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Supreme Court Hands HNW Clients New Trust Planning Strategy

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Although many clients tend to focus heavily on federal income tax planning, for high net worth clients with significant assets in trust, state-level taxes can often throw a wrench into trust planning—adding an extra layer of taxes based on any number of factors, including the residency of the trustee and beneficiaries, as well as the formal location of the trust’s assets.

The rulings handed down in the recent U.S. Supreme Court term substantially simplified these state-level issues for clients interested in trust planning strategies that focus on wealth accumulation rather than distribution. Under this newly developing legal regime, states will be required to establish a much more concrete nexus between the trust and the state in order to impose any state-level taxes—meaning that, with proper planning and advice, clients may be able to avoid state-level taxes entirely.

The Supreme Court’s Rulings

In the first case, North Carolina attempted to tax all trust income under circumstances where the trust was established in another state, the beneficiary did not receive any trust distributions, the trust had no assets located in the state and the trust had no income derived from the state. Here, the Supreme Court ruled that states are not permitted to impose state-level taxes on an out-of-state trust solely because a trust beneficiary resides in the state so long as the trust assets remain within the trust. The Court held that the Due Process Clause prohibits states from taxing undistributed trust income based solely on a beneficiary’s residency within the state.

Under the Due Process Clause, there must be a “minimum connection” between the state and the person or property subject to the state tax. The Court held that minimum connection to be lacking because the beneficiary received no income from the trust in the years in question, had no right to demand the income and there was not even the certainty that the beneficiary would receive the income in the future—in other words, the trust was entirely discretionary.

In the second case, Minnesota attempted to tax a trust on the basis that the original trust creators resided in Minnesota at the time that the trust became irrevocable. Because the trust had no other connection to the state—the beneficiaries and trustee did not even reside in Minnesota—the Minnesota supreme court eventually ruled that the state did not have the authority to tax the trust. The U.S. Supreme Court declined to review the case, essentially agreeing with the state court that the mere residency of the original trust creator at some time in the past did not convey taxing authority on the state.

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A New Planning Regime

Because of these rulings, many high net worth clients with substantial assets in trusts may wish to consider revising the terms of those trusts to minimize potential state tax exposure. In some cases, this could mean moving the trust assets entirely or replacing the trustee to ensure no state has a sufficient nexus to tax the trust assets.

Some clients may wish to create a non-grantor trust, such as an incomplete gift non-grantor trust, in a trust-friendly state such as Nevada or Delaware, because NINGs and DINGs provide both powerful asset protection tools as well as help clients avoid tax at the state level.  For clients who actually reside in higher tax states, the possibility that a discretionary NING or DING will become subject to state taxes based on that residency alone has now been eliminated if the trust is formed correctly.

Importantly, NING, DING and other state tax avoidance strategies only work if the beneficiaries receive no distributions from the trust—the state has the clear right to tax any distribution received by a beneficiary in that state’s jurisdiction. Additionally, it is also possible that the beneficiary’s right to demand distributions could be sufficient to allow the state to tax the trust, as the Supreme Court case involved a trust where the trustee had complete discretion over distributions.

Conclusion

While the Supreme Court has essentially opened the door to trust planning that could avoid state taxation altogether, it is important to remember that these strategies require careful planning and the help of competent legal and tax advisors.  For clients who reside in high tax states and have sufficient funds to take advantage of these trust accumulation strategies, however, the tax savings may be dramatic.