Look for residence in a state with low income tax.

Generally, the income earned by an irrevocable trust is subject to state income tax in addition to federal income tax. Making strategic decisions in establishing your client’s trust, such as selecting a trustee who resides in a state without a state income tax, can potentially reduce this tax liability.

Two-Step Test

A state may determine that it has an interest in taxing an irrevocable trust based on a variety of factors, including residency of the grantor/settlor, residency of the beneficiary, residency of the trustee and the location of the trust administration. However, in general, a state may have an interest in taxing the income of an irrevocable trust only if: (1) there’s “some definite link, some minimum connection” between the state and the irrevocable trust it seeks to tax, and (2) the income the state seeks to tax is rationally related to values connected with the taxing state.

This two-step test increases the burden for a state to show its interest in taxing an irrevocable trust and was recently affirmed in a decision by the U.S. Supreme Court (North Carolina Dep’t of Rev. v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S. 6/21/19)), which unanimously held that a beneficiary’s residency in a state isn’t a sufficient basis on its own for that state to tax an irrevocable trust. If the beneficiary doesn’t receive, or have the right to demand, distributions in that state, then there isn’t a sufficient minimum connection with the irrevocable trust for the state to impose an income tax that is based solely on the beneficiary’s residency.

Individual Trustee’s Residency

However, in the case of trustees who are individuals (as opposed to a trust company), a trustee’s residency does typically create a sufficient connection with the state for the state to tax an irrevocable trust. This is because the trustee has a close relationship with the trust assets, has an ability to incur obligations pursuant to the trust and may become personally liable for contracts for the trust. Also, in the course of their duties in administering the trust, trustees avail themselves to the benefits and protections of the state. Accordingly, a state may tax the income of an irrevocable trust solely on the basis of a trustee’s residency. This means the tax burden of your client’s irrevocable trust may be affected by the income tax rate of the state where your trustee lives.

Forty-two states impose a state income tax on irrevocable nongrantor trusts, and the income tax rate among these states ranges from 2.9% to 13.3%. If your client’s trustee lives in a state that taxes income based solely on trustee residency, this may substantially increase the tax burden on your client’s irrevocable trust. Choosing a trustee in a state with no income tax, such as Florida, can potentially eliminate this additional source of tax liability.

Mike Okaty, co-chair of the Transactions Practice at Foley & Lardner LLP and managing partner for the firm’s Orlando office, serves as an advisor and trustee to high-net-worth individuals and families

Jamil Daoud, of counsel in Foley’s Estates & Trusts Practice, focuses his practice on tax, estate and wealth transfer planning, closely held business planning, asset protection planning, and estate and trust administration.

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