Taxation of irrevocable trusts has always been complicated, but in recent years the level of complication has increased due to state tax laws being passed that attempt to bring trusts within a state’s tax reach that previously would not have been subject to such tax. Trusts generate more than $120 billion in earnings every year, so the question of which state is entitled to tax that income is a significant one. Currently, there are 44 states that impose an income tax on trusts. 12 of them use the location of the trustee as the primary consideration in determining taxability; 27 of them provide for taxation based on either the location of the beneficiary or the location of the grantor, without reference to the location of the trustee; and six of them use multiple factors. The issue was recently addressed in a unanimous ruling by the U. S. Supreme Court in an opinion written by Justice Sotomayor which struck down a North Carolina law allowing the state to tax irrevocable trusts on the basis of a beneficiary residing within its borders.
Facts of the Case
An irrevocable trust created by a settlor residing in New York in 1992 became the subject of litigation over state income taxes imposed on it by North Carolina from 2005 through 2008. North Carolina law permits the state to collect state income taxes from a trust when one of its beneficiaries resides in the state.
After filing state tax returns and paying the tax, the trustee filed a lawsuit against the state seeking a refund of the taxes paid by the trust. The trustee claimed North Carolina law violated the Due Process Clause of the Fourteenth Amendment to the U.S. Constitution.
The trustee noted that beneficiaries of the trust had not been paid any distributions, and they lacked the right under the terms of the trust to demand distributions. It is also important to note that discretionary authority over the trust rested solely in the hands of the trustee.
The Ruling of the Court
The Court agreed with the position taken by the trustee. It based its ruling, according to the majority opinion, on the following facts pertaining to the trust for the 2005 through 2008 tax years:
- No distributions had been made to the in-state beneficiaries.
- The beneficiaries had no right to demand distributions or to exercise any control over assets of the trust.
- Control and authority over trust management, including distributions from trust assets, rested solely within the discretion of the trustee.
- The beneficiaries had no guarantee of ever receiving any distribution of trust income.
North Carolina law violated the Constitution because the residence of the beneficiaries within the state did not create a sufficient connection with the trust to allow it to impose an income tax liability on it.
The Decision Does Not Prevent States from Taxing Trusts
The tax law the Court was presented with based North Carolina’s taxing authority over the trust on only the residence of the beneficiaries. Absent evidence that the beneficiaries had the ability to take distributions but chose not to as a way to avoid income taxes, the Court held that under the specific set of facts presented that North Carolina could not tax the trust. Although not definitive on the issue of which state(s) can tax the income of an irrevocable trust, the case is instructive and should result in trustees of irrevocable trusts with discretionary distribution provisions to review the terms of the trust, the residency of the settlor(s), trustee(s) and beneficiary(ies) of the trust to see which state(s) may impose state income taxes on the trust and whether there is a planning opportunity or a potential tax landmine that should be dealt with.
Obtain Advice from a Trust Attorney
If you have questions about the application of this recent Supreme Court decision to your trust, the attorneys at Magee & Adler have years of experience providing advice and guidance about creation, management and other issues related to trusts and estates. Call them now at 562-432-1001 to schedule an appointment.