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.