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Legacy Matters

July 30, 2019

Is It Time for a Trust Taxation Tune-Up?

Two new taxpayer-friendly rulings regarding trusts, one from the U.S. Supreme Court in the North Carolina Department of Revenue v. Kaestner case, and one from the Minnesota Supreme Court in the Bauerly v. Fielding case, support the idea that it may be unconstitutional for a state to tax a trust unless there exists certain minimum contacts with the state. Michigan courts have previously addressed this issue, so these new rulings might not lead to many tax refunds for people with Michigan trusts, but the cases are a good reminder that it is vital to periodically review the state (and foreign) income tax obligations of your trusts, for two reasons:
 
  • Laws are constantly changing, making the tax environment more or less favorable for your trust.
  • Changes may be needed when family members or trustees move to or create trusts in states with different tax laws.
 
The Kaestner Case Facts
 
A grantor created a trust in his home state (New York) for the benefit of his children and chose a resident of his state as the trustee. When a beneficiary moved to North Carolina, the trust was divided into three subtrusts, one formed for the benefit of the relocated beneficiary and her children. North Carolina taxed the Kaestner family’s trust on the basis that the trust income was “for the benefit” of a state resident. However, the beneficiary had no control over the distribution of trust assets and did not receive distributions from the trust.
 
The Fielding Case Facts
 
A grantor domiciled in Minnesota created irrevocable trusts while a resident there and later moved out of the state. Minnesota levied taxes on the trusts’ sale of business interests on the basis that the grantor was domiciled in Minnesota at the time the trust was created (and therefore the trust was a “resident” trust) even though the grantor no longer resided in Minnesota, the trust was not administered in Minnesota, none of the trustees resided in Minnesota and only one beneficiary was a Minnesota resident.
 
The Lawsuits
 
In both Kaestner and Fielding, trustees sued on the basis that the taxes violated the Due Process Clause under the 14th Amendment (“nor shall any state deprive any person of life, liberty, or property, without due process of law”). This clause has been interpreted in previous cases to mean that there should be more than a tenuous connection between the taxing state and the trust the state is taxing.
 
The Court Rulings
 
The U.S. Supreme Court in Kaestner found that the North Carolina tax statute, as applied, violated the Due Process Clause, noting that due process requires “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” The ruling determined that residency of a trust beneficiary alone was not enough of a connection between a state and trust assets to allow the state to tax a trust’s undistributed income – in this case “income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain to ever receive it.”
 
Although the U.S. Supreme court chose not to hear the Fielding case, Minnesota’s tax court and supreme court both found that the state’s statute, as applied, also violated the Due Process Clause, indicating that a grantor’s residence at the time the trust was created alone did not provide a sufficient connection between the trust assets and the state to allow for perpetual taxation of trust assets.
 
Triggering State Income Taxation of Trusts
 
Under the current laws of many states, the actions below could create a sufficient connection to trigger the application of a state’s income tax to your trust:
 
  • Having a grantor, trustee or beneficiary as a resident of the state
  • Ongoing administration of a trust in the state (such as holding trust records there, having meetings there or having a physical presence there, such as an office)
  • Having investment advisors/asset custodians in the state
  • Having a resident with the right to control trust assets or distributions now or in the future
  • Having the trust engage in business/investment activity in the state or receive state-source income
 
Michigan imposes income tax on trusts based on where the grantor of a testamentary trust (at death) or irrevocable inter vivos trust (during life) was domiciled at the time of trust creation. If the grantor was domiciled in Michigan at such time, Michigan will consider the trust to be a “resident” trust for income tax purposes. However, it is possible to convert to non-resident trust status if:
  1. The trustee is not a Michigan resident;
  2. The trust assets are not located or administered in Michigan; and
  3. All of the beneficiaries reside outside of Michigan.
 
In Blue v. Michigan Department of Treasury, from 1990, the Michigan Court of Appeals held that a trust was not considered a “resident” trust (and therefore not subject to Michigan state income tax) where the only contacts with the state of Michigan were that the trust was created by a Michigan resident and the trust held non-income producing real property located in Michigan.
 
In its opinion on the case, the Court used an analogy that authorizing a state to tax a trust because someone lived in that state when the trust was created is like authorizing “that any person born in Michigan to resident parents is deemed a resident and taxable as such, no matter where they reside or earn their income.”
 
Kaestner, Fielding and Blue should prompt trustees and their advisors to pay closer attention to the criteria each state uses to tax trusts, and take action to minimize the trust’s overall tax exposure from trustees and beneficiaries on the move.
 
Action Items
 
1. Ascertain if you can structure trusts to avoid state taxes altogether.

Kaestner and Fielding have further chipped away at the right of a state to tax a trust based solely on one contact with the state. Between the Due Process analysis and the fact that states have differing criteria for imposing residency status, it is sometimes possible to shift state income tax residency and avoid state income tax entirely.
    
2. Regularly review your trusts with your advisors.

Ensure that you are being tax-efficient based on current laws for all states (or countries) which might attempt to tax your trusts. You may be able to strengthen your trust’s tax position by:
 
  • Replacing trustees who have moved to other states (possibly with institutional trustees)
  • Moving the trust to a more tax-friendly state (or a no-tax state)
  • Decanting trusts into new ones with better provisions (including, in some cases, removing beneficiaries who reside in problem jurisdictions such as foreign countries that may not recognize trusts)
 
3. Prepare trusts for tax implications of a move.

You should understand and plan for the taxation of trusts in states where the grantor, trustee or beneficiary is planning to become a resident.
 
  • States and countries have different views on taxing trusts, and the connections needed to be able to tax your trust will differ from state to state.
  • Consider whether it is possible to bifurcate a trust into shares so that the entire trust does not become subject to a new tax system.           
 
4. Consider filing refund claims.

If you have trusts which were taxed by another state solely because a beneficiary of the trust (or a trustee) lives in that state, your attorney or CPA can help you decide if you have the ability to file refund claims in that state.              
 
The Takeaway
 
The legal issues that can arise from living in such a highly mobile society are many, and trust taxation is one of the most complicated - but it is often an afterthought. Each state, and country, has its own tax laws, so it is especially important to consult your advisors about the tax implications that will arise and the changes that you should make whenever a trustee or beneficiary of one of your trusts plans a move to a new location, whether within the U.S. or outside of the U.S.
 
At Warner, we help clients with trusts make tax-efficient decisions and plan for mobility within the family, whether moves are to another state or another country. Contact your Warner attorney or Laura Jeltema (616.752.2161 or ljeltema@wnj.com) for assistance in understanding how recent court decisions and your family’s geography could impact taxation of your trust assets.

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