New York’s 2014 Trust Income Tax Changes

By:
Jonathan J. Rikoon
Published Date:
Sep 1, 2014

The estate tax law changes that New York enacted earlier this year (see this author’s article in the June 2014 issue of the Tax Stringer) were accompanied by new rules intended to close two perceived loopholes in New York’s taxation of trust income. Although the original version of the proposals would have been far-reaching, the final changes that went into effect on Apr. 1, 2014, are somewhat more modest.

Current New York Taxation of Trusts

Before discussing the recent changes, it helps to review how New York currently taxes trusts. First, trusts are categorized in several different ways. Based on the federal rules, trusts can either be grantor trusts (i.e., all of the income and gains are taxed to the grantor, and for most purposes these trusts are ignored) or nongrantor trusts (i.e., separate taxpayers with their own rate schedules).

Nongrantor trusts can be either New York resident trusts or nonresident trusts. A resident trust is one that was created by a person who was a New York resident at the time the trust became irrevocable—that is, upon creation for an irrevocable trust or, for a trust under a will (i.e., a testamentary trust), it would mean the testator was a New York resident at the date of death. With one exception, resident trusts are taxed on their worldwide income, excluding income from real estate, tangibles, or businesses outside of the state, whereas nonresident trusts are only taxed on income from New York real estate, tangibles, or businesses.

Exempt resident trusts. Based on cases interpreting the federal constitution and the limitations on the powers of a state to tax entities or persons without sufficient contacts to that state, New York recognized—first by regulation and now by legislation—an exception to the worldwide taxation of a resident trust. In particular, for any year in which the trust meets the following three conditions, a resident trust will be taxed as if it were a nonresident trust:

  • No trustee of the trust is a New York domiciliary.
  • The trust does not own any New York real estate, tangible personal property (physical objects) located in New York, or a New York business.
  • The trust does not have any income from any of the items described in the second item above. (Caution: sometimes investments in hedge funds or other partnerships will generate a small amount of income attributable to a New York business enterprise, and in that year a resident trust will not satisfy this branch of the safe harbor exception.)

A resident trust satisfying all three elements of the exemption becomes a New York “exempt” resident trust (NYERT). Because it will not have any New York source income that year, it will not be subject to New York tax at all.

Nevertheless, under recent changes, each resident trust must file a New York return even if it is an NYERT. This requirement ties in to some of the changes in New York’s taxation of trust beneficiaries.

New York generally follows the federal classification of nongrantor trusts as either simple (must distribute all accounting income annually) or complex (all other nongrantor trusts). Trust taxation depends upon a concept known as “distributable net income” (DNI). This is a modified version of taxable income that, for example, does not include capital gains for domestic trusts, except in certain circumstances. The beneficiary of a simple trust is required to include in gross income all of the DNI that was actually distributed to the beneficiary or was supposed to have been distributed, whether or not that actually happened.

Beneficiaries of complex trusts include in their gross income only the portion of DNI distributed to them. In either case, the trust can deduct from adjusted gross income the DNI distributed to the beneficiary. In effect, the income tax on the DNI is shifted from the trust to the beneficiary.

New Throwback Tax

The effect of these rules, as they stood until this year, could lead to permanent New York tax savings. For example, a NYERT pays no New York tax. While any current distributions from a NYERT to beneficiaries who are New York residents are subject to New York tax at the beneficiary level, if the trust makes no distributions in the year when the income is earned, the income accumulates inside the trust, free of New York tax. If the trust distributes the accumulated income to a New York beneficiary in a subsequent year, there would still be no New York tax imposed on the accumulated income (because the only tax impact on a beneficiary, under the old rules, applies to current-year DNI, not prior-year undistributed income).

But New York decided to stop this perceived abuse and close the “loophole” by adopting a “throwback” tax on “accumulation distributions”—an approach that applies, to a limited extent, under federal law (to foreign trusts distributing accumulated income to a U.S. beneficiary) and the law of certain other states, such as California. Under the new New York throwback tax, when accumulated income is distributed in a future year, the beneficiary will be taxed as if the income had been subject to the New York tax in the year it was earned.

The changes enacted are narrower than those originally proposed. The new throwback tax only applies if several conditions are met:

  • The trust is a NYERT in a particular year (based on the statutory safe harbor outlined above).
  • The trust accumulates income during that year.
  • The trust then distributes the accumulated income in a future year to a New York resident who was also a New York resident when the trust accumulated the income.

The new rule does not apply to income accumulated prior to Jan. 1, 2014, and it is limited to exempt resident trusts (the original version would have applied to all trusts not subject to New York resident taxation, including all nonresident trusts in the world).

Two Quirks: Capital Gains and Minors

Some anomalies result from New York’s decision to define the new tax by reference to the federal tax. The federal accumulations throwback tax originally applied to all trusts, both domestic and foreign, but included an exception for domestic trusts that distribute accumulated income to a beneficiary younger than 21 at the time the income was accumulated. Beneficiaries of domestic trusts also benefitted from the rule that capital gains were not automatically included in the DNI of domestic trusts, as they are for foreign trusts. Thus, under the original federal throwback tax, the undistributed net income (UNI)—essentially the amount of DNI not distributed in the year earned—would be smaller for a domestic trust than an otherwise identical foreign trust. The federal throwback tax applies to UNI distributed in a subsequent year to a U.S. taxpayer.

The 1997 change that reduced the scope of the original federal accumulation throwback tax so that it no longer applied to domestic trusts was accomplished by adding one subsection, under which the throwback tax does not apply to domestic trusts, to the federal Internal Revenue Code (IRC). The now-irrelevant exceptions for capital gains and under-age-21 accumulations in domestic trusts were never removed from the IRC. New York has incorporated essentially all of the federal rules, except for the 1997 exemption of domestic trusts; thus, it has included the two old special rules for domestic trusts.

As a result, the New York throwback tax applies to both foreign and domestic New York resident exempt trusts, and the two favorable former federal provisions applicable to domestic trusts described above (no capital gains included in DNI or UNI, and no throwback tax on accumulations prior to age 21) have now been adopted into the New York tax for any NYERT that is not a foreign trust. While the legislative history is not particularly clear on this point, a close reading of the interplay between the federal and state tax laws does yield this result.

The federal classification of a trust as foreign or domestic has not generally made much difference for New York purposes; however, the classification now matters for NYERTs because a foreign NYERT will apparently suffer the same accumulation throwback tax consequences in New York as under the federal rules: capital gains are included in UNI, and there is no exception for accumulations under age 21. (It is possible for a trust to be both a foreign trust for federal purposes and a resident trust for New York purposes—for example, if the trust was created by a New York resident but is governed by the law of a foreign country or has only foreign trustees.)

If that view of the new legislation is correct, the accumulation throwback tax in New York has quite a narrow focus in most cases and applies only to 1) ordinary income that is accumulated starting in 2014, 2) by a New York resident exempt trust (in the year of accumulation), 3) that is then distributed in a subsequent year to a beneficiary, 4) who was a New York resident in the year of accumulation, 5) who was also at least 21 years old in the year of accumulation, and 6) who is (still or again) a New York resident in the subsequent year of distribution. As noted, items 1 and 5 of this list would not apply to a foreign NYERT.

Nevertheless, all NYERTs with any potential beneficiary who is a New York current resident at least 21 years old will now need to keep track of all undistributed income in case the tax is applicable to a distribution in a future year.

Trust Filing Requirements

The 2014 legislation codified the former regulatory requirement for all NYERTs to file an information return. There is also a new, different filing required for a NYERT that makes an accumulation distribution subject to the throwback tax, which has specific disclosure requirements regarding the distribution.

ING Trusts

Some New York taxpayers had adopted a strategy of creating “incomplete gift nongrantor trusts” (ING) in other states in an attempt to avoid New York income tax on the income and gain from assets transferred to the trust without incurring a current gift tax. The basic idea was to identify a state with no income tax and create a trust in that state, with no contacts with New York that would remove the trust from the “exempt” New York resident trust safe harbor. Because the grantor was a New York person, if the trust were a grantor trust, there would be New York tax on its income. In order for this strategy to work, the grantor would not retain any of the interests or powers that would make the trust a grantor trust under the IRC and simultaneously avoid any gift tax on transfer of assets to the trust. Remember that most of the retained connections sufficient to avoid gift tax would result in grantor trust status, so achieving the competing goals is far from simple. As a result, there are a number of private letter rulings from the IRS identifying exactly what types of trusts are not taxable gifts but also not grantor trusts.

One way that New York could have attacked the use of INGs (advocated by some commentators, including this author) would have been to declare that INGs do not qualify for the safe-harbor exemption from treatment as resident trusts. INGs would then be taxed as independent entities—nongrantor trusts—for both federal and New York purposes. Instead, New York decided to treat INGs as grantor trusts, so that they are ignored for state and city income tax purposes, and their income and gains are taxed to the grantor on the grantor’s income tax return. This will result in a disparity between state and federal taxation of the same trust’s income, though it does provide a serious disincentive to the use of INGs in New York.


Jonathan J. RikoonJonathan J. Rikoon is a partner at Loeb & Loeb LLP practicing in the areas of trust and estate planning, administration and litigation. He engages in sophisticated estate and tax planning for wealthy individuals and families, preparation of wills and trusts, and the administration of trusts and estates. He helps to establish various tax-efficient multitier family, business, and investment vehicles, such as partnerships, limited liability companies, and closely held corporations with trust ownership, and he structures third-party business transactions to facilitate tax and estate planning. Mr. Rikoon has also pioneered the development of estate planning techniques customized for private equity fund principals and hedge fund managers. He was instrumental in the N.Y. State and City bar comments on the legislation discussed in this article. He can be reached at 212.407.4844 or jrikoon@loeb.com.

 
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