This article explores some of the tax and nontax advantages of moving a trust, including (1) the logistics of transferring the situs of a trust and (2) drafting suggestions that will provide flexibility for future situs changes.
Author: PHILIP J. MICHAELS AND LAURA M. TWOMEY, ATTORNEYS
PHILIP J. MICHAELS is a partner in the
Many would assume that a trust is administered, taxed, and governed pursuant to the laws of the state in which the trust was created. Perhaps it is this assumption that has given rise to the idea that a trust has an identifiable "situs" or home base. In reality, the concept of trust situs is not so simple. A trust can be administered in one state, governed by the laws of another state, and subject to tax in multiple states.
Many articles and commentaries have described such trusts as having more than one situs. Rather than referring to such trusts as having multiple situs states, it may be more appropriate to think of a trust's "situs" as being the state whose courts have primary jurisdiction over the trust, and to acknowledge that often a trust is governed by or taxed by states outside its situs jurisdiction. Regardless of terminology, it is clear that fiduciaries and drafters alike should not presume that the laws of the state of the grantor's domicile will apply for all purposes. In fact, during the administration of a trust, it is frequently beneficial to reevaluate and even take action to change the laws applicable to a trust.
State income tax may be a significant expense for trusts that accumulate income as well as for trusts that incur large capital gains. For example, assume Client Smith funds an irrevocable trust (the Smith Trust) with the stock of the Smith family business. Over time, the business greatly appreciates in value and is about to be sold by the Smith Trust at a substantial gain. It would be wise to ascertain prior to the sale whether the Smith Trust would be subject to state tax on the capital gain, and to determine whether anything can be done to reduce or eliminate the tax liability. To do this, one must ascertain which types of trusts will be subject to tax in Client Smith's domicile, and decide what changes can be made to ensure that the Smith Trust "fails" to meet those requirements.
Generally, states tax resident trusts on all their world-wide income, and tax nonresident trusts only on the income generated from real property, tangible personal property, or business interests within the state. While the definition of "resident trust" varies from state to state, the statutory schemes fall into two main categories: (1) a majority of states define "resident trust" as a trust created by in-state residents, and (2) a minority of states define "resident trust" as a trust whose beneficiaries or trustees are residents of the state, or a trust that is administered in the state. Some states impose no income tax on trusts at all.
If Client Smith resides in a state that taxes trusts created by its domiciliaries (hereinafter "Resident Trusts" 1), a quick reading of the statutes in these states would seem to indicate that all of the Smith Trust's income would be subject to tax merely because the trust was created by a resident. However, several state courts have found that it would be unconstitutional to tax all the income of a trust where the only contact with the state is the residence of its grantor. These cases open the door for some income tax planning. After a careful review, it may be possible to completely eliminate state income tax on the Smith Trust by reducing the trust's contacts with the state of Client Smith's domicile.
Accordingly, if Client Smith were a
If the Smith Trust had owned an art
collection instead of company stock, the trustee would need to actually move
the artwork out of state in order to satisfy the requirement that all trust
property be located outside the state. Alternatively, if the Smith Trust owned
The exemption set forth in the instructions,
however, applies to a narrower class of trusts than those exempt from tax by
the Blue court. First, the instructions take a firm position that all
beneficiaries must be nonresidents whereas the Blue court does not seem
to consider the residency of the beneficiary an important factor. The court
specifically stated that it was following
Not all state courts ruling on the constitutionality of the Resident Trust type of statute have reached the same result. Connecticut 14 and the District of Columbia 15 have ruled that the only contact necessary to justify taxation of a trust is the residency of the grantor, under the theory that, like a corporation, the trust owes its very existence to the laws of its home state. 16 Consequently, if Client Smith resided in either of these locations at the time the Smith Trust was created, it would not be possible to move the tax situs out of state under any circumstance.
The courts in
Quill does not address the taxation of trusts, but focuses on the ability of
What if Client Smith resided in a Resident Trust state such as Illinois 20 or Pennsylvania 21 that has not ruled on the constitutionality of its state's taxation statute? Because Safe-Deposit has not been overruled, one could reasonably take the position that the Smith Trust is not subject to tax under the insufficient contacts analysis employed in the Mercantile line of cases. 22 In these states, practitioners should be on the alert for regulations, rulings, or tax return instructions which might provide insight into the policy of the state's tax department on this issue, and should use the facts of cases such as Mercantile and Blue in minimizing a trust's contacts with a given state.
For trusts created in states that do not
attempt to tax based solely on the residence of the grantor, it is much simpler
to determine whether the trust can be moved. For example,
Perhaps the easiest states to vacate for
income tax purposes are states such as
Moving a trust out of state can be difficult
if a corporate fiduciary
is required or preferred because many trust companies now conduct business in
numerous states. The approach that
Once you determine that you can successfully eliminate tax in your home state by making an adjustment to the administration of the trust, such as moving the trustee or the trust assets out of state, you must be cognizant of the tax laws in the new jurisdiction. For example, if the new trustee resides in a state with a trustee-based taxation statute, you will have again subjected the entire trust to state tax. This is something to keep in mind if you are moving the trust to California, which taxes the income of a trust if either a trustee or a beneficiary resides in state, 32 or to Delaware, which taxes a trust with Delaware trustees if there are Delaware beneficiaries. 33
On the other hand, states with Resident Trust
statutes are generally ideal "in-bound" states, since a trust created
by a nonresident will be subject to tax only on income derived from sources in
that state (which is a tax that would have been due even if the trust had not
been moved). Jurisdictions such as
In addition to saving capital gains tax on
the sale of a major trust asset, it is wise to consider the state income tax
effects to the trust whenever there are major changes to the trust assets, or a
change of residency of a trustee or beneficiary. For example, if a trustee
If double taxation seems inevitable, a
thorough examination of the laws in both states may provide a creative
solution. For example, suppose that the income beneficiary of a trust created
We have seen that the location of a trust's assets, beneficiaries, trustees, and grantor all affect a trust's liability for state income tax, and that a conscious reordering of these elements can often provide significant financial gain to the trust. Similarly, many benefits may be derived from a change in the law governing the administration of a trust.
The laws governing the allocation of receipts and expenses differ widely from state to state and can have a major impact on the property rights of the income beneficiary and remaindermen. As with the matter of taxation, a trustee should be mindful of which state's law will govern the administration of a trust not only at the outset, but also upon such events as the relocation or death of a beneficiary or trustee, or the sale of a large trust asset. Moreover, with the emergence of the Uniform Principal and Income Act of 1997 (UPIA), many states have recently changed or are in the process of amending the manner in which various types of receipts and expenses are allocated, making this an ideal time to assess the appropriateness of the trust's current "situs" for governing law purposes.
Given the recent change in the law, trustees
of trusts created by artists, authors, or inventors, and any trust expecting
significant income from royalties, copyrights and patents would be wise to
consider whether the needs of the income and remainder beneficiaries would be
better met in another jurisdiction. For instance, if the income beneficiary has
substantial outside assets and wants to minimize the distributions from the
Besides changing many of the default rules governing the allocation of specific receipts and expenses, UPIA includes a provision called the "power to adjust," which has already been adopted in many states. Trustees in states that have not adopted the power to adjust may be motivated to move their trust to take advantage of this flexible provision. The power to adjust authorizes a trustee to make adjustments between principal and income when the traditional allocations are not fair and reasonable to all beneficiaries. 44
For example, a trustee who invests the entire trust portfolio in capital growth assets would be permitted to allocate stock dividends and capital gains to the income beneficiary, or a trustee who places an entire portfolio in bonds due to concerns about the stock market could allocate some of the interest payments to principal. The power to adjust is especially helpful to trustees who have no authority to distribute principal, and trustees who have no discretion under the governing instrument with respect to allocation of receipts and expenses. 45 Accordingly, trustees may find it worthwhile to move a trust to a state that can provide them with this power.
While the power to adjust provides many options, some trustees may be unwilling to exercise this power for fear that one or more of the beneficiaries will be unhappy. Other trustees will not be eligible to exercise the power to adjust. 46 These trustees might consider moving to a state that permits the conversion of an income interest into a unitrust interest. The unitrust concept was dropped from UPIA prior to the final draft. However, approximately a dozen states have adopted statutes in varying forms which allow trustees the option of defining the income beneficiary's interest as a unitrust amount. 47
For example, in
We have explored the advantages available to trustees who are open-minded about a trust's home base. Assuming we have identified a more favorable jurisdiction, we must now turn to the logistics of moving the trust. It is not always easy, or even possible, to get from here to there, and in many cases the rules and procedures are unclear.
The steps to be taken will depend on what you are trying to accomplish. If you are looking to achieve tax savings, the procedure will be based on which characteristics of the trust need to be changed to fall outside the scope of the state's taxation statute. For example, if the trust needs an out-of-state trustee, you will need to (1) determine if the current trustee is willing to resign, (2) locate a suitable out-of-state trustee, and (3) orchestrate the change of trustees.
For a testamentary trust, this will generally involve a court proceeding. For an inter vivos trust, a court proceeding will often be unnecessary, assuming the trust instrument or state law permits the resignation of the trustee and provides a mechanism for the appointment of a successor trustee. If you need to move a trust's tangible property out of state to achieve the tax results, the trustee may need court approval prior to removing the property from the state.
It will not always be necessary to move the jurisdictional situs of a trust in order to achieve the sought-after tax savings. Although Wisconsin will, in some instances, tax a trust created by a resident unless a state court has granted a change of situs, 52 most state income tax statutes are not based on whether the grantor's home state has jurisdiction over the trust. Hence, this type of court proceeding can be avoided if your goals are solely tax-oriented.
The steps are different if you are looking to change the law governing the administration of the trust. Many state courts will entertain proceedings to change the jurisdictional situs of a trust. This usually involves requesting that the court relinquish its jurisdiction over the trust and permit the trust's administration to be removed to another state. The practitioner must examine the case law in the trust's home state and determine whether the court is likely to permit the transfer. Some courts will permit the situs of a trust to be moved only if this is specifically authorized in the trust instrument. Generally, the courts will require a showing that the new state has sufficient contacts with the trust to justify the move, and that the move will somehow benefit the administration of the trust. Often, the state relinquishing control will issue an order which is contingent upon the new state accepting jurisdiction over the trust; thus, two court proceedings may be necessary.
Prior to initiating a transfer of situs proceeding, the practitioner should examine the choice of law rules of the new state, and should determine whether the trust instrument contains a choice of law provision. If the trust instrument contains a provision that specifies which state's law governs its administration, that provision will be honored even where the chosen state has no relation to the trust. 53 If the trust instrument does not contain a choice of law provision, the administration of an inter vivos trust will generally be governed by the law of the state having the most substantial relationship with the trust, taking into account the grantor's intent, and the nature of the contacts between the state and the trust. 54 While all the trust's contacts should be examined, it is doubtful that a state court would accept jurisdiction over the trust if there were not substantial contacts with the state. Therefore, a formal acceptance of jurisdiction by the court of the new state should weigh in favor of applying the law of the new state.
In contrast, if no governing law has been designated with respect to a testamentary trust, some courts apply the law of the state of the testator's domicile to the administration of the trust, while others apply the law of the state with the most substantial relationship. 55 Thus, if you are moving a testamentary trust with hopes of applying the law of the new state to the administration of the trust, a review of that state's choice of law rules is essential to your success.
Once a determination has been made that the new state's law will govern the administration of the trust, the practitioner should be mindful that it will apply for all matters of administration, such as the trustee's duty to account, and the trustee's commissions, and not just for the matter that originally motivated the transfer of situs. 56 Moreover, the practitioner should not assume that the new state's law will apply for all purposes. While the law governing the administration of a trust can often be changed using the above procedure, substantive issues relating to the disposition of the trust property will usually be determined based on the law of the grantor's domicile. 57
During the initial preparation of a trust, consideration should be given as to the most suitable initial situs for the trust. This includes choosing which state's law will apply, and analyzing the tax consequences of who is being appointed as trustee and where the trust assets are to be administered. The state of the grantor's domicile will not always be the best option. For example, if the trust is to be funded principally with patents and copyrights, the drafter should be cognizant of how receipts from those assets will be allocated in the chosen state. In advising a client whose sibling will be trustee, the tax consequences in the state of the sibling's domicile should be reviewed.
In addition, thought should be given to the types of assets being gifted and the location of the beneficiaries. For instance, if a client from a Resident Trust state like New Jersey planned to gift an in-state rental property and a portfolio of marketable securities, perhaps the assets should be gifted to two separate trusts—one trust holding the rental property, which will always be subject to New Jersey tax so long as the rental property is retained, and one holding the marketable securities, which can be structured so that it is not subject to state income tax.
Multiple trusts could also be useful if some
of a client's beneficiaries reside in states that impose a tax based on the
residency of the beneficiary. For example, suppose that a
Because the duration of a trust can often outlast all predictable events, it is important for the drafter to provide flexibility for a potential change in situs in the future. The drafter should consider adding a provision to the trust instrument which specifically authorizes a trustee to move the situs of the trust and to change the law governing the administration of a trust. 58 The drafter should also include provisions enabling a trustee to resign and should provide a method for the appointment of successor trustees.
The laws governing the administration and taxation of a trust have a significant impact on the trust's beneficiaries. The consequence of these laws should be evaluated upon the creation of the trust, and should be reassessed throughout the administration of the trust, particularly upon the relocation or death of a trustee or beneficiary, or upon a meaningful change in a trust's assets. With a little creativity and a careful review of all relevant authorities, beneficial results can frequently be achieved by orchestrating a few changes in the administration of the trust.
A drafter should consider adding a provision to the trust instrument which specifically authorizes a trustee to move the situs of the trust and to change the law governing the administration of the trust.
In this article, the capitalized term "Resident Trust" will have the meaning accorded to it in a majority of jurisdictions.
19 App Div 2d 765 , 242 NYS2d 26 (N.Y. App. Div. 3rd Dep't, 1963), aff'd 203 N.E.2d 490 (N.Y., 1964) (citing Safe Deposit & Trust Co. v. Va., 280 US 83 , 74 L Ed 180 (S.Ct., 1929) (ruling that Virginia had unconstitutionally imposed a property tax on a trust with insufficient contacts with the state; the trust, which consisted of intangible assets, was administered in Maryland by a Maryland trustee, but had been created by a Virginia resident and had Virginia beneficiaries)).
N.Y. Comp. Codes
R. & Regs. Tit. 20 §105.23(a) (hereinafter N.Y.C.R.R.). While the
regulations create a safe harbor for the taxpayer to follow, the
See N.Y.C.R.R. Tit. 20 §105.23(a).
Petition of Charles B. Moss Trust, Income Tax Advisory Opinion, TSB-A-94(7) I (4/8/94); 1994 N.Y. Tax Rep. ¶401-594 at 45084 (citing Safe Deposit & Trust Co, infra note 18, Mercantile-Safe Deposit Trust Co., supra note 2; Taylor v. State Tax Commission, 85 App Div 2d 821 , 445 NYS2d 648 (N.Y. App. Div. 3rd Dep't, 1981)).
N.Y.C.R.R. Tit. 20 §105.23(a)
For a thorough
analysis of the taxation of
The New Jersey
statute defines a resident trust as "(2) a trust, or portion of a trust,
consisting of property transferred by will of a decedent who at his death was
domiciled in this State; or (3) a trust, or a portion of a trust, consisting of
the property of: (a) a person domiciled in this State at the time such property
was transferred to the trust, if such trust or portion of a trust was then
irrevocable, or if it was then revocable but has not subsequently become
irrevocable; or (b) a person domiciled in this State at the time such trust, or
portion of a trust, became irrevocable, if it was revocable when such property
was transferred to the trust but has subsequently become irrevocable."
The lack of
clarity can be advantageous to a trust that has very few contacts with
It is unclear
462 NW2d 762 (Mich. Ct. App., 1990).
Mich. Comp. Laws §206.18(1)(c). Under the Michigan statute, "any trust created by, or consisting of property of, a person domiciled in Michigan at the time the trust becomes irrevocable" is a "resident" trust and thus subject to Michigan income taxation. Taxable income of a resident trust includes federal taxable income, subject to certain modifications. Mich. Comp. Laws §206.36. Form 2000 MI-1041 (The instructions do not specify whether this includes contingent beneficiaries).
Chase Manhattan Bank v. Gavin, 733 A2d 782 (1999), cert. den. (upholding constitutionality of Conn. Gen. Stat. §12-701(a)(4)). For a summary of this case, see Volkmer, "New Fiduciary Decisions: State Taxation of Trust Income Upheld," 27 ETPL 41 (Jan. 2000) .
District of Columbia v. Chase Manhattan Bank, 689 A2d 539 (D.C., 1997) (upholding constitutionality of D.C. Code Ann. §47-1809 (1990)).
For a discussion of the constitutional issues raised in the Connecticut and District of Columbia cases, see Moore and Silliman, "State Income Taxation of Trusts: New Case Creates Uncertainty," 24 ETPL 200 (June 1997) .
The Connecticut court's reliance on Quill is seemingly inappropriate. It is factually dissimilar not only because it did not concern trusts, but because it involved the partial taxation of a nonresident entity. The Quill court ruled that even where a nonresident entity was not physically present within the state, it was reasonable to subject the entity to tax in that state as a nonresident where it had purposefully availed itself of an economic market in that state. The Connecticut court then used the "no physical presence is necessary" rationale of Quill to justify taxing, as a resident, a trust with no contacts to the state, other than the fact that it was created by a resident. As stated by Jordan M. Goodman, "the holding [in Quill] does not give authority to the illogical proposition that a party with no physical presence in a state may be considered a resident of that state." Goodman, "State Taxation of Business Trusts: Limits, Concerns and Opportunities," 9 J. Multistate Tax'n 6 (Feb. 2000) .
35 Ill. Comp. Stat. 5/301 (residents are taxed on all taxable income, including income derived from sources outside Illinois); 35 Ill. Comp. Stat. 5/1501(a)(20)(C), (D) (defining resident trust as testamentary trust of a decedent domiciled in Illinois at death, or inter vivos trust where grantor was domiciled in Illinois at time trust became irrevocable).
72 Pa. Cons. Stat §7301(s) (defining resident trust as trust created by the will of a decedent who was a resident of Pennsylvania at death, or a trust consisting of property transferred by a person who was a Pennsylvania resident at the time of the transfer).
See Bell and Lasher, supra note 10, at 7 (suggesting that many trustees of trusts created by Pennsylvanians do not file Pennsylvania returns on grounds of unconstitutionality of the state statute).
727 SW2d 880 (Mo., 1987).
Mo. Rev. Stat. §143.331 (adding to the definition of resident trust the requirement of "at least one income beneficiary who, on the last day of the taxable year, was a resident of this state").
See Cal. Rev. & Tax Code §17742-45. California imposes income tax on the entire income of a trust if one or more noncontingent beneficiaries or fiduciaries are California residents. Cal. Rev. & Tax Code § 17742. If the tax is based solely on the residence of a fiduciary (i.e., all beneficiaries are nonresidents), the portion of the trust income subject to California income tax is reduced proportionately by the presence of out-of-state fiduciaries. Cal. Rev. & Tax Code §17743; in other words, the trust is taxable on (1) California source income and (2) the proportion of non-source income which the number of resident fiduciaries bears to total fiduciaries. Cal. Code Regs. Tit. 18, §17743. If the tax is based solely on the presence of a beneficiary (i.e., all fiduciaries are nonresidents), the trust is taxed on (1) California source income and (2) that proportion of non-source income which is to be distributed to resident beneficiaries. Cal. Rev. & Tax Code §17744; Cal. Code Reg., Tit. 18, §17744. See Del. Code. Ann. Tit. 30, §§1102(a), 1601, 1631-1640. Delaware will tax all the income of a trust where (1) the trustee and beneficiary are residents, or (2) the grantor and beneficiary are residents. If only some of the beneficiaries are residents, only a portion of the non-Delaware source income will be subject to tax. Del. Code. Ann. Tit. 30, §1636. See e.g., Ga. Code Ann. §48-7-22(a)(1)(C); Mass. Gen. Laws Ann. ch. 62, §10.
Ariz. Rev. Stat. §43-1301 (applying to taxable years beginning from and after 12/31/02) (taxing all income of a resident trust and defining resident trust as a trust in which at least one fiduciary is a resident, or in the case of a corporate fiduciary engaged in interstate trust administration, as a trust in which the corporate fiduciary conducts the administration of the trust within Arizona). See also Ark. Code Ann. §26-51-1-302 (if one trustee is a resident and the other is a nonresident, Arkansas will tax one-half of all the trust income).
Or. Rev. Stat. §316.282 (imposing tax on federal taxable income of resident trust and defining resident trust as trust where the fiduciary is an Oregon resident or where the trust is administered in Oregon).
Colo. Rev. Stat. §39-22-401 (imposing tax on all income of resident trust); Colo. Rev. Stat. §39-22-103 (defining resident trust as a trust administered in Colorado).
Utah Code Ann. §59-10-103(1)(l)(i) (defining resident trust as trust consisting of property transferred by will of decedent who was domiciled in Utah at death or a trust administered in Utah).
Utah Code Ann. §59-10-103(1)(l)(ii)-(iii). Under the Utah statute, for example, a trust is administered within the state if the place of business where the fiduciary transacts a major portion of the trust administration is located in Utah, or the usual place of business of the trustee is in Utah, or if there is more than one fiduciary, if the situs of the corporate or professional fiduciary with primary responsibility for trust administration is located in Utah.
Or. Admin. R. §150-316.282 (5).
Cal. Rev. & Tax Code §17742.
Del Code. Ann. Tit. 30, §1636.
Some relief may be available in the form of a credit for taxes paid to another state.
Florida intangibles tax will be imposed on a trust if the income beneficiary is a resident, and if the income beneficiary either has a general power of appointment over the trust, or may revoke the trust. Fla. Stat. Ann. §199.023(7).
Fla. Stat. Ann. §199.185(1)(c).
See note 25, supra.
For an even better tax result, the Californian could place all the trust's assets in a limited liability company (LLC), then resign as trustee and serve as manager of the trust's LLC. This would eliminate the California tax and would enable the former trustee to remain in control of trust investments.
N.Y. Est. Powers & Trusts Law §11A-4.10. Among others, New Jersey, California, and Connecticut have also enacted this rule as part of the adoption of the Uniform Principal and Income Act of 1997 (UPIA). N.J. Stat. Ann. §3B: 19B-18; Cal. Prob. Code §16362; Conn. Gen. Stat. §45a-542r.
760 Ill. Comp. Stat. 15/12.
Vt. Stat. Ann. Tit. 14, §3311 (allocating all receipts from copyrights, royalties, and patents to income where the trustee is "not under a duty to change the form of the investment of the principal").
12 Del. Code Ann. Tit. 12, §§6109, 6102 (granting discretion to the trustee to allocate copyright and patent receipts as "reasonable and equitable").
UPIA §104, 7B U.L.A. 141 (2000). The purpose of the power to adjust is to bring the UPIA in line with the total return philosophy embodied in the Uniform Prudent Investor Act. As such, the power to adjust is available only to trustees who invest in accordance with the Prudent Investor Rule.
For a discussion of the advantages and disadvantages of the power to adjust, see Glikman, "The New Uniform Principal and Income Act: Friend or Foe?," 31 McGeorge L. Rev. 463 (Winter 2000).
If all the trustees are trust beneficiaries, or if the trust remainderman is a charity, the trustee may not make any adjustments. UPIA §§104(c)(4), 104(c)(7-8), 104(d), 7B U.L.A. 142-143 (2000).
"The Well-Adjusted Trust: Revisiting the Uniform Principal and Income Act (1997)-Part II," U.S. Trust's Practical Drafting, p. 6918 (July 2002).
N.Y. Est. Powers & Trusts Law §11-2.4.
Del. Code Ann. Tit. 12, §3527.
As with the power to adjust, a trust whose remainderman is a charity may not convert to a unitrust (unless the income interest is also charitable). See, e.g., N.Y. Est. Powers & Trusts Law §11-2.4(c)(9); Del Code Ann. Tit. 12 §3527(l).
Bogert, The Law of Trusts and Trustees §§296-297 (2nd ed., 1992) (citing Restatement (Second) of Conflict of Laws §§271-272 (1971)).
Auchincloss, and Shanabrook, "Changing the Situs of a
Bogert, supra note 53, at §§296-297.
Blattmachr, "Drafting and Practical Issues Relating to the Situs of a Trust," 3 Chase J. 79 (1999).
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