Avoiding State Income Tax with Discretionary Trusts

Discretionary trusts just received another endorsement. Last Friday The Nine, otherwise known as the United States Supreme Court, gave discretionary trusts a big boost with the Court’s ruling in North Carolina Dept. of Revenue vs. Kimberly Rice Kaestner 1992 Family Trust (“Kaestner”).  In Kaestner, the Court, in a unanimous decision, held a state, in this case, North Carolina, could not tax a trust’s beneficiary on the beneficiary’s share of the trust’s income just because the beneficiary lived in North Carolina.

Just the facts ma’am.  The Kaestner Trust was created by Ms. Kaestner’s father, a New York state resident, and named a New York state resident as trustee.  The trust was based in New York, and all trust administration took place in New York. (Had the trustee resided in North Carolina or had the trust administration taken place in North Carolina, NCDOR would have been within its authority to tax the trust’s income).  Ms. Kaestner resided in North Carolina from 2005 through 2008, which are the years for which NCDOR sought to tax her share of the trust’s income.

The Court based it’s ruling on three points: First, the trust was a “pure discretionary trust.”  This means the trustee had total and absolute discretion whether to distribute trust assets to the beneficiary.  Because the trust was a pure discretionary trust, Ms. Kaestner had “no right to demand trust income or otherwise control, possess, or enjoy the trust assets. The decision of when, whether, and to whom the trustee would distribute the trust’s assets was left to the trustee’s ‘absolute discretion.’”

Second, the beneficiaries did not, in fact, receive any distributions from the trust during the years in Ms. Kaestner and her children lived in North Carolina.  The Court made clear that had Ms. Kaestner or any of her children actually received a distribution while residing in North Carolina, that distribution would have been taxable to the beneficiary who received it.

Third, the beneficiaries “could not count on necessarily receiving any specific amount of income from the trust in the future,” which is consistent with a pure discretionary trust. Interestingly, the trust was to terminate in 2009 on Ms. Kaestner’s fortieth (40th) birthday, at which point all of the trust assets would have been distributed outright, free of trust to Ms. Kaestner.  Even though absent any action on her part the assets would be distributed to her on her fortieth birthday, the Court held she could not count on receiving anything from the Trust.

So how does this help you?  More and more, we recommend the use of pure discretionary trusts to our clients.  Pure discretionary trusts provide a host of asset protection features for the trust’s beneficiaries no other type of trust can offer.  By using a pure discretionary trust, family assets can be preserved and protected from creditors, predators, in-laws, outlaws, and the law, and instead preserved for the family.

Currently, eight states, Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington, and Wyoming, have no income tax, even on residents.  If the creator of a discretionary trust provided that the trust were to be located and administered in one of these eight states, and if the trust made no distribution to a beneficiary in a high tax state, then neither the trust or the beneficiary would pay any state income on the trust’s income. This would, effectively add 5.25% to the trust’s investment performance if the beneficiary is a North Carolina resident (13.3% if the beneficiary is a California resident).

Now, more than ever, clients should strongly consider making a pure discretionary trust part of their basic estate and income tax planning strategy.

Hagan Barrett, PLLC guides individuals in the most tax efficient ways to structure their estate plans, including selecting more advantageous states within which to locate trusts and the trust administration  We would be happy to assist you or your counsel in structuring your estate plan to reduce or eliminate potential taxes.