Peripatetic Clients: No, It’s Not an Illness but They Need Your Constant Care

January 20, 2020

By Scott Testa

Presented by Jonathan G. Blattmachr, Pioneer Wealth Partners, LLC

Also: Have You Successfully Crossed State Lines or Have You Lost Your Way?
Presented by Jonathan G. Blattmachr, Pioneer Wealth Partners, LLC; G. Michelle Ferreira, Greenberg Traurig LLP; and Diana S.C. Zeydel, Greenberg Traurig, LLP

Starting off day 2 of the Heckerling Institute was Mr.  Blattmachr’s presentation on planning for the migratory client.  This was followed up on Day 3 with a special session where he, along with Ms.  Ferreira and Ms. Zeydel, further discussed a number of topics that dealt with planning where clients have ties to more than one state.  This included discussions on a number of state taxation issues such as: changing residency and domicile (and the steps one must take to successfully do so), incomplete nongrantor (ING) trusts (and how states tax these trusts) and the state income taxation of trusts after a recent decision by the United States Supreme Court.

The case, published on June 21, 2019, was North Carolina Dept. of Revenue vs. Kimberley Rice Kaestner 1992 Family Trust and will be the focus of this discussion.  In this case, the Supreme Court addressed a state’s ability to tax trusts under the due process clause of the Fourteenth Amendment.  The Supreme Court decided this case in favor of the trust and said that North Carolina cannot tax the undistributed income of a nongrantor trust just because a beneficiary, who could receive a distribution but did not, is a North Carolina resident.  There must be sufficient nexus – “some definitive link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” 

The Kaestner case is very specific.  It only applies where a discretionary beneficiary COULD get a distribution (but didn’t actually get it).  We are not sure how this might impact other states or what ripple effect it will have.  Other states, such as New York, New Jersey and Connecticut, for example, tax a trust if the settlor was resident at the time (or when it became irrevocable or when she died).  These states carve out an exception when (1) all trustees are out of that state, (2) all real and tangible assets are out of that state and (3) there is no state-sourced income.  These states’ rules would pass the Kaestner due process test because they recognize that there is not enough nexus to tax the trust there. 

This is the concept of the “resident exempt trust.”   A resident exempt trust will not be subject to income taxation in its resident state if all assets (intangibles don’t count) and all trustees are out of that state and it doesn’t have sourced income to that state.  And if the individual goes to the “right” state, then she can avoid state income taxation all together. 

The impact of this planning is huge.   An individual can set up a nongrantor trust and avoid any state income taxation of that trust. If an individual has stock that she plans to sell, she can move it to a “resident exempt trust” and not pay any state income tax on the gain.  Of course there are a number of non-income tax issues that must be addressed.  One issue that should be considered is limited or no access to the trust’s assets.  The individual and her spouse can’t be beneficiaries; otherwise, the trust would be deemed a grantor trust (plus there are other grantor trust rules that must be avoided).  Another issue is that the gift tax may be triggered. If the transfer is a completed gift, there may be gift taxes imposed if the individual used her gift tax exemption.  Another related issue is that the basis of property given is limited to the cost basis of the donor. There is no step-up to fair market value.  If this is an issue, the individual may wish to consider doing an incomplete gift (ING) trust.

However, if the individual is a resident of New York, she has these issues to worry about.

  1. New York has “throwback rules.” New York will tax a later distribution to a New York resident beneficiary:
    1. BUT these rules apply to accounting income only – not capital gains. So the capital gain income is safe from state taxation.
  2. An incomplete gift trust (ING) (just mentioned above) does not work since New York has anti-ING statutes that tax INGs as grantor trusts.
  3. New York’s position is that any amount of New York sourced income (say from a flow-through entity) will cause the individual to fail the resident exempt trust rules. Other states (such as New Jersey) are not as harsh and would only tax the income from that source. 

So why is this case so important?  First of all, it reminds us that there are ways that a nongrantor trust that is set up in one state can be taxed in another state.  Our clients, their beneficiaries and trustees are migratory.  We don’t always know when someone has moved.  This is important to know because there are still some states that attempt to tax a trust based on the residency of a beneficiary.  It’s possible or likely that these state laws may be unconstitutional.  In this case, it may be prudent to file a protective claim for refund in those states. 

Be careful though, as different states have different rules.  Some states attempt to tax a trust on where it is administered or where a trustee resides (California and South Carolina, for example).  So before an individual chooses her out-of-state trustee, the laws of the state where the trustee lives should be reviewed. 

Finally, this case also reminds us that there is a great planning opportunity here for the right client.  There is a way to avoid income tax in a trust’s resident state and, if done right, NOT pay any state tax at all.



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About Scott E. Testa

Scott Testa is a Tax Partner and a leader in the Trusts and Estates practice within the Personal Wealth Advisors Group.