States have been increasingly aggressive taxing trust income, as the need for revenue increases. Only seven states do not impose an income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.

Even if you are a resident of a state that does not impose an income tax, you should be aware that the creation of a trust that benefits a beneficiary in a state that does impose state income tax will likely result in the payment of state income tax by the trust’s beneficiary.

So if you’re a Florida resident and create an irrevocable trust for your granddaughter in New York, then when trust income is distributed to your granddaughter she will have to remit New York state income tax payments.

But what happens when you create a discretionary trust that does not distribute its income in a given year? By definition, the trustee of a discretionary trust can choose not to distribute income; instead the income would accumulate inside of the trust. Can the state of the beneficiary’s residence impose an income tax on that undistributed income?

In other words, in my example where a Florida resident creates a trust for the benefit of a New York beneficiary, where the income is not actually distributed would the trust still have to pay New York state income tax?

The answer to that question can be found in a 2015 North Carolina case, Kimberley Rice Kaestner Family Trust v. North Carolina Department of Revenue.  In 1992 Joseph Rice created a trust for the benefit of his three children, which in 2002 divided on its terms into separate trust shares. One of the children was a North Carolina resident.

The North Carolina Department of Revenue assessed the taxes in the amount of $1.3 million in three years that the trustee never distributed income to the North Carolina beneficiary. The rationale for the tax was a North Carolina state statute that imposed tax on out of state trusts that benefit North Carolina residents.

The trust paid the tax, and after its request for a refund was denied, petitioned a North Carolina court to seek the return of the tax paid.

During the time in question, the trustee was a Connecticut resident, the trust records were maintained in New York State, and the assets were custodied with a financial firm in Boston. Trust tax returns and accountings were prepared in New York, and trust meetings occurred in New York.

The court granted the trust’s motion for summary judgment (putting an end to the case – a win for the trust) ruling that the statute in question imposing tax based on the residency of beneficiaries alone violates the Due Process Clause of the United States Constitution as well as the North Carolina State Constitution.

The court noted that the trust did not have a physical presence in the state, own real or personal property in the state, or invest directly in state investments. Trust records were maintained out of state, and the principal place of administration was out of state. The trust did not avail itself of the benefits of state law (the trust indicated that New York law applied), and the court found that the trust itself is a separate legal entity from the beneficiaries. The fact that a beneficiary is a North Carolina resident did not persuade the court that undistributed income should be taxed in the state.

What can we learn from this case? It would seem that if a grantor establishes a trust in a state like Florida that does not impose a state income tax, even if a beneficiary resides in a state that does tax income, so long as that income is not distributed to that beneficiary then no state income tax will apply.

If you hope for a similar result in this case, you should work to have a similar fact pattern, leaving no ties to the state that is attempting to impose the state level income tax.

You should be aware, however, that income accumulated inside of a trust is taxed at the federal income tax level regardless, and that tax is calculated on a compressed rate schedule, resulting in the highest marginal federal rate (39.6%) on amounts above $12,300. Unless the beneficiaries are also in the highest marginal income tax rate bracket, accumulating income inside of a trust may, for federal tax purposes, result in higher tax payments.

When you consider state income tax rates, however, then the combined state and federal tax bracket associated with any specific beneficiary could be higher than 39.6%. In such event it might make sense to accumulate income in the trust, as was the likely fact pattern of the Kimberley Rice Kaestner Family Trust case.

I believe these types of cases will become more common in the coming years. When creating trusts for the benefit of loved ones who live in a state that imposes state income tax, it would be wise to discuss these issues with your estate planning counsel.

Leave a Reply

Your email address will not be published. Required fields are marked *