Trusts: Situs, Star Wars, and State Taxation

Summary: All you Wookies hear about is estate tax repeal. Be on guard, a Jedi Light Tax Saber can nick your money when and where you least expect it. So you followed the advice of the legendary Jedi Tax Master Obi-Wan Kenobi: "Let go, Luke. Luke, trust me," and you set up a trust. Ahh, but it will take the likes of Jedi Master to sort out the myriad of state tax issues affecting your trusts.

Change Situs of Real Estate

State “B” may assess a state estate tax on real estate (and tangible personal property) located in its jurisdiction. If you live in (domiciled) State “A” your real estate in State “B” may thus be taxed. However, it may be possible to avoid State “B” estate tax on your real estate there by transferring title to the real or tangible personal property located in State “B” into a trust. If you (grantor) and perhaps the trustee live in State “A” this might convert the asset in State “B” from real estate into an intangible interest that State “A” won’t tax for a non-domiciliary. This bit of tax alchemy can save a bundle of galactic credits. But Hans, if you thought Jabba the Hutt was a tough creditor – some states will disregard a living trust (some might disregard a single member LLC) as not sufficing to transform real estate into a non-taxable intangible interest.

An LLC May Change Situs of Trust Real Estate

State tax laws differ considerably on these issues, but since NY tends to lead the way in state tax sophistication (and baseball teams), let’s look at a recent Empire State pronouncement.  The decedent was not resident in NY. Decedent had interest in a revocable living trust which owned interests in several limited liability companies (LLCs) that owned NY real estate. NY held that he was is not subject to NY estate tax. The issue was whether the nonresident decedent's interest in a revocable trust should be characterized as intangible. The conclusion depends on the nature of the property in the revocable trust. Here the nonresident decedent's revocable trust owned interests in LLCs that own NY realty. The LLCs in question were multiple member LLCs that have chosen to be treated as partnerships under the federal income tax check-the-box regulations. Note the implication is that a single member LLC may not have the same positive NY tax result. Assuming that IRC § 2036 or related economic substance doctrines do not apply, an LLC taxed as a partnership is considered to be separate from its owner. Therefore, the estate's interest in the revocable trust constituted an intangible asset and was not included in the estate's NY gross estate. NY Advisory Opinion TSB-A-10(1)M, 04/08/2010.

Investment Advisers and State Law

Under some state laws the trustee can transfer (direct) full responsibility and liability of trust investment decisions to an investment adviser. If the state law does not include such a provision, then the trustee may merely retain (delegate) an investment adviser, but will be left with some level of residual liability. OK Chewbacca this gets a bit hairy. ◙ The laws in various states differ considerably as to the impact on a trustee for following the direction of a designated person. ◙ The distinctions could be critical if a major goal of the grantor is to have a family business, or other concentrated position, retained.  ◙ In states with the most liberal directed trust statues the trustee following the direction will have no liability unless the trustee commits willful misconduct. ◙ In many other jurisdictions the protection afforded a trustee following investment direction is less secure. ◙ Some states follow the Uniform Trust Code (UTC). Article 808(b) of the UTC provides: “Powers to direct are most effective when the trustee is not deterred from exercising the power by fear of possible liability. On the other hand, the trustee does have overall responsibility for seeing that the terms of the trust are honored….A trustee must generally act in accordance with the direction. A trustee may refuse the direction only if the attempted exercise would be manifestly contrary to the terms of the trust or the trustee knows the attempted exercise would constitute a serious breach of a fiduciary duty owed by the holder of the power to the beneficiaries of the trust. The provisions of this section may be altered in the terms of the trust….” While a trustee can find some comfort in following direction to retain an investment under a trust with a situs in a jurisdiction adhering to the UTC that comfort must be guarded. The trustee must still demonstrate that adhering to the direction would not be “manifestly contrary to the terms of the trust,” or a “serious breech of the duty owed.” While this is clearly less oversight than a trustee must exercise without a direction statute, it is not a guarantee escape from the Death Star. ◙ In a situation where one beneficiary is active in the business the trust owns, and other beneficiaries are not, the risks associated with the interpretation and application of these standards could be significant. Some states, such as Delaware, have created far more secure standards.

Investment Adviser Can Be Tax’n

Caution should be exercised in retaining an investment adviser since the impact can extend beyond mere legal liability issues. For example, if a trust protector for a Delaware directed trust designates a NY person as investment adviser, NY may seek to tax the income of the trust even though, but for that investment adviser, the trust would not have any tax nexus to NY. TSB-A-04(7) I, 2004 N.Y. Tax Lexis 259 (Nov. 12, 2004). It is not clear how many states may view investment advisers and other quasi-fiduciaries.

NY View of Intangibles and Trustees Real estate was discussed above. Now consider intangible assets and the NY tax paradigm. The situs of intangible assets is deemed to be the domicile of the trustee. See TSB-A-94(7) I, 4/8/94. In this Advisory Opinion the assets involved were cash, money market accounts, marketable securities, etc. most held by a NY trust company. None were connected with or derived from a business carried on in NY. The Opinion held that the situs of intangible assets of a trust is deemed to be at the domicile of the trustee.

Trustee Domicile

And how can a CPA confirm where the Trustee hangs his hat? NY, similar to many states, is becoming increasingly aggressive in arguing that NY'ers remain domiciled in NY even if they are absent.  NYS Taxation of Nonresidents, Pub. 88, says: “In general, your domicile is the place you intend to have as your permanent home. Your domicile is, in effect, where your permanent home is located. It is the place you intend to return to after being away (as on vacation abroad, business assignments, educational leave, or military assignment). You can have only one domicile. Your NY domicile does not change until you can demonstrate that you have abandoned your NY domicile and established a new domicile outside NY State…A change of domicile must be clear and convincing. Easily controlled factors such as where you vote, where your driver’s license and registration are issued, or where your will is located are not primary factors establishing domicile… A change of domicile is clear and convincing only when your primary ties are clearly greater in the new location.” How will this new aggressiveness impact trust taxation? Is it ever safe to use an individual trustee that may be subject to the uncertainty of where they’re domiciled? Why not always use an institutional trustee that’s based in a tax favored state? Should lawyers draft provisions that if a trustee moves into a bad tax state they’ll be removed automatically as trustee the prior to the move?

If the assets are intangible and the trustee is domiciled outside NY you’re still not NY tax free yet. There’s a 3^rd test: “All income and gains of the trust are derived from or connected with sources outside of the NY state...” While this has been liberally interpreted landmines do exist. For example, in a series of Advisory Opinions NY has consistently held that managing bank accounts and trading securities for ones own account “does not constitute the carrying on of a business, trade, profession or occupation in NY State…” In this particular ruling the taxpayer lived in NY City. She formed and funded an LLC, then transferred 99% of the LLC to a trust, retaining 1%. The trustee of the trust owned 99% of the LLC but was not a NY resident. The taxpayer remained the managing member of the LLC, conducted all LLC business, and the LLC had a NY post office box as its address, etc. The trust LLC income was deemed not connected and NY tax was avoided. TSB-A-00(2)I, 3/29/00.

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