Case Law Opens Options for Trusts Looking to Minimize State Income Taxes

Editor: Mindy Tyson Weber, CPA, M.Tax.

Estates, Trusts & Gifts

A handful of 2013 cases involving the taxation and administration of trusts should grab the attention of tax professionals looking to reduce the state income tax liabilities of their testamentary and inter vivos trust clients. Armed with two planning strategies derived from these recent cases, tax advisers can take steps to alleviate the state tax burden on undistributed trust income.

Using the first of these approaches, a taxpayer could fight a state’s assertion of nexus. This would involve making a case to the state that, even though a trust falls under a technical definition of a “resident trust,” insufficient connections exist between the trust and the state to constitutionally subject the trust to taxation on its out-of-state income. Depending on the laws of the resident state, a second option may be to change the situs of the trust to a more taxpayer-friendly jurisdiction.

When Does the State Lack Authority to Tax a “Resident Trust” on Out-of-State Income?

The trusts at issue in McNeil v. Commonwealth, 67 A.3d 185 (Pa. Commw. Ct. 2013); Residuary Trust v. Director, Division of Taxation, 27 N.J. Tax 68 (2013); and Linn v. Department of Revenue, No. 4-12-1055 (Ill. App. Ct. 12/18/13), were all classified as resident trusts by the states in which the petitioners sought relief. As the common thread among the cases, each trust retained minimal connections with those states in the years that followed their creation, despite having been created by residents of the respective states.

In McNeil, resident discretionary beneficiaries represented the only additional connection to the state. Deciding the case under the U.S. Constitution’s Commerce Clause, the court found that the “substantial nexus to the taxing jurisdiction” necessary to satisfy the first prong of the Commerce Clause standard in Complete Auto Transit v. Brady, 430 U.S. 274 (1977), could not be sustained based on the residency of discretionary beneficiaries alone. The court also noted that, according to the state’s own regulations, “for residency purposes of a trust, ‘[t]he residence of . . . the beneficiaries of the trust shall be immaterial’” (McNeil, 67 A.3d at 194). That left the settlor’s residency in Pennsylvania as the lone connection to the state. The court held that “to rely on Settlor’s residence in Pennsylvania approximately [48] years before [the year] in question to establish the Trusts’ physical presence in Pennsylvania . . . would be the equivalent of applying the slightest presence standard rejected by the U.S. Supreme Court in Quill [504 U.S. 298 (1992)]” (McNeil, 67 A.3d at 195).

Residuary Trust and Linn were decided under the U.S. Constitution’s Due Process Clause. In Residuary Trust, a New Jersey Tax Court decision, the only additional connections between the state and the plaintiff trust were the trust’s ownership of S corporation stock in a company that conducted business in New Jersey and the trust’s use of a New Jersey address on its tax return. Relying on the precedent established years earlier by Pennoyer v. Taxation Division Director, 5 N.J. Tax 386 (1983), and Potter v. Taxation Division Director, 5 N.J. Tax 399 (1983), and pointing to the state’s own published guidance to taxpayers, the court held that due process was not satisfied where the trustee and assets were not located in New Jersey. The court also held that (1) ownership of S corporation stock did not equate to ownership of the S corporation’s assets and that “simply using a New Jersey address . . . does not create the required contacts . . . to overcome the due process threshold” (Residuary Trust, 27 N.J. Tax at 74). In Linn, the trustee, protector, beneficiaries, and assets were all located outside Illinois, and the court found the residency of the grantor, standing alone, insufficient to create nexus with the state.

However, not all courts have sided with resident trusts in similar types of nexus cases. Courts in Connecticut (Chase Manhattan Bank v. Gavin, 733 A.2d 782 (Conn. 1999)) and Washington, D.C., (District of Columbia v. Chase Manhattan Bank, 689 A.2d 539 (D.C. 1997)) have established that the residency of the settlor can be sufficient grounds for universal taxation of a trust’s undistributed income. In Gavin, the inter vivos trust’s noncontingent beneficiary was a resident of the state, marking a slight distinction from the cases cited above. In District of Columbia, the court held the trust’s creation in the district as sufficient on its own to create nexus for taxation.

Takeaways From These Nexus Limitation Cases

The U.S. Supreme Court may step in and clarify what additional connections to a state, if any, are required to satisfy the Commerce and Due Process Clause provisions with respect to taxing the out-of-state income of resident trusts. Until then, it appears from these cases that the best way to avoid state taxes on the undistributed income of a trust is to reduce the trust’s connection to its resident state. Advisers should recommend that trustees administer the trusts in other jurisdictions and, where appropriate and feasible, divest the trust of any real or tangible personal property or other assets located in the state.

Advisers also should be mindful of states’ advancing a “panoply of benefits” argument for nexus. This argument centers on the concept that establishment of a trust in a particular state entitles trustees and beneficiaries to a “panoply of legal benefits and opportunities.” In Linn, the Department of Revenue used such reasoning to justify Illinois’s expansive interpretation of nexus. If a trust is domiciled in a state that follows the holdings of Gavin and District of Columbia and will be taxed based on the location of the assets, trustees, or beneficiaries, another option may be to simply move the situs of the trust and establish its residency elsewhere.

Moving the Situs of the Trust

Another strategy that advisers should consider for minimizing the state-level tax liability for a trust is moving the situs of a trust to a more taxpayer-friendly jurisdiction, such as Delaware. (For more on the mechanics of this technique, known as decanting, see the next item.) A trio of Delaware Supreme Court cases released in October 2013, collectively referred to as the Peierls cases, offers guidance on (1) how to transfer the situs of a trust using the court system; (2) how to argue against the permanence of a choice-of-law provision in a trust agreement; and (3) how to draft or amend trust agreements to maintain situs flexibility through the appointment of new trustees.

In one of the cases, In re Peierls Family Testamentary Trusts, No. 16810 (Del. 10/4/13), the court gave its judicial blessing to a series of maneuvers designed to shift the situs of a pair of testamentary trusts from New York to Texas and then encouraged the petitioners to use the same tactics to achieve their goal of moving the situs of the trust to Delaware. The trusts’ two individual trustees were residents of New Jersey and Washington state, respectively. The trusts were created under a will probated in New York.

The most notable portion of the case involves what the court described as the game of “pitch and catch,” by which the trusts were effectively moved from New York to Texas. The process began with the trustees appearing before a Texas court in 1999 to petition the court to “exercise jurisdiction with respect to the Trusts and to make certain determinations relating to the administration of the Trusts” (slip op. at 15). The Texas court promptly exercised jurisdiction, confirming a change in the situs of the trusts to Texas and appointing U.S. Trust Co. of Texas as corporate trustee. However, the Texas court continued the matter “pending action in the [New York] court with respect to the replacement of U.S. Trust New York by U.S. Trust Texas and the change in the situs of the Trusts” (slip op. at 16).

The next year, the petitioner received the New York court’s order approving the replacement of the corporate trustee and the change in situs. The petitioner then in 2001 obtained a court order from Texas reiterating the previous findings and “declaring that Texas law governs the administration of the trusts” (slip op. at 5). In concluding, the Delaware Supreme Court’s decision states: “[The Delaware courts] invite petitioners to play ‘pitch and catch’—this time between the Texas Probate Court and the Delaware Court of Chancery—to first change the Trusts’ situs as well as the law governing their administration” (slip op. at 18).

Advisers should not ignore the significance of this decision. The Delaware courts have issued a notice stating that if a taxpayer can obtain from the current state of residency an order similar to what New York signed for the petitioners in Peierls, then Delaware will accept jurisdiction. Just like that, a New York or Texas trust can become a Delaware trust and benefit from Delaware’s favorable laws regarding the administration of trusts.

What If a Trust Has a Choice-of-Law Provision?

The Delaware courts answered the question of a trust with a choice-of-law provision in another of the Peierls decisions, In re Peierls Family Inter VivosTrusts, 77 A.3d 249 (Del. 2013), stating that “[w]ithout evidence that the settlor intended for the law governing administration of the trust at its inception toalways govern the trust, a settlor’s initial choice of law is not absolute and unchangeable” (slip op. at 16). Thus, even in the face of a choice-of-law provision, a trustee may move the situs of the trust to take advantage of a new jurisdiction’s laws of administration. In this Peierls case, the trustees attempted to resign and name a local corporate successor trustee in Delaware to hasten the departure of their trusts from the present states of domicile. The Delaware court was receptive to this tactic. Quoting theRestatement (Second) of Conflict of Laws, Section 272, the court provided that:

“A simple power to appoint a successor trustee may be construed to include a power to appoint a trust company or individual in another state.” Whether the trust instrument expressly or implicitly authorizes a change in the trust’s administrative governing law, “the law governing the administration of the trust thereafter is the local law of the other state and not the local law of the state of original administration.” That rule applies even when the trust instrument contains a choice-of-law provision. Therefore, when a settlor does not intend his choice of governing law to be permanent and the trust instrument includes a power to appoint a successor trustee, the law governing the administration of the trust may be changed [slip op. at 16–17].

Accordingly, in the words of the court, “a change in the place of administration accomplished by appointing an out-of-state trustee will effect a change in the law governing administration, if the settlor has not indicated a contrary intent” (slip op. at 39).

Based on the language of the choice-of-law provisions that were the subject of this determination, it is clear the Delaware courts will require specific language to indicate a desire for a choice-of-law provision to operate permanently. The three trust agreements in the case had choice-of-law language providing, respectively, that: (1) “all questions pertaining to [the trusts’] validity, construction, and administration shall be determined in accordance with the laws of the State of New York” (slip op. at 3); (2) the “validity and effect [of the trust instrument are] determined by the laws of the State of New Jersey” (slip op. at 4); and (3) each of the trusts “shall be governed by and its validity, effect and interpretation determined by the laws of the State of New York” (slip op. at 32). Citing a lack of specific intent and the absence of geographical limitations on successor trustees, the Delaware court had no difficulty determining that the settlor of each trust did not intend for the choice-of-law provision to remain in effect permanently. Accordingly, the threshold at which a Delaware court will determine that a settlor intended for a choice-of-law provision to govern the trust in perpetuity has been set extraordinarily high.

Conclusion

In some instances, moving the situs of a trust may not allow the trust to escape state taxation. Many states’ laws determine nexus based on the location of the trustees, assets, or beneficiaries. Some trusts do not permit successor trustees to be named outside specified geographic boundaries. With respect to multinational corporate trustees, which are used by many large trusts, the states have adopted different rules for determining exactly where the trustee is domiciled. Rulings in California, Arizona, and Wisconsin exemplify these different standards. Often, it is not simple to engineer a mass exodus of beneficiaries and trust property out of the harsh taxing jurisdiction the trustee seeks to escape.

States also interpret differently the discretion provided to trustees in trust agreements to make decisions regarding trust administration. Some states have liberal decanting statutes, while others have either no statute or more restrictive statutes. Many states may not allow a trustee to simply move the situs of a trust without showing some good cause, and escaping climbing rates of taxation on undistributed income is unlikely to suffice. However, despite these obstacles, it is clear that these 2013 cases create new options for advisers and their clients to minimize and even avoid state tax liability on undistributed trust income. They also offer insight into drafting strategies to provide maximum flexibility in the future to move the trust’s situs.

EditorNotes

Mindy Tyson Weber is a senior director, Washington National Tax, for McGladrey LLP.

For additional information about these items, contact  Ms. Weber at 404-373-9605 or mindy.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey LLP.