The Tax Cuts and Jobs Act, enacted at the end of 2017, ushered in a wave of planning around limiting state income taxes on assets transferred into trusts by capping the deduction of state income taxes paid for federal income tax purposes to $10,000 per single taxpayer or married couple.
But getting around that cap through the use of trusts can be difficult in certain states. For example, N.Y. Tax Law Sec. 605(b)(3) says that New York determines residence of a trust based on where the settlor of the trust resided at the time that the trust was originally settled. 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. To address the inherent constitutional conflict that might arise from taxing the income of a trust with no nexus to the state, New York codified a three-prong test to allow fiduciaries to claim an exemption from state income tax, where: (1) all trustees are domiciled outside of New York; (2) all trust property is located outside of New York, and (3) there’s no New York source income (NY Tax Law Sec. 605(b)(3)(D), codifying the holding in Mercantile-Safe Deposit & Trust Co. v. Murphy, 15 NY2d 579 (1964)).
A popular technique recommended for N.Y. state residents involves creating so-called “resident exempt trusts” by funding a nongrantor trust with income-producing assets that aren’t located within the state of New York. Such trusts would purposely name a nonresident to serve as trustee to avoid N.Y. state income tax for any income earned by the trust. More aggressive strategists might fund resident exempt trusts with ownership interests in a closely held business so that when such interests were later sold, the sales proceeds might be realized without N.Y. income tax.
N.Y. Opinion Letter
A February 2020 advisory opinion (TSB-A-20(2)I) issued by the New York State Department of Taxation and Finance should serve as a cautionary tale for planners seeking to employ this strategy for the benefit of their clients. Per the facts laid out in the advisory opinion, the taxpayer trust held two primary intangible investments: New York exempt bond funds and a publicly traded partnership. In the end, only about 1% of the trust’s total taxable income was sourced to New York state. Nonetheless, despite the taxpayer’s constitutional argument that “imposition of tax on the Trust would violate due process” because the N.Y.-source income was de minimis in comparison with the rest of the taxable income, the state concluded that “all the income, regardless of source, earned by the [ ] Trust is subject to New York income tax as a resident trust.” While it’s not clear what the magnitude of this advisory opinion had on the overall plan for the trust taxpayer, it’s patently obvious that the trust hadn’t planned on subjecting 100% of the trust’s income to N.Y. taxes.
Importance of Collaboration
This conclusion underscores the importance of collaboration among advisors to ensure that income tax strategies aren’t inadvertently disrupted.
On receipt of the N.Y. advisory opinion finding that just 1% of N.Y.-source income made the entire trust taxable in New York, the trustee may have turned to the trust’s investment advisor to understand how the trust came to invest in an asset that generated N.Y. source income. The hapless advisor may have pointed to investor reports and charts that proved out the soundness of the investment; all of which, of course, would be beside the point. The trustee may have expressed annoyance with the accountant for having flagged the issue (or not) as part of the preparation of the return. Perhaps the trustee turned its ire on the attorney for having drafted a N.Y. resident trust in the first place; as though any attorney has any control over where a trust’s settlor might live at the time when the trust was funded.
In the end, any frustration aimed at any one of the trust’s advisors was likely misplaced. Rather, the answer lies in encouraging collaboration among the trust’s advisors to foster a better outcome.
In the simplest sense, the advisors should start by sketching out the outline of their mutual client’s planning objectives. Advisors should talk together about the purposes of the planning and identify any key issues that might disrupt the plan. They should brainstorm and openly vet the various strategies that might achieve the goals set out by the client, taking advantage of the different perspectives of each advisor from each different discipline. The planning outline drafted by counsel should incorporate the investment advisor’s thoughts and insight from the tax preparer about income tax opportunities and pitfalls. This collaboration will not only ensure that all advisors are on the same page, but it also will bring together different professional perspectives invariably leading to robust and comprehensive wealth transfer plans.
For the trust still reeling from the advisory opinion issued against it, collaboration would very likely have meant that the investment advisor avoided investing the trust in assets that might generate N.Y. source income. Perhaps attorneys could have drafted the trust agreement so that the trust could be bifurcated into N.Y. resident and N.Y. resident exempt trust shares. Then, the accountant could apportion the trust income between each share so that the N.Y.-source income would hopefully avoid tainting the entire trust. By working together, professionals can ensure that our wealth transfer plans are well-crafted, thorough and not easily disrupted.