These laws can complicate things, as beneficiaries might move at any time. Bear in mind, too, that states may have broad definitions for the term “beneficiary” in this context. They could ensnare not only mandatory beneficiaries but also discretionary or contingent remainder beneficiaries living there.
However, in 2019, the U.S. Supreme Court dealt a blow to trust taxation based entirely on the residence of beneficiaries. In North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust (139 S. Ct. 2213, 2019), the Court unanimously held that the presence of in-state beneficiaries alone doesn’t empower a state to tax undistributed trust income if the beneficiaries have no right to demand the income and may not even receive it. According to the Court, the residence of the beneficiaries doesn’t provide the minimum contacts necessary if the resident doesn’t have a right to receive the property — or at least some degree of possession, control or enjoyment of the trust property.
- Where the trustee resides. Some states will tax a trust if a trustee resides in the state. States also may consider the residence of co-trustees, including trust advisors and other non-trustee fiduciaries. For example, a trustee could reside in Nevada, but, if the trust also has a fiduciary living in California, California treats the trust as subject to its income tax.
- Where the trust is administered. States may tax a trust that’s administered in the state.
Steps to Minimize the Risks
Trust settlors need to pay attention to those four factors for both existing and new trusts. By knowing how they’re affected by the relevant laws, it may be possible to reduce the related taxes.
For example, the Supreme Court in Kaestner acknowledged that, in states that tax based on a beneficiary’s residence, the beneficiary could delay taking distributions until after relocating to a state with a more favorable tax regime. Trusts can avoid taxation in states that tax based on trustee residence by appointing nonresident trustees or replacing resident trustees. A similar approach could be taken to avoid taxation based on where a trust is administered. Another alternative is removing certain nondiscretionary powers and rights from settlors or beneficiaries.
It’s worthwhile to review a trust’s connections to high-tax states on an annual basis. Trustees, administrators and beneficiaries may have moved, potentially creating or eliminating tax nexus with different states. In some cases, however, other priorities may outweigh tax considerations.
Proceed with Caution
Without careful planning, a trust can end up on the hook for significant income taxes in more than one state. Contact your tax advisors to help avoid unintended consequences for existing and future trusts.