Legal Blog

Discretionary Trusts Can Avoid State Income Tax

Hand holding piece of jigsaw puzzle with word INCOME TAX.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 Kaestener 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 Carlina 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 its 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 purely 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 which 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 purely 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 purely discretionary trust, family assets can be preserved and protected from creditors, predators, inlaws, 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 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, effectively adding 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 purely discretionary trust part of their basic estate and income tax planning strategy.

Offit Kurman 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.

ABOUT SCOTT TIPPETT | 336.232.0671

Scott Tippett focuses his practice on wealth management law and corporate, business, and real estate issues for individuals, families, and small to mid-sized closely held companies including medical, dental, and veterinary practices.

Mr. Tippett began practicing law in 1987 in Atlanta where he litigated major construction project disputes, complex white-collar crime matters, and significant business and estate issues. In addition to practicing law, he ran a manufacturing company in High Point in the mid -1990s, which provided him with a unique and broad perspective on understanding the various issues faced by business owners and managers.






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