the Supreme Court decision, a Massachusetts settlor can set up a trust with a Connecticut trustee and the only way any state can tax any of its income is if the trust does business in that state or distributes to a beneficiary in that state. Throw in that capital gains are generally not distributable income.
A Caveat
The Kaestner Trust was a discretionary trust. The discretion is with the trustee. What that means is that if you set up a trust with a view to having your beneficiaries taken care of, you have to select somebody that you can, you know, trust. Giving the beneficiaries rights to demand distributions may create enough nexus to allow a state to tax the trust. At least that seems to be the concern.
Other Withers Comments
David Lehn sees the decision as confirming what was generally believed.
Historic jurisprudence has not been changed. Confidence retained. The Court (both the majority and concurrence) were clear that historic cases supported the conclusion that mere presence of a discretionary beneficiary is not sufficient to meet constitutional standards for state income tax nexus.
James Dougherty emphasizes why you don’t want to just download a trust form from a free internet site if you want it to work.
Careful drafting. One important takeaway is that absolute discretion trusts bring real advantages. Often absolute discretion standards are touted for the creditor protection and flexibility they provide. Today’s decision highlights that it also limits the ability of a state to claim there is nexus over the trust for tax purposes. If there was an enforceable right, such as under a HEMS standard, this case could have turned out differently.
Ivory Tower
The oddest thing to me about Justice Sotomayer’s decision is what I see as stunning naivete.
Finally, the State urges that adopting the Trust’s position will lead to opportunistic gaming of state tax systems. There is no certainty, however, that such behavior will regularly come to pass, and in any event, mere speculation about negative consequences cannot conjure the “minimum connection” missing between the State and the object of its tax.
I would be inclined to replace “certainty” with “doubt” in that sentence.
About Trust Lawyers
When you are talking about large wealth, there are of course a great number of non-tax considerations, but I’m not going to be able to help you much there. Other than to tell you based on what I have observed through my career it is about fifty-fifty whether inheritance is good or bad for people, which is a little demoralizing for estate planning.
As to the lawyers who work on these issues, I would observe that there is a danger that they can get into ruts. They may be attached to the state that they practice in. Clearly, that narrows your option. Also planning in this area tends to be focused on transfer taxes which is really big money for large estates, but not something that happens every year. Income tax planning can get short shrift sometimes or the income tax implications of estate planning techniques can be overlooked.
Finally, state income taxes tend to be at the bottom of the list. The money is not as big, but it looks to me that trusts that pay substantial state income tax might likely be missing out on savings opportunities. If a trust is paying substantial state income taxes, particularly in light of Kaestner a close look should be taken at the planning.
Other Coverage
In blogging time this is an old story and Supreme Court decisions about any sort of taxes are pretty rare, so there is a a lot of other coverage. I will mention a bit though.
Martin Shenkman of Forbes had Can Your Trust Get A State Tax Refund? Supreme Court Rules In Kaestner Case?. Mr. Shenkman emphasizes the practical:
If you’re a trustee or beneficiary of a trust that has been taxed on that basis, call your CPA and have refund claims filed for any open tax years you can.
I would note that if your CPA was on the ball, the claims are already pending.
Call your estate planning attorney, and if you have an institutional trustee, your trust officer, and review what you might do to improve a trust you have to strengthen a position that tax is not due to a particular state. In many cases trusts can be moved, trustees replaced, existing trusts merged (decanted) into new trusts with better provisions to avoid state income tax. The Kaestner case recognized and approved the decanting of the trust in that case to extend the term of a trust which may have been a factor in the favorable ruling. So, you too may be able to have your trust improved.
I just love that “decanting” thing. I know an estate attorney that any instrument she writes is solid as the Rock of Gibraltar, who can make anybody else’s instrument jump through hoops and turn itself blue.
Also on Forbes “Tax Girl” Kelly Phillips Erb had Supreme Court Rules Against North Carolina In Trust Tax Case.
She focused on constitutional issues.
Jay Adkinson also of Forbes had New York Trust Not Subject To North Carolina Tax Because of In-State Beneficiaries In Kaestner.
Todd Ganos of Forbes had U.S. Supreme Court Hands Two Massive Tax Wins To High Asset Families & Business Owners.
The second case was Minnesota v. Fielding. Minnesota sought to tax a trust “the grantor of which was domiciled in this state at the time the trust became irrevocable.” This is express language from Minnesota’s statute. While the facts of this case are a bit different from the example above, the rule of law in play is nonetheless the same. Without requiring any nexus more than the residency of the person who created the trust, the trustee and beneficiaries objected. The state lost at the Minnesota appellate court level and the Minnesota supreme court. On the heels of the North Carolina case — which expressly referred to states seeking to base nexus solely on the trust settlor’s residency — Minnesota appealed to the US Supreme Court.
The US Supreme Court denied certiorari to Minnesota’s tax authority — which means it refused to hear the case and the lower court’s decision stands.
Mr. Ganos literally delves into ancient history in his discussion, which I thought was pretty cool.