A trust canโt help someone avoid paying federal income tax. However, shifting assets into a trust in a tax free state is a way that many people minimize their state income taxes. Trusts in tax free states are often used by people that live in states with high state income taxes and have: (a) a large asset income portfolio; and/or, (b) an asset they expect will have a significant appreciation event.
Many people hear about using trusts in tax free states to minimize their tax burden and immediately have two questions: (1) wonโt I just have to pay state income tax when I get the money out of the trust; and, (2) how is it legal to avoid state income taxes by moving my assets into a trust in a state with no income tax when I am still living in a high income tax state?
In this post we are addressing the second of these questions. (See this post for question one.)
More Questions on Trusts and State Income Tax
This is perfectly legal when done properly, and it has been affirmed by the US Supreme Court as recently as 2019 in a case referred to as Kaestner.
In the Kaestner case, the North Carolina Department of Revenue tried to tax the income of a trust situated in another state because the beneficiary lived in North Carolina. The Supreme Court held that in-state residency of a trust beneficiary did NOT supply North Carolina with the minimum connection necessary to tax trust income, and that doing so would be a constitutional violation of the Due Process Clause. In other words, the Due Process Clause of the Fourteenth Amendment to the Constitution prohibits a state from taxing an out-of-state trustโs income simply because a beneficiary of the trust lives within the state.
Notably, the Supreme Courtโs opinion in the Kaestner case was unanimous, which is quite rare these days.
If you are interested in learning more about Kaestner, here are some links:
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