Farewell New York
According to a report issued by the National Association of Realtors a couple of days ago, last year saw a large outmigration of people from California and New York, while Florida and Texas experienced a comparably large influx.[i] I suppose we shouldn’t be surprised by these findings as they reflect the continuation of what has already been a multiyear trend.[ii]
Consistent with the above-referenced report, over the last few weeks several individuals have approached me about changing their domicile from New York to a tax-friendlier jurisdiction. In addition to the usual discussion that one would have under such circumstances,[iii] a few of these folks asked me how New York would tax the income and gain realized by the trusts they have established, or will establish, for members of their family.
A couple were especially concerned about shares of stock in a closely held business that they had gifted to a trust for the benefit of their issue. These owners were interested in understanding the income tax consequences to the trust from the ultimate sale of the business. Because the trust took this stock with the same, very low, adjusted basis as the owners making the gift, it is likely the trust will incur a significant income tax liability upon the sale of the stock.[iv]
It should come as no surprise that individuals who are seeking to abandon their New York domicile may have already done a fair amount of estate planning or are in the process of doing so. After all, many of them have significant wealth that they would like to pass along to their families while also avoiding federal and state “death taxes”; indeed, their relocation to a new domicile may be motivated in no small part by a desire to escape the reach of New York’s 16 percent estate tax.
Trusts, In General
A wealthy individual (the “settlor”) will often utilize a trust to pass their wealth on to their family. A properly drafted trust will prevent the trust’s property from being included in the settlor’s gross estate for purposes of the estate tax; it will implement the disposition of such property among the beneficiaries of the trust in accordance with the settlor’s wishes[v]; it may also shield the property from the reach of the beneficiaries’ creditors.
Unfortunately, there is an important aspect of the trust of which the settlor is often ignorant, one that is often overlooked by the settlor’s advisers but that may have a significant effect upon the economic success of the settlor’s estate plan; specifically, the federal and state income tax treatment of the trust and of its beneficiaries.
Many wealthy taxpayers believe that they have done all they can to preserve as much of their hard-won wealth as possible by utilizing as much of their federal exemption amount as practicable to make gifts of property to a trust for the benefit of family members without incurring gift tax liability.[vi]
In addition, such taxpayers may have established trusts as vehicles for shifting the appreciation in the value of a property to family members while minimizing the amount of the taxable gift arising from the transfer of the property, thereby preserving their exemption (for use in subsequent transfers) or reducing their gift tax liability; GRATs and sales to “intentionally” defective grantor trusts come to mind.[vii]
It makes perfect sense for a New Yorker who is hoping to leave the state to consider the state income tax consequences of their move on the trusts through which they are implementing their estate plan. The soon-to-be-former New Yorker is well aware of the state’s formidable income tax rates.
However, before considering New York’s income taxation of trusts, it may behoove us to briefly review the applicable federal rules.
As you know, any assets that a settlor may transfer to the trust will be held by the trustee subject to the terms of the trust agreement. This agreement will generally reflect the settlor’s directions or preferences for the disposition of the income from the asset, and of the asset itself, for the benefit of one or more members of the settlor’s family.
In order for a trust to be effective for purposes of the estate and gift tax – i.e., in order to remove a property and the appreciation in value of such property from a settlor’s gross estate – the trust to which the property is transferred must be irrevocable and the property transfer must be complete.
But how will the trust and its beneficiaries be treated for purposes of the income tax?
That will depend upon whether the trust is a non-grantor or grantor trust.
This is no small matter when one considers that a non-grantor trust is itself a taxpayer[viii] and is generally subject to the same graduated federal income tax rates as individuals, except that the rate brackets applicable to a trust are compressed, with the result that a trust will generally pay more federal income tax than an individual would on the same amount of taxable income.[ix]
However, a non-grantor trust may not have to pay federal income tax for a taxable year if it distributes its taxable income for such year (with certain modifications)[x] to its beneficiaries on a current basis. The trust is allowed to claim a deduction in respect of the distribution for purposes of determining its taxable income for the year.[xi] In turn, the distribution “carries out” the trust’s income into the hands of the recipient beneficiaries,[xii] thereby shifting the liability for the distributed income to the beneficiaries.[xiii]
In this way, the non-grantor trust’s income is taxed only once: to the trust to the extent that it does not distribute its income, or to the trust’s beneficiaries to the extent such income is distributed to them by the trust. Income that has already been taxed to the trust in a prior year is not taxed again when it is distributed to the beneficiary.
Of course, to the extent the trust is required to pay income tax with respect to the income and gain recognized by the trust, the value of the trust property that is available for the beneficiaries of the trust is reduced. For example, the gain from the sale a very valuable low basis asset – i.e., one that has greatly appreciated – will be subject to federal tax at the rate of 23.8 percent.[xiv] In other words, more than 20 percent of the trust may disappear into the federal coffers thanks to the income tax.
That being said, there is a special set of rules that causes the taxable income and gains of a trust to be taxed, neither to the trust nor to its beneficiaries, but to the settlor of the trust.
Under the “grantor trust” rules,[xv] the individual settlor who contributes property to the trust will be treated as the owner of the trust property, and of the income and gains arising from such property, if they retain certain rights with respect to the property.[xvi] In that case, the settlor will be required to include the trust’s income and gains on their own individual income tax return, and will pay the tax thereon.[xvii]
By shifting the liability for the income tax away from the trust (and its beneficiaries) to the settlor, the trust may grow without being reduced by tax payments; moreover, the settlor further reduces their gross estate by applying their other assets to satisfy the income tax liability arising from the trust.[xviii]
New York Taxation of Trusts
For the most part, New York follows the federal rules as to the income taxation of trusts subject, however, to some uniquely New York modifications. In applying these rules, the state first divides trusts into resident and non-resident trusts, and then into grantor[xix] and non-grantor trusts.
In general, a trust will be treated as a New York resident trust if it consists of property:[xx]
- that was transferred to a new trust under the will of a decedent who, at the time of their death, was domiciled in New York;
- that the will directs be added to an existing trust that is otherwise a nonresident as to New York (for example, a trust formed by the settlor before moving to New York);
- in that case, the trust may have dual residency – the portion of the trust funded by the New York decedent’s will is treated as a New York resident, and the portion of the trust that existed prior to this testamentary funding is treated as a nonresident.
- that was gifted to the trust by a person who was domiciled in New York at the time of the gift (i) if such trust was then irrevocable or (ii) if the trust was then revocable and remains revocable.[xxi]
- As indicated above, a trust created during an individual’s lifetime can have both a resident portion and a nonresident portion.
- Assume New York parent creates an irrevocable trust for child and makes gifts to the trust.
- Parent moves to Texas, at which time they make another gift to the irrevocable trust; the portion of the trust that was funded while the parent-transferor was domiciled in New York is treated as a New York resident trust, while the portion of the trust funded after the move to Texas is treated as a nonresident trust.
- As indicated above, a trust created during an individual’s lifetime can have both a resident portion and a nonresident portion.
- that was transferred to a revocable trust, and the trust becomes irrevocable while the transferor is domiciled in New York.
- If the individual is no longer domiciled in New York when the trust becomes irrevocable, the trust will be considered a nonresident trust.
Neither the residence of the trustee nor that of any beneficiary will have any affect upon the status of a trust as a New York resident or nonresident taxpayer.
The resident status of a trust (or a portion of a trust) is determined in accordance with the above rules and remains so until the trust terminates.
Unlike the settlor of the trust, the trust cannot move to another state and thereby chance its residence.
Nonresident and NY Source
A trust that is not a resident trust, as defined under the above rules, is treated as a nonresident trust for purposes of the New York income tax.[xxii]
The New York taxable income of a resident trust is its federal taxable income for the tax year (regardless of source), subject to certain modifications. The resident trust is subject to tax on its New York taxable income at the rates applicable to individual taxpayers.[xxiii]
By contrast, a nonresident trust is subject to New York income tax only as to its New York source income.[xxiv] Thus, income and gain attributable to the trust’s ownership of any interest in real or tangible personal property in New York is taxable by the state.[xxv]
The trust’s income also includes its distributive share of partnership income that is sourced in New York, as well as the trust’s pro rata share of S corporation income sourced in the state; these include the income or gain attributable to a trade or business carried on in the state.[xxvi]
As indicated earlier, under certain conditions, the settlor of a trust may be treated as the owner of the trust’s assets for income tax purposes, in which case the income and gain recognized by the trust will be taxable to the settlor rather than to the trust.
If the settlor of the trust is treated as the owner of the trust under the grantor trust rules, then the trust’s status as a resident or nonresident trust for purposes of New York’s tax law is irrelevant. The income and gain of the trust will be taxed to the settlor based upon the settlor’s status vis-à-vis the state.[xxvii]
Of course, if the trust ceases to be treated as a grantor trust – for example, because the settlor has waived or disclaimed whatever rights they had that caused the trust income and gain to be taxable to the settlor – then the trust’s resident or nonresident status, pursuant to the rules described above, will determine its New York income tax liability.
An “Exempt” Resident Trust?
There is, however, an exemption from New York income tax for a resident trust that is not a grantor trust and that meets the following requirements:
- the trustee is not domiciled in New York;[xxviii]
- the trust has no New York assets;
- intangible assets, like stock of a corporation, are deemed sitused at the domicile of the nonresident trustee, outside New York;[xxix]
- if the trust has any tangible assets located in New York (e.g., real estate), the trust will remain subject to New York tax; and
- the trust does not have any New York source income or gain; this includes, for example, flow-through income from a partnership or S corporation; any New York income will cause the trust to be taxable in the state.[xxx]
A New York resident trust that satisfies these conditions will not be subject to New York income tax.[xxxi]
Of course, if the exempt resident trust were to make a current distribution to a New York beneficiary – whether mandatory or discretionary – an amount up to the trust’s taxable income for that tax year would be included in the beneficiary’s federal adjusted gross income for the year and, thereby, in their New York adjusted gross income for that year.[xxxii] Thus, the income would be subject to New York income tax in the hands of the beneficiary.
However, if the trust does not make current distributions to its New York beneficiaries, the trust’s income for the tax year will not be subject to New York income tax either in the hands of the trust or of its beneficiaries, though the trust will, of course, be subject to federal income tax with respect to such undistributed income.
The “Throwback” – Sort Of
This raises the following question: what happens when an exempt resident trust distributes income to its New York beneficiaries that the trust accumulated in earlier tax years, on which the trust paid federal income tax, but no New York income tax?
A New York resident beneficiary of an exempt resident trust must include in their New York adjusted gross income any income that was accumulated by the trust in a tax year beginning on or after January 1, 2014, and that is distributed to such a beneficiary of the trust in a year subsequent to the year in which the trust included the income on its federal tax return (an “accumulation distribution”).[xxxiii]
In order to facilitate the enforcement of this rule, New York requires an exempt resident trust to submit Form IT-205-C, “New York State Resident Trust Nontaxable Certification” every year with its Fiduciary Income Tax Return (on Form IT-205).[xxxiv]
When an exempt resident trust makes an accumulation distribution for a tax year to a beneficiary who is a New York State resident, the trust must report the distribution on Form IT-205-J, “New York State Accumulation Distribution for Exempt Resident Trusts,” which is filed with its Form IT-205 for that year.
According to the Form IT-205-J instructions, an accumulation distribution is the excess of the amounts properly paid, credited, or required to be distributed during the tax year of the distribution (other than income required to be distributed currently), over the trust’s DNI for the year reduced by income required to be distributed currently. To have an accumulation distribution, the distribution must exceed the accounting income of the trust.
In general, a resident beneficiary receiving an accumulation distribution from an exempt resident trust must include the accumulation distribution in their New York adjusted gross income for the year of the distribution.[xxxv]
According to the English poet, William Blake, “hindsight is a wonderful thing, but foresight is better.” I don’t understand the first part of this statement, but I wholeheartedly agree with the second.
Many a former New Yorker who established and funded trusts while domiciled in the state has been surprised and frustrated by New York’s ability to tax the trusts as resident taxpayers even after the settlor moved elsewhere.
If the settlor had better understood the applicable tax laws before departing from the state, they may have planned differently and, thereby, avoided or at least reduced New York’s ability to tax the trust.
That why they need to consult experienced tax advisers before acting. It’s the next best thing to foresight.
[ii] This week, Governor Hochul announced that she wants to increase a payroll tax on businesses in the New York City area while also extending the “temporary” income tax rate increase for corporations for another three years.
[iii] For example, what factors does New York consider when determining an individual’s domicile?
[iv] The owner has to be careful about a sale that follows close on the heels of a gift. First, the sale may fix the fair market value of the gifted shares notwithstanding what the owner’s appraisal concludes. Second, if negotiations for the sale preceded the gift transfer and the principal terms were agreed upon, the owner may be charged with the gain from the sale under assignment of income principles.
[v] There are so many formulations. For example, the trust agreement may authorize the trustee to distribute so much of the income or principal of the trust, at such times and in such amounts, as the trustee, in the exercise of their sole discretion determines; it may direct that all income be distributed at least currently, and authorize the trustee to distribute any part of the principal that the trustee determines necessary for the health, education, maintenance and support of the beneficiary.
In each case, the advisor’s responsibility is to see that the grantor act reasonably in light of the property being transferred, its likely future, the unique traits of each known beneficiary, and the advisor’s own experience.
[vi] An individual may have several reasons for utilizing a trust, rather an outright transfer, to pass along their wealth to their spouse or children. For example, where a child is the issue of the owner from a prior marriage, the owner may want to provide for their current spouse while also ensuring that the child will receive their share of the remainder of the trust upon the death of the second spouse. Or the owner may be interested in setting aside assets to provide for the well-being of the child while preventing the child’s creditors (present or future) from reaching such assets. Then there are those individuals who are control freaks, for whom death is not the end insofar as their ability to control their wealth is concerned.
Regardless, an inter vivos trust should be funded with an asset that is reasonably expected to appreciate significantly in value.
[vii] In general, an owner-grantor will try not to incur a gift tax liability on an inter vivos transfer; rather, they will seek to maximize and leverage the use of all or a portion of their remaining exemption amount.
[viii] This is in contrast to a pass-through business entity, such as a partnership/LLC or an S corporation, the “taxable income” of which flows through and is currently taxed to the partners/members and shareholders, without regard to whether it has been distributed to them. IRC Sec. 702 and Sec. 1366. The partnership and the S corporation are not, themselves, taxable entities (at least in most cases). IRC Sec. 701 and Sec. 1363(a), respectively.
[ix] The same holds true for the federal surtax on net investment income.
[x] Its distributable net income, or DNI. IRC Sec. 643.
[xi] A distribution deduction.
[xii] And preserves its character in the hands of the beneficiaries. See, e.g., IRC Sec. 662(c).
[xiii] The deduction by the trust is under IRC Sec. 651 and Sec. 661; the inclusion by the beneficiaries is under IRC Sec. 652 and Sec. 662.
In recognition of the fact that a trust may not be able to determine its DNI for a tax year before the end of such year, the trust is allowed to claim a distribution deduction for the year for distributions made to its beneficiaries during the first 65 days of the immediately succeeding year. IRC Sec. 663(b).
[xiv] The 20% tax on long-term capital gain plus the 3.8% surtax on net investment income.
[xv] IRC Sec. 671 through Sec. 679.
[xvi] These rights need not be of a kind that would cause the trust property to be included in the grantor’s gross estate. For example, the grantor’s right to reacquire the contributed property from the trust in exchange for property of equivalent value will cause the trust to be treated as a grantor trust without exposing the trust property to inclusion in the grantor’s estate. IRC Sec. 675(4). In addition, the right to borrow from the trust without adequate security will result in grantor trust treatment, without inclusion in the estate (provided there is adequate interest charged). IRC Sec. 675(2). It is this disconnect between the estate and income tax rules that facilitates some very effective estate tax planning strategies.
[xvii] IRC Sec. 671.
[xviii] This assumes the grantor has enough liquidity from other sources with which to pay the income tax liability. The grantor may waive or release their rights under the trust agreement, thereby “converting” the trust to a non-grantor trust.
[xix] If the individual who is treated as the grantor-owner of the trust is a N.Y. resident, the income and gains of the trust will be taxed to them accordingly. NY Tax Law Sec. 601(a). Likewise in the case of a nonresident grantor-owner as to the N.Y. source income of the trust. NY Tax Law 601(e).
[xx] Tax Law Sec. 605.
[xxi] For purposes of these rules, a trust is revocable if it is subject to a power, exercisable immediately or at any future time, to revest title in the person whose property constitutes such trust, and a trust becomes irrevocable when the possibility that such power may be exercised has been terminated.
[xxii] NY Tax Law Sec. 605(b)(4).
[xxiii] NY Tax Law Sec. 618 and Sec. 601(c).
[xxiv] NY Tax Law Sec. 631 and Sec. 633.
[xxv] In general, an interest in real property includes an interest in a partnership/LLC, S corporation, or non-publicly traded C corporation with no more than 100 shareholders, that owns real property located in N.Y, provided the fair market value of such real property represents at least 50-percent of the value of all of the entity’s assets, excluding those assets that the entity has owned for less than two years.
[xxvi] NY Tax Law Sec. 631 and Sec. 632.
[xxvii] Imagine a settlor who abandons their New York domicile and establishes a new domicile elsewhere. Imagine also that the grantor trust holds an installment obligation from the sale of property. The state’s exit tax – which is determined by applying the accrual method to the departing former resident – will cause the settlor (as the deemed owner of the obligation) to recognize the deferred gain for New York tax purposes.
[xxviii] This is often accomplished by appointing a non-N.Y. corporate trustee.
[xxix] NY Tax Law Sec. 605(b)(3)(D)(ii).
[xxx] NY Tax Law Sec. 631(b)(1). See also TSB-M-18(1)I.
[xxxi] NY Tax Law Sec. 605(b)(3)(D)(i).
[xxxii] IRC Sec. 662; NY Tax Law Sc. 612.
[xxxiii] NY Tax Law Sec. 612(b)(40).
[xxxiv] In general, the due date is April 15 of the succeeding year. There is a failure to file penalty.
[xxxv] NY Tax Law Sec. 612(b)(40). There are exceptions: where the accumulation distribution is attributable to a tax year that the trust was subject to N.Y. tax, or a tax year starting before January 1, 2014; where the accumulation distribution is attributable to a tax year prior to when the beneficiary first became a N.Y. resident, or a tax year before the beneficiary was born or reached age 21; or where the income was already included in the beneficiary’s gross income. See also TSB-M-14(6)S.
Interestingly, when one works through the federal “throwback” provisions, which are incorporated by reference into the N.Y. rule, it appears that capital gains that are not distributed during the year in which they are recognized by the trust for federal tax purposes may not be subject to the N.Y. accumulation regime when distributed in a later year. That’s because capital gain is generally not included in DNI. In other words, capital gain attributable to an earlier tax year may escape N.Y. tax when distributed by an exempt resident trust in a later year to the trust’s N.Y. resident beneficiaries. See IRC Sec. 667(a), 666, 662(a)(2), 661(a)(2), and 643(a)(3).