TBA Law Blog


Posted by: Dan Holbrook on Jul 22, 2019

Journal Issue Date: Aug 2019

Journal Name: Vol 55 No 8

In the last two decades, Tennessee trust laws have changed dramatically.1 Some changes were intended to give Tennessee residents greater flexibility, while others were designed to attract money from out-of-state grantors.2 As a result, Tennessee is often ranked among the top states for trust laws.3

Three recent developments enhance Tennessee’s reputation, both for Tennessee residents and for nonresidents considering creating a trust situs in Tennessee.

Kaestner and State Income Tax

In a unanimous opinion issued on June 21, 2019, the U.S. Supreme Court in Kaestner4 held that the State of North Carolina violated the Due Process Clause of the Fourteenth Amendment by taxing the accumulated income in a trust where the only connection to North Carolina was the primary beneficiary’s residence in that state.

The Kaestner trust was created by a New York resident, under New York law, with a New York trustee, with trust records in New York. The successor trustee was a Connecticut resident, and the custodian of assets was in Massachusetts. The only connection to North Carolina was that the primary beneficiary had moved there after the trust was executed. The trustee had total discretion over the timing and amount of any distributions and had made no distributions to the beneficiary in the years in question, accumulating all the income in the trust. The North Carolina Department of Revenue assessed tax of over $1.3 million on such income. The trustee paid the tax under protest and filed in state court for a refund. The trial court, court of appeals, and state supreme court all found that the taxation violated the Due Process Clause.

The Supreme Court affirmed, holding that there must be “some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax.”5 The court recognized that each component of a trust relationship needed to be evaluated separately. “In sum, when assessing a state tax remised on the in-state residency of a constituent of a trust — whether beneficiary, settlor, or trustee — the Due Process Clause demands attention to the particular relationship between the resident and the trust assets that the State seeks to tax. Because each individual fulfills different functions in the creation and continuation of the trust, the specific features of that relationship sufficient to sustain a tax may vary depending on whether the resident is a settlor, beneficiary, or trustee.”6 Ultimately, it held that the residence of the beneficiary alone did not supply the minimum connection to the state to sustain the tax, since the beneficiary lacked “control, possession, or enjoyment of the trust assets,” with no right to demand any distributions or to direct any investments.

There are at least two important applications of Kaestner to Tennessee trusts.

First, the Tennessee Hall Income Tax, which like North Carolina looks solely to the residence of the beneficiary as the basis for taxation of trust income,7 may no longer tax undistributed trust income where the only Tennessee connection is the residence of the beneficiary. Trusts that have previously paid the Hall tax solely on this basis, without other minimum contacts with Tennessee, may file for refunds if within the statute of limitations.

Second, and far more importantly, only a few states do not tax trusts,8 which makes those states attractive as trust residences when there are sufficient contacts with one of those states. The Tennessee Hall Income Tax will be fully repealed effective Jan. 1, 2021. By soon becoming one of only nine states (and the only state in the southeast besides Florida) not to tax trusts, Tennessee may even more likely become a haven for trusts created by out-of-state grantors.

Special Purpose Entities  (SPEs) as Trust Protectors

In 2013, the Tennessee Uniform Trust Code (TUTC) was amended to add language about the use of Trust Protectors and Trust Advisors (hereinafter “Protectors”)10 in Tennessee trusts,11 explicitly making such Protectors fiduciaries.12 Only an individual or a corporate fiduciary could serve as a Protector.

But who would ever want to serve? Although Protectors have the same right to reasonable fees as trustees,13 the body of law on Protectors’ fiduciary duties is far less settled, potentially creating greater exposure to liability. Individuals could rarely if ever obtain individual liability insurance, other than attorneys or accountants.

Effective May 10, 2019, a Protector may be an LLC, to be known as a “Special Purpose Entity” (SPE), if it meets certain requirements.14 The trustee of the trust must be a Tennessee corporate trustee, but the LLC may consist of one or more individuals. Such an LLC may be only thinly capitalized, or perhaps have no capital at all, thus effectively reducing the risk of liability for breach of fiduciary duty. It may also provide continuity in the event of an individual Protector’s death or disability. The cost is an initial fee of $1,000 to the Department of Financial Institutions plus an annual renewal fee of $1,000. In the context of the Kaestner decision discussed above, where it may be desirable for state income tax purposes to maintain exclusively Tennessee connections to the extent possible, a Tennessee SPE would give Tennessee resident status to nonresident Protectors.

Nonjudicial Modification of an Irrevocable Trust: Goodbye, Claflin?

Prior to adoption of the Tennessee Uniform Trust Code (TUTC) in 2004, an irrevocable trust could not be modified or terminated without a court order. A limit on any such action was the Claflin15 doctrine, that a court may not modify or terminate an irrevocable trust, even if all beneficiaries consent, unless the modification or termination would not be contrary to a material purpose of the trust.
A useful tool under the TUTC as initially enacted was greater flexibility to modify existing irrevocable trusts. If the grantor were still alive, no court order was required as long as the grantor did not object after receiving notice, since the grantor could decide for himself whether there was any material purpose. If the grantor were deceased, however, a modification still required a court order and the application of the Claflin doctrine.

Effective May 10, 2019, if the grantor is deceased, a trust in Tennessee may be modified without court order by the unanimous agreement of the trustee and all qualified beneficiaries, “if such modification does not violate a material purpose of the trust.”16 In other words, the trustee and beneficiaries may now determine for themselves, by unanimous vote, whether there remains any material purpose that would be violated by the modification. This risks putting the fox in charge of the hen house.

A draftsman for a concerned grantor might try to alleviate this concern by including a clause prohibiting any modification without a court order and satisfaction of the Claflin doctrine. However, after the grantor’s death, the trustee theoretically could unilaterally “decant”17 the trust to another trust that does not contain such a prohibition, without any participation by the beneficiaries, providing cover for an end run around the grantor’s explicit desire. Or following the trend in increased flexibility and power by trust beneficiaries, there may be further amendments to Tennessee trust law that increase the ability to modify, despite a grantor’s express wishes to the contrary. Ultimately, grantors’ dead hands may be losing their grip.



DAN W. HOLBROOK practices estate law with Egerton, McAfee, Armistead & Davis PC, in Knoxville. He is a fellow and regent of the American College of Trust and Estate Counsel, and is certified as an estate planning law specialist by the Estate Law Specialist Board Inc. He can be reached at dholbrook@emlaw.com.

NOTES

1. Examples of Tennessee trust law changes include adoption of the Uniform Trust Code (2004); decanting power (2004); extension of the rule against perpetuities period to 360 years (2007); Tennessee Investment Services Trusts (i.e., domestic asset-protection trusts) (2007); community-property trusts (2010); directed trusts (2013); trust protectors and trust advisors (2013); and tenancy-by-the-entirety trusts (2014).
2. It is fascinating that many of the changes to Tennessee trust law have either originated or been endorsed by the Tennessee Bankers Association, which promotes its role in doing so. In some states, bankers’ associations have actively fought these kinds of changes, concerned that such laws increase creditor protection and are therefore against their own interests. In other states, such as Tennessee, the bankers have promoted these changes to attract out-of-state capital to their trust departments, a tradeoff against potential loan losses in other departments of the bank.
3. For example, see the oft-cited state rankings by Steven J. Oshins, Esq., of Las Vegas, Nevada, at www.oshins.com, where Tennessee currently ranks third for dynasty trusts, third for decanting, and tied for fifth for domestic asset protection trusts.
4. N.C. Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Tr., No. 18-457 (U.S. June 21, 2019).
5. Id., slip op. at 5.
6. Id., slip op. at 10. The court affirmed, consistent with prior precedents, the right of a state to tax trust income based on (1) an actual distribution to an in-state resident, (2) the in-state residence of a trustee, or (3) the situs of trust administration. After Kaestner, it is questionable whether a state may tax income based solely on either (1) the mere residence of the grantor of the trust or (2) a statement in the trust instrument that the law of a certain state governs.
7. Tenn. Code Ann. § 67-2-110(a).
8. The seven states with no income tax are Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. New Hampshire’s income tax does not tax trusts. Tennessee will join those other eight states on Jan. 1, 2021, when the Hall Income Tax is fully repealed after a phase-out period. Tenn. Code Ann. § 67-2-102 (2017).
9. An example illustrates the significance. The highest state income tax rate in the country is 13.3%, in California. California law explicitly looks, inter alia, to the trustee’s residence to establish a minimum contact for income tax purposes. Cal. Rev. & Tax Code § 17742. Capital gains from sales of stocks and other intangible assets are included in the state definition of income. Cal. Rev. & Tax Code § 25125(c). Assume that a trust has no California contacts other than a California resident trustee, that there are no substantial contacts with other states, that the trust incurs a $1 million capital gain and does not distribute it to the beneficiaries, and that the trust is in a maximum tax bracket. The California income tax on the gain would be $133,000, in addition to any federal income tax. If the trustee had been a Tennessee resident, the state income tax would be zero, partly because Tennessee does not currently tax capital gains (only dividends and interest) and partly because after 2020, the Tennessee income tax will be fully repealed. However, beware that various contacts with other states on account of real property or asset management could make accumulated trust income taxable in more than one state, so careful review of all facts and circumstances is necessary. A chart summarizing each state’s law governing taxability in each of the 50 states and D.C. can be found at www.oshins.com.
10. Tenn. Code Ann. § 35-15-1201, et seq. The concept of Trust Protectors and Trust Advisors (two names for the same office) originated in the 1980s when grantors created offshore trusts and needed some independent person to have certain powers superior to the trustee, without actually being a trustee. The concept was then seen as useful for a much broader range of purposes in domestic trusts, such as replacing trustees easily, or voting interests in a family business. Tenn. Code Ann. § 35-15-1201(a) contains a lengthy non-exclusive list of potential powers of a Protector, many of which powers are amazingly broad. Few state Protector statutes contain such a list.
11. This amendment was made in conjunction with a series of amendments to the TUTC creating the concept of “directed trusts” (Tenn. Code Ann. § 35-15-710, et seq.), where fiduciary duties could be divided among parties, and a party not participating in a particular activity became an “excluded fiduciary” (Tenn. Code Ann. § 35-15-103(12)) as to that activity.
12. Tenn. Code Ann. § 35-15-1202.
13. Tenn. Code Ann. §35-15-708.
14. Tenn. Code Ann. § 35-15-1301, et seq. Tennessee is only the second state to adopt an SPE statute, the first being South Dakota in 2011 (SD Codified Laws § 51A-6A-66). Per Christopher M. Reimer, “The Undiscovered Country: Wyoming’s Emergence as a Leading Trust Situs Jurisdiction,” 11 Wyo. Law Review 165 (2011), at least four other states permit unregulated SPE’s, namely Alaska, Delaware, Nevada and Wyoming.
15. Claflin v. Claflin, 20 N.E. 454 (Mass. 1889). The holding of this Massachusetts Supreme Court case was adopted almost universally among states and included in the Uniform Trust Code.
16. Tenn. Code Ann. § 35-15-411(c).
17. Tenn. Code Ann.§ 35-15-816(b)(27).