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State Income Tax Planning and Opportunities

These become more important as the future of federal law remains uncertain.

As our country works together to stem the spread of COVID-19, one major issue that seems to have been pushed to the side for the moment is the upcoming presidential and Congressional elections in November. It’s possible that whatever happens in November will mean the end of the Tax Cuts and Jobs Act (TCJA)1 and the high estate and gift tax exemptions provided for under the TCJA. There’s a strong possibility that there won’t be enough political will in Washington to make the TCJA permanent if President Trump is defeated, the Democrats retain control of the House or the Republican party can’t achieve a filibuster-proof majority in the Senate. With the future of the federal estate and gift tax uncertain, clients should focus on taking advantage of state income tax planning opportunities. 

State and Federal Interplay

The interplay between the state and the federal rules isn’t new for wealth transfer strategists. We’ve always had to consider how any plan that would work well under federal law might be impacted by state rules, particularly because any one trust may be governed by the rules of more than one state.   

The TCJA, enacted at the end of 2017, capped the deduction of state income taxes paid for federal income tax purposes to $10,000 per single taxpayer or married couple and spurred a wave of planning around limiting state income taxes on assets transferred into trusts.  In the post-TCJA world, commentators have urged practitioners to consider creating non-grantor trusts in so-called trust-friendly states like Alaska, Delaware, Nevada and South Dakota to save state income taxes, achieve asset protection and preserve other tax savings, such as maximizing the qualified business income deduction available under Internal Revenue Code Section 199A.  

Trust Residence

Many states,2 like New York3 and Illinois,4 determine residence of a trust based on where the settlor of the trust resided at the time that the trust was originally settled. For these states, residence is permanent; no matter where the beneficiaries live, the corpus is located, the trustees are located or where the settlors someday move, the trust will remain a resident trust for state income tax purposes. Generally speaking, most of these states have laws—whether by enacted statute or decided by common law—that allow fiduciaries to claim an exemption from state income tax. For example, in 1983, New Jersey determined in two landmark cases that it was unconstitutional for the state to impose an income tax on the undistributed income of trusts when both the fiduciaries and current beneficiaries resided outside of New Jersey, and no trust property was located within the state.5 In 2013, a New Jersey tax court made clear that when a resident trust had New Jersey source income, this wouldn’t create a sufficient nexus to allow the state to tax all of the income earned by the trust.6 Rather, the court confirmed that only the New Jersey source income would be taxable in New Jersey for income tax purposes, so long as the fiduciary and current beneficiaries weren’t New Jersey residents, and there were no assets located within New Jersey.  

New York’s three-prong test for exemption from income taxes is: (1) all trustees domiciled outside of New York; (2) all trust property located outside of New York, and (3) no New York source income. However, New York residents may be subject to an accumulation tax on any distributions received from a New York resident exempt trust to the extent that any distribution received is deemed to have included any undistributed net income earned in a prior year.7  

Connecticut also determines whether a trust is a resident for income tax purposes based on the residence of the settlor at the time that the trust became irrevocable.8 However, whereas other states allow exemptions from state income taxes for both inter vivos and testamentary trusts based on various factors, Connecticut treats testamentary trusts differently from inter vivos trusts. Specifically, in Chase Manhattan Bank v. Gavin,9 the Connecticut Supreme Court concluded that testamentary trusts established on the death of a Connecticut resident will remain taxable in Connecticut regardless of whether the trust has any other nexus with Connecticut. Pointing to the fact that the Connecticut probate courts were required to approve the original trustees and their successors and otherwise assure the continued existence of testamentary trusts established as part of the probate process, the court opined that the minimum contacts with the state required to satisfy due process were met by the benefits and opportunities afforded the trusts by the Connecticut courts and legal system. The state’s laws determined the validity of the trusts and assured their continued existence.  

The Illinois appellate court in Linn v. Department of Revenue10 found it compelling that the Gavin court distinguished testamentary trusts from inter vivos trusts. The Illinois court pointed out that the connection between an inter vivos trust created by a resident settlor and the state was “more attenuated than a testamentary trust” because the inter vivos trust “does not owe its existence to the laws and courts of the state of the grantor in the same way a testamentary trust does and thus does not have the same permanent tie.”11  

For both Connecticut and Illinois, an inter vivos trust established by a resident may avoid state income taxes so long as: (1) neither the trustee nor any current beneficiaries reside within the state; and (2) the trust doesn’t own any assets located within the state.  

Beneficiary Residence 

Some states tax trusts based on the beneficiary’s residence.12  In North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust,13 the U.S. Supreme Court evaluated whether states could tax the accumulated income of trusts based on the residence of beneficiaries. The Court was particularly swayed by the fact that the resident beneficiary didn’t have any rights to compel distributions nor any control over the assets held by the trust. In Kaestner, the trustee was also a nonresident and had no contacts with the state.  

While the Court made clear that its opinion was specific to the facts at issue in that case, other states have laws on the books that are almost identical to the North Carolina statute that the Court struck down.14 It’s not clear how Georgia, North Carolina and Tennessee might update their legislation to preserve taxability by addressing the concerns raised by the Court in Kaestner. Additionally, while it appears that Kaestner didn’t strike down all beneficiary residency trust taxation statutes, it’s not entirely clear whether the findings in Kaestner might have an impact on enforcement of beneficiary residency statutes in other states.  

For example, California imposes tax on any trust with a California resident trustee or a California non-contingent beneficiary.15 The Court’s conclusion in Kaestner is inapplicable to this type of statute because the beneficiary must have a present interest to receive distributions under the California system, whereas in North Carolina, the beneficiary had no power to compel distributions and hadn’t actually received any distributions during the period at issue.  

For other states, a trust will be taxable to the extent that there’s a resident beneficiary and other factors such as assets located within the state, resident trustees, source income and/or creation of the trust by a state resident.16 Still other states determine taxability of a trust  based on the administration of the trust within the state or on the location of the fiduciary within its borders.17

Drafting Strategies

Practitioners hoping to mitigate state income tax exposure should be mindful of the various state laws that may be applicable to the particular circumstances of any given client. Possible drafting alternatives include:

1. Identify a trustee residing in a tax-friendly jurisdiction (possibly an institutional trustee); 

2. Avoid contacts with high tax jurisdictions by, for example, ensuring that trust asset custodians are physically located in tax-friendly states, not renting or owning an office within the taxing state and not owning any tangible property in the taxing state.

3. Avoid trust source income in any high tax jurisdiction by avoiding direct investments within the taxing state. Assets could be segregated among different trusts to limit the taxability of non-source income.   

4. Avoid having trusts make distributions to resident beneficiaries.  

5. To the extent that a settlor wishes to benefit an individual who resides in a beneficiary-residence trust taxation state, consider creating a separate trust for that resident beneficiary.  

For existing trusts, particularly those established in settlor-resident trust taxation states, a practitioner should review trust instruments to determine whether there might be any opportunities to achieve resident exempt status. Practitioners should confirm how the taxing jurisdiction determines whether an asset is considered tangible such that it will create a sufficient nexus to allow for resident trust treatment. Perhaps the asset should be dropped into a limited liability company (LLC). States such as New Jersey and New York view LLC membership interests as intangibles. In these states, LLC interests holding tangible property located within the state would nevertheless be considered a non-situs asset.  

Sometimes, despite a planner’s best efforts, a trust will still be subject to income taxes in a high tax jurisdiction. In such circumstances, it may help to know that New York and California both allow itemized deductions against gross income for investment fees and other expenses that had been eliminated by the enactment of the TCJA. Further, trusts that are taxable in Connecticut may reduce their tax burden based on the ratio of the number of noncontingent beneficiaries who reside in the state over the total of all current trust beneficiaries.  

Several states don’t impose income taxes on trusts.18 To take advantage of the opportunities presented by no-tax states, practitioners must be aware of the specific laws applicable in each relevant jurisdiction. This would be a great time for advisors to collaborate with one another.  

For example, a taxpayer anticipating the sale of a closely held business in a high tax jurisdiction such as New Jersey may be able to fund a trust established with a South Dakota trustee with an ownership interest in the business. The trust must be administered in South Dakota by a South Dakota trustee and have neither a New Jersey resident serving as a trustee nor any New Jersey real or tangible property so that it may be exempt from New Jersey income taxes. So long as the sale of the business is structured as a stock sale and not as an asset sale, the trust wouldn’t be deemed to have any New Jersey sourced income and should be able to avoid New Jersey state income taxes on the proceeds.19  

Those taxpayers who aren’t considering a sale of their business might minimize their overall tax burden by using non-grantor trusts established in no-tax jurisdictions to maximize deductions otherwise capped by income limitations at the federal level, such as the qualified business income deduction, which phases out as taxable income rises.20 Practitioners should be wary of the application of regulations that prevent taxpayers from establishing non-grantor trusts solely to avoid taxes.  

An incomplete non-grantor (ING) trust could be a powerful planning tool for individuals residing in high tax states other than New York who would like to minimize state income taxes without giving away their assets. New York doesn’t recognize ING trusts and will instead require these trusts to be treated as grantor trusts for state income tax purposes. New York residents would be ill-advised to set up an ING trust, as all of the income earned by the trust would nevertheless be taxable to them on their New York state income tax return.  

Practitioners should consider the effect of the 3.8% net investment income tax on those taxpayers considering a non-grantor trust to shield closely held business income from state income taxes.21 To the extent practicable, trusts should be structured to name a fiduciary who’s materially participating in the trade or business activities of the entity owned by the trust and not a resident of any state that would trigger additional income taxes.  

Changing the trustee of an existing trust may enable the trust to avoid being treated as a taxable resident of any state. For example, a trust established by a Colorado resident and administered by a New York state fiduciary won’t have any tax residence for state income tax purposes, because Colorado bases residence on the state where the trust is administered, and New York is a settlor-residence taxation trust state. Practitioners should review existing trusts for opportunities to make a change that could have a significant impact on the taxability of the trust.  

Alaska,22 Tennessee23 and South Dakota24 each have  enacted community property trust (CPT) statutes that may allow nonresidents to obtain a full basis step-up on the first spouse’s death on all assets owned by the trust. Nonresidents may settle CPTs so long as they choose a qualified trustee domiciled within the state. While other states are also contemplating adding CPT statutes, this strategy isn’t without significant risk. Practitioners would be well-advised to consider it only for clients who are in long and stable marriages because there are risks to equitable distribution determinations on divorce for assets held by the trust. Finally, there’s no guarantee that the Internal Revenue Service won’t challenge these structures as they gain in popularity and allow families to mitigate income taxes on additional depreciation or sales before the death of the surviving spouse.    

Be Prepared for Change

Our challenge is that planning may never again be more urgent or necessary than it is right now. As planning is likely far from top of mind in this unprecedented time in our collective history, wise practitioners should be educating wealthy clients that the current climate has presented the perfect storm for planning purposes. The confluence of low interest rates, artificially depressed asset values and very high federal estate and gift tax exclusion rates makes this the perfect time to leverage wealth out, address state concerns and possibly trigger opportunities available under state law to lower the overall tax burden for their clients and their clients’ families.  

The TCJA, with its exceptionally high federal estate and gift tax exclusion rates of $11.58 million per taxpayer, may not last beyond the current federal elections, and there’s reason to be concerned that the exclusion rates may be lowered as early as 2021.25 The sudden drop in economic activity and low interest rates are likely to be relatively short-lived, allowing taxpayers to transfer assets at a lower gift tax value today than the asset may be worth in six months or a year from now.  

The impending federal elections are less than six months away, and while it’s far from clear how the results might adversely impact opportunities, it seems certain that federal planning will be much different in 2021 than it is right now. Planners must act now to ensure that their clients have all of the advantages currently available to protect their future financial security as well as that of their small businesses and future generations of their families.  


1. The “Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (Pub. L. 115-97) is set to expire on Dec. 31, 2025 by its own terms, unless Congress passes a bill to make it permanent.    

2. See, e.g., Alabama, Connecticut, Illinois, Maine, Michigan, Minnesota, Nebraska, New Jersey, New York, Oklahoma, Pennsylvania, Rhode Island, Vermont, Washington, D.C., West Virginia and Wisconsin. This list is non-exhaustive. State laws are subject to change. Always check specific state statutes for guidance, and don’t rely on this listing. See Steve Oshins, “5th Annual Non-Grantor Trust State Income Tax Chart” (Oshins Chart),

3. N.Y. Tax L. Section 605(b)(3).  

4. 35 ILCS 5 Illinois Income Tax Act Sect. 1501(a)(20).   

5. N.J. Rev Stat Section 54A:1-2(o). See Pennoyer v. Taxation Div. Dir., 5 N.J. Tax 386 (1983) and Potter v. Taxation Div. Dir., 5 N.J. Tax 399 (1983), concluding that imposing state income taxes in such circumstances would violate the due process clause of the constitutions of both the United States and the state of New Jersey.  

6. See Residuary Trust A u/w/o Fred E. Kassner v. Director, Div. of Taxation, 27 N.J. Tax 68 (2013).  

7. See NY Tax L. 612(b)(40). Note that a distribution from a New York resident exempt trust to a New York resident beneficiary won’t be subject to the accumulation tax if one of the following exemptions apply: the trust’s income has already been subject to New York tax; the income was earned before Jan. 1, 2014; the income was earned during a period when the beneficiary wasn’t a New York resident; or the income was earned before the beneficiary turned 21. Generally, income for these purposes will include interest and dividends but not capital gains.

8. See CT Gen Stat. Section 12-701(a)(4)(C)-(D) (2018).   

9. See Chase Manhattan Bank v. Gavin, 249 Conn. 172, cert. denied, 528 U.S. 965 (1999).

10. Linn v. Dept. of Rev., 2013 IL App (4th) 121055, at para. 25. Pursuant to CT Gen. Stat. Section 12-701(a)(4) (2018), when an inter vivos trust “… has one or more nonresident noncontingent beneficiaries, the Connecticut taxable income of the trust” is determined by multiplying all non-Connecticut source income by “a fraction the numerator of which is the number of resident noncontingent beneficiaries and the denominator of which is the total number of noncontingent beneficiaries” and adding the product to all Connecticut source income. Additional modifications are required under the statute to determine the alternative minimum taxable income of the trust, based on the ratio of noncontingent nonresident beneficiaries to all noncontingent beneficiaries.  

11. Linn, ibid., at para. 28.   

12. For example, California, Connecticut, Georgia, North Carolina and Tennessee. This list is non-exhaustive. State laws are subject to change. Always check specific state statutes for guidance, and don’t rely on this listing. See Oshins Chart, supra note 2.  

13. See North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, 588 U.S. ___ (2019). An in-depth evaluation of the Kaestner case is beyond the scope of this article. 

14. See, e.g., GA Code Section 48-7-22 (2017) and TN Code Section 67-2-110 (2017). The North Carolina statute can be found at NC Gen. Stat. Section 105-160.2 (2018).  

15. See Cal. Rev. & Tax. Code Section 177442.  

16. See, e.g., Delaware, Hawaii, Idaho, Iowa, Massachusetts, Missouri, North Dakota, Ohio and Rhode Island. See Oshins Chart, supra note 2.  

17. E.g., Arizona, Colorado, Indiana, Kansas, Kentucky, Mississippi, Montana, New Mexico, Oregon, South Carolina, Utah and Virginia. See Oshins Chart, supra note 2.   

18. E.g., Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington and Wyoming. See Oshins Chart, supra note 2.   

19. This is a somewhat oversimplified explanation of the planning strategy that must be vetted carefully for each taxpayer. Practitioners are urged to consult the laws of the relevant jurisdictions to confirm the availability of any opportunity for any particular client.  

20. See IRC Section 199A. 

21. See IRC Section 1411.  

22. AK Stat Section 34.77.100 (2019).  

23. TN Code Section 35-17-103 (2014).  

24. SD Codified L. Section 55-17-1 (2019).   

25. This could happen on the defeat of President Trump if the Democrats retain control of the House and achieve a majority in the Senate. In that case, it’s conceivable that Congress will pass a law repealing the Tax Cuts and Jobs Act, which will be signed by the Democratic president and made retroactive to the first of the year.  

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