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.

State’s Want More Info

Trust
income tax reporting to the state of NY has been broadened. TSB-M 10(5)I issued
July 23, 2010. The purpose of this pronouncement is undoubtedly to improve tax
compliance and identify trusts that are taking the position that they are not
subject to NY income tax when in fact they may be.  Effective 1/1/10 if the trustee believes that
the trust is not subject to NY income tax under 605(b)3)(D) it must file Form
IT-205-C, “NY State Resident Trust Nontaxable Certification.”