Can Another State Tax Your Trust?

Smartly setting up trusts requires knowledge of state tax laws, not just federal rules. Consider Robert L. McNeil, a chemist and onetime Pennsylvania resident who amassed a fortune as the business brain behind Tylenol. McNeil established trusts for his family but chose to locate them in Delaware, for tax purposes.

When Pennsylvania sent the trusts a tax bill of more than $500,000, the chemist’s family fought back. In May 2013, the Pennsylvania Commonwealth Court ruled that, despite McNeil’s residency in Pennsylvania at the time of the trusts’ creation, there was insufficient connection to the state for it to impose its income tax.

Score one for wealthy families who set up trusts in no-tax states like Delaware and South Dakota, then fight against another state’s tax grab. Fighting back isn’t easy. Pennsylvania has one set of rules and California has another, while New York — wising up to some of the complex tax-avoidance techniques used by wealthy families — changed its rules last year to crack down on certain maneuvers. “Each state has its own little unique twists and turns,” says Heather Flanagan, a senior wealth planner at PNC Wealth Management. “It’s kind of a hodgepodge right now. It would be nice to have some uniform law.”

Start by knowing that there are two types of trusts for tax purposes, grantor and nongrantor. With a grantor trust, all of the trust’s income-tax items (gains, losses, deductions, and credits) pass through to the person who set up the trust. With a nongrantor trust, the accumulated income in the trust is taxed at the trust level. The highest federal income-tax rate for trusts is 39.6% (plus the 3.8% Medicare surtax) on trust income above $12,300 for tax year 2015; state tax rates can reach double digits in places like California and New York. Beneficiaries, meanwhile, owe income tax on the distributions they receive from a trust, subject to complex calculations on what constitutes income.

IF YOUR TRUST HAS INCOME that’s sourced from another state — a rental property located there, say — you’ll generally owe tax to that state. But for a state to tax all of a trust’s undistributed income, it needs to have a substantial connection, called a “nexus,” to that state. The rules are all over the map: Your trust could be considered a resident of a state simply because the person who set it up was a resident there, or because the trustee, fiduciary, or beneficiary lived there.

You could, in fact, owe state income tax in several locales. In one infamous case, California levied a tax on a beneficiary of a Missouri trust when he received a final distribution, even though the trust had been paying Missouri state taxes during the previous years. PNC’s Flanagan points to a client who lived in Maryland and was paying taxes on a Delaware trust in several states, and wanted to decant the trust, or move the assets in it to another trust, to lower state taxes (see “How to Bust a Trust,” Penta, March 4, 2013). “We were not comfortable with their stance, so they went to another trustee,” she says.

While you may be able to get a tax credit in one state for state tax paid to another, the overlapping rules are so complex it’s not always clear how to claim one. Double taxation can happen, says Ronald Finkelstein, a tax partner at Marcum, a national advisory firm. Such issues regularly crop up in California, where there are many traps. If a New York family set up a directed trust in Delaware, then named a financially sophisticated friend in California to oversee the trust’s portfolio or to make distributions, it could face a tax hit in California.

What’s a person to do? Some wealthy families will pre-emptively move — or switch trustees — to avoid such problems. In one such case, a Californian who had sold a building-materials business for hundreds of millions of dollars, relocated out-of-state in advance to avoid the hefty state-tax hit. No surprise: Going into internal exile for tax reasons has become “a highly contentious issue in California,” says Matthew Brady of Wells Fargo Private Bank.

A client of Finkelstein’s switched from a grantor to a nongrantor trust and dropped a trustee who would have established a connection with a Midwestern state that could have staked a claim. Hundreds of millions of dollars of stock were in the trust, with a cost basis of zero for tax purposes, explaining why we were asked not to identify the players.

This, in short, is a high-stakes game of cat-and-mouse, pitting rich families wanting to hang on to their assets against states desperate for revenue. New York’s new rules crack down on a complicated planning technique known as an Incomplete Non-Grantor Trust; the strategy is to essentially straddle the rules of grantor and nongrantor trusts to cut state income taxes for residents of high-tax states. States, of course, are on to the technique. “New York is the most aggressive on doing this,” says PNC’s Flanagan. “Other states may follow.”

The game is ongoing.