Wealthy clients who use trusts should know the possible tax implications of a recent court decision.
The U.S. Supreme Court’s Kaestner decision in June opened the door for states to reexamine the taxation of trusts. In the case, the court ruled that North Carolina could not tax undistributed trust income in a family’s trust based solely on a beneficiary living in that state. The trust, the court decided, had no nexus in the state.
But the decision was also said to potentially apply only to a narrow set of circumstances when states decide to tax.
“Many specific facts contributed, ... in particular that the beneficiary was not taxed on trust income because the trust didn’t have physical presence. As a result, the beneficiary had no right to receive, nor did receive, distributions, and there was no real property in North Carolina,” said attorney Steve Wittenberg, director of legacy planning in SEI’s Private Wealth Management group in Oaks, Pa.
“This case is based on North Carolina’s statute subjecting a trust’s income to its state income tax based solely on the residency of a beneficiary,” said Nancy Novak, a CPA and senior tax manager with SobelCo in Woodcliff Lake, N.J. “Since Georgia and Tennessee are the only two other states with similar statutes, its direct impact may be quite limited.”
But “for the handful of states that use a beneficiary’s residence as one of its factors, both states and taxpayers should be aware of how each state applies its residency statute,” Novak said.
State taxation of trusts is often overlooked by wealthy clients and their advisors. “I generally review the situs of the trust and where the trustees, beneficiaries and settlor reside to analyze potential state exposure,” added Kathleen A. Buchs, a CPA and director at MAI Capital in Cleveland. “Ideally, this should be reviewed prior to establishing the trust.”
“Many clients have the misconception that if they set up a trust outside of California, they avoid California tax,” said Larry Pon, a CPA and CFP in Redwood City, Calif. “They need to look at their own residency. Also, trust income taxes are much higher than [income taxes for] individuals.” Key questions, according to Pon, include, what assets are in the trust? Is it real estate and, if so, where is the real estate? Is it securities? Who and where is the trustee? When and how is the trust funded?
Michael Roberts, president of Arden Trust Company in Wilmington, Del., believes that the Supreme Court’s decision is ultimately good for trusts and beneficiaries.
“The court was clear that a state cannot tax a trust based solely on the location of the beneficiaries,” he said. “Kaestner will not make states any more aggressive than they already are. If anything, I believe it would make them less so if the state’s claim to jurisdiction is based on beneficiary residence.”