We recently reviewed and extolled the benefits of Inheritance Trusts in three blog posts on this website. Two of the principal benefits of such trusts are to provide creditor and divorce protection for beneficiaries on accumulated trust income and to immunize such accumulated trust income and capital gains from future estate taxation.
Inheritance Trusts can be created for beneficiaries using either wills or revocable trusts. One of the underappreciated benefits of revocable trust estate planning is the potential revocable trusts allow for saving future state income taxes on accumulated Inheritance Trust income. In this post, we discuss moveable trusts and how Inheritance Trusts created under revocable trust planning can reduce or avoid state income taxation on accumulated trust income.
Moveable Trusts
Trusts are moveable in three aspects: They are moveable with regard to the state law that controls the construction and interpretation of trust provisions. They are moveable as to the law governing how the trust is required to be administered. They are also, and separately, moveable with regard to the jurisdictions to which they are required to pay taxes.
Construction and Interpretation of Trust Provisions
In general, a trust settlor (“Trustmaker”) is free to select what state law governs the meaning and effect of the terms of his or her trust. The jurisdiction selected need not have any other connection to the trust, and the Trustmaker is free to select the governing law regardless of where the trust property may be physically located, whether it consists of real or personal property, and whether the trust was created by will or during the Trustmaker’s lifetime. The only limitations to this freedom of choice is that a court of equity will be reluctant to give effect to trust action based on the law of a state that is contrary to the declared public policy of the state in which the court sits.
If a Trustmaker fails to designate the law that is to control his or her trust, the meaning and effect of a trust’s terms are determined by the law of the jurisdiction having the most significant relationship to the matter at issue. In this situation, a court would consider such factors as the place of the trust’s creation, the actual physical location of trust property, and the residence of the Trustmaker, the trustee, or the trust’s beneficiaries.
If a Trustmaker has expressly chosen the state law intended to govern his or her trust, that choice may be changed in the future by the trustee or the trust beneficiaries. Trustmakers realize that information about one state’s laws may not be readily available to future trustees and/or beneficiaries, so most trusts include provisions specifying precisely how such changes in governing law may occur. Even absent such express authorization, Maryland trustees and beneficiaries (and those of many other states) can change the originally designated governing law by court action to modify the otherwise express terms of the trust by a showing that the modification is not inconsistent with a material purpose of the trust.
Where a Trustmaker has failed to designate the law that is to control his or her trust, the circumstances of the trust may also force a change in the governing state law. The location of the trust’s principal place of administration, assets, or the residence of the trustee or the trust’s beneficiaries may change, and thereby change the jurisdiction having the most significant relationship to a given matter at issue. Finally, the Maryland Trust Act specifies a procedure by which a trustee may change the principal place of a trust’s administration with acquiescence of qualified beneficiaries. (Following this procedure is not mandatory if, as is often the case, the Trustmaker has provided an easier alternative for the trustee or a “trust protector” to change the trust’s principal place of administration.)
Trust Administration
Usually, the law of the principal place where the trust is administered will govern administrative matters, and the law of the place of trust creation will govern a trust’s dispositive provisions. Since the cardinal rule of trust administration is to give effect to the intent of the Trustmaker, the Trustmaker can influence the governing law of trust administration and disposition by stating his or her intent in this regard. However, with regard to administration and disposition, a connection (or “nexus”) is required between the jurisdiction of choice and the activities of the trust itself. For example, if a Trustmaker chooses Maryland law to govern administration and disposition, something must occur in Maryland to connect the State to the trust, e.g., ownership of land in Maryland, carrying on a Maryland business, trustee residence or location in Maryland, or the occurrence of actual trust investment and/or accounting activities in Maryland. Here again, this choice of applicable law can be changed either by a change in trust circumstances or, so long as a connection exists with the new jurisdiction, by a formal change of the trust’s designated principal place of administration.
Trust State Income Taxation
With regard to what state can tax the income of a trust, the focus shifts from what the Trustmaker wanted (after all, what Trustmaker actually wishes for state income taxation?!) to whether a state has a sufficient connection to the trust and its income to allow it to tax that trust income. For example, regardless of a trust’s principal place of administration, Maryland (and most other states that have a state income tax) taxes a fiduciary who “is required to file a federal income tax return” and who receives “income . . . derived from a business, occupation, profession, or trade carried on in Maryland”. Absent a direct investment in a Maryland business enterprise or income derived in Maryland from “a business, occupation, profession, or trade”, however, the question becomes: what makes a trust sufficiently connected to the state to allow Maryland to tax its undistributed income?
Maryland answers this question by declaring that it has a sufficient connection to the trustee to tax non-Maryland source trust income if the “fiduciary” is a resident of Maryland. For purposes of Maryland income tax, that means the state can tax the income of “a fiduciary . . . of a trust if:
- the trust was created, or consists of property transferred, by the will of a decedent who was domiciled in the State on the date of the decedent’s death;
- the creator or grantor of the trust is a current resident of the State; or
- the trust is principally administered in the State.”
In the case of an Inheritance Trust, the trust does not occur unless and until the Trustmaker dies, so the creator of grantor of the trust can no longer be a current resident of Maryland. Thus, whether or not the income of the trust can be taxed by Maryland comes down to whether “the trust was created, or consists of property transferred, by the will of a decedent who was domiciled in the State on the date of the decedent’s death” and whether “the trust is principally administered in the State”. The benefit of revocable trust estate planning is that Inheritance Trusts are not created by the will of a Maryland decedent. With regard to the income taxation of non-Maryland source income of an Inheritance Trust created under a revocable trust, the question thus comes down to where the trust is principally administered.
Moving the Inheritance Trust’s Principal Place of Administration
As noted above, a trust’s principal place of administration can be changed either under the terms prescribed by the Trustmaker in the trust instrument or by complying with Maryland’s statutory procedure. Often, such a change need only require notice to the trust’s qualified beneficiaries specifying:
(i) The name of the jurisdiction to which the principal place of administration is to be transferred;
(ii) the address and telephone number at the new location at which the trustee can be contacted;
(iii) An explanation of the reasons for the proposed transfer;
(iv) The date on which the proposed transfer is anticipated to occur; and
(v) the date, not less than 60 days after the giving of the notice, by which the qualified beneficiary must notify the trustee of an objection to the proposed transfer.
If no qualified beneficiary objects to the change, the trustee then merely goes ahead with the change. Where previously authorized by the Trustmaker, even this notice and objection procedure may not be required because the notice procedure specified above is not mandatory if the Trustmaker deems otherwise.
Over the lifetime of a trust, such a change in principal place of administration can have a substantial financial impact, especially if an Inheritance Trust has a trustee who resides in Florida or another state that does not have a state income tax or whose income tax is lower than Maryland’s relatively expensive rates. Even where this may not be the case, it may be possible to add a co-trustee who “resides” in such a state and to whom the administration of the trust may be delegated. In the case of a corporate trustee located in such a state, the immunity from state income tax may offset the cost of paying a commission to the nonresident trustee.
As such, creating an Inheritance Trust under a revocable trust (rather than a will) plus the moveability of the trust can give rise to significant potential savings in future state income taxes on accumulated Inheritance Trust income.
© Richard Wright 2024
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