Supreme Court Decision May Boost TN Trust Business

A new U.S. Supreme Court ruling in the Kaestner case means that more out-of-state residents will be able to fully realize the benefits of Tennessee’s progressive trust laws and zero income tax on non-residents. On June 21, 2019, the Court unanimously ruled that states may not apply state income tax to trusts where the trust’s only connection to the state is the residence of a discretionary beneficiary who has no control over trust assets or right to demand trust income. The Court held that the residence of a discretionary beneficiary does not satisfy the “minimum connection” necessary for a state to impose tax under the Due Process Clause.

Previously, many states relied on the residence of a trust beneficiary as one of the criteria for taxing a trust (i.e., taxing the out-of-state trust itself as an “entity” on its accumulated income, rather than only taxing distributions to a resident beneficiary). In essence, the new ruling makes that criteria alone unconstitutional. It is important to note that each state has different laws and criteria regarding taxation of out-of-state trusts, and some of those criteria may remain valid, so families considering moving or establishing trusts in Tennessee must seek sound tax advice regarding the application of their home state’s tax laws to Tennessee trusts. This ruling also does not prevent a state from taxing a trust based on income that comes from sources within that state.

While the decision is limited in scope, the import of the decision is that some residents of other states who have or are considering establishing trusts to be located and administered in Tennessee will be able to avoid state income tax on income accumulated in the trust. The case applies by its terms only to the facts of Kaestner, which involved a trust with its only connection to the taxing state being the in-state residency of discretionary beneficiaries, who had no right to control or demand trust property. The Court described three trust tax regimes that do pass the Due Process Clause: taxation of actual trust distributions to a resident, taxation based on the residence of a trustee, and taxation based on place of trust administration. The Court left open the question of what degree of beneficiary influence or control over a trust will trigger taxation, as well as the question of what additional contacts may satisfy the Due Process Clause, such as the residence of a trust creator.[1]

New Opportunities with Tennessee Special Purpose Entities

As a complement to the Kaestner ruling, a brand new Tennessee law makes it easier for families to locate trusts in Tennessee while maintaining a level of control over the trust in a way that may not cause their home state to tax the trust. The Tennessee law allows families to establish Tennessee “special purpose entities” (“SPEs”) to serve in a fiduciary capacity as trust “advisors” or “protectors” as part of a directed trust structure. In essence, a non-resident family could establish one or more SPEs to serve as trust “distribution advisor” or “investment advisor” (thereby controlling trust distributions or investment decisions), in conjunction with a Tennessee corporate fiduciary serving as “directed trustee.” Non-resident family members could serve in various roles with decision-making input for the SPE, but as long as the SPE is structured and administered in a manner where the SPE itself is respected as a Tennessee resident, then the SPE may help avoid state income tax in states that tax trusts based on the residence of fiduciaries or place of trust administration.

The favorable Supreme Court ruling and the new Tennessee SPE law further enhance all of the existing tax benefits, flexibility, and progressive trust planning opportunities that are available to families choosing Tennessee as their trust jurisdiction.