Several states have either passed or introduced bills to tax wealthy taxpayers.1 These taxing strategies involve increasing income tax rates, wealth taxes, estate/inheritance taxes and/or insurance premium taxes. Only 12 states2 and Washington, D.C. have estate taxes, and only six states3 have inheritance taxes, with many states trying to mirror the federal estate tax exemption of $12.92 million per individual. Consequently, state estate and inheritance taxes haven’t been the most popular way to tax the wealthy either at the federal or the state level. On the other hand, proposing wealth taxes and increased income tax rates on the wealthy have been extremely popular both at the federal and the state levels. The states have followed the federal government’s lead in many cases.
The uncertain current and future status of state income, wealth, premium and estate taxes plays a key role in a client’s tax, financial and estate planning. Here’s an update on these taxes and how they could impact your client’s planning needs.
Wealth Tax
The Biden administration has introduced a billionaire tax bill,4 similar to a bill introduced in the House on July 28, 2022 (H.R. 8558), which imposes a minimum tax on taxpayers whose net worth for the taxable year exceeds $100 million. The proposed tax is 20% of the total of a taxpayer’s taxable income plus net unrealized gains for the taxable year. A 25% minimum rate on unrealized capital gains would be applied. Such a tax on unrealized capital gains would most likely lead to a decrease in charitable donations5 and may be unconstitutional.6 President Biden is also proposing to increase the top tax rate for individuals with $400,000 or more of income to 39.6% from 37%, thus reversing the tax cuts that were introduced in the Tax Cuts and Jobs Act.7
National wealth taxes have also been unsuccessfully proposed for several years.8 Generally, a wealth tax is an additional annual tax imposed on the market value of a household’s total assets, less the market value of a household’s total liabilities subject to certain thresholds. The tax is effectively an annual surcharge on the net worth of a family subject to possible exceptions such as a primary residence or other directly owned real estate. The rationale for the real estate exemption is that the real estate property tax is already an indirect form of a wealth tax.
Enacting a wealth tax in the United States, whether at the federal or state level, most likely won’t be easy. Previously, national proposals by Senators Bernie Sanders (I-Vt.) and Elizabeth Warren (D-Mass.) have both been broad based.9 Neither proposal provided for asset exceptions such as directly owned real estate (for example, a home) or closely held business (for example, a family-owned business). The concern has been that such a wealth tax could put a strain on taxpayers who generate much of their wealth from illiquid assets such as closely held entities, real estate and/or alternative investments because additional liquidity may be needed to pay the wealth taxes. In addition, the accurate valuation of these assets annually could prove quite burdensome. Consequently, instead of providing economic relief, wealth taxes may actually provide economic distress, as has been the case in Europe.10 Despite all of these negatives, state lawmakers from California, Connecticut, Hawaii, Illinois, Maryland, New York and Washington are hoping to pass wealth taxes.11 These states have approximately 60% of the nation’s wealth.12 Proponents of a wealth tax argue that such a tax would make the U.S. tax system more progressive and reduce income inequality.13 Even though these states are trying to act in a coordinated effort, most likely any state wealth taxes passed would vary due to each state’s different constitutional constraints.14
One argument that a wealth tax is unconstitutional involves the 16th amendment, which states that Congress has the power to “lay and collect taxes on income from whatever source derived.” Consequently, the government may impose taxes on wages, dividends and interest but not on property itself or its unrecognized growth in value. Another constitutional objection to wealth taxes is Article 1, Section 9, Clause 4 of the Constitution, which requires any direct tax to be appointed among the states based on population. So if 12% of the population lives in California, California must pay 12% of any direct tax. Many argue that wealth taxes may be classified as direct taxes.15
Effect on Trusts
How trusts might be affected by a wealth tax is also a very important planning question. For example, in Switzerland, beneficiaries with mandatory distributions are required to pay the wealth tax. Additionally, revocable trusts require the settlor to pay the wealth tax, while discretionary trusts aren’t subject to it.16 None of the U.S. proposals have elaborated on how trusts would be treated under a wealth tax. Sen. Sanders and Sen. Warren have stated generally that assets placed in a trust would be treated as owned by the grantor of the trust (by the individual giving assets to the trust) until that individual’s death.17 No other details have been provided. Other general recommendations for implementation of the wealth tax in the United States have stated that irrevocable trusts should owe a wealth tax unless a beneficiary claimed their portion of the wealth tax owed by the trust.18 This may also be difficult to determine in many cases.
Typically, the federal government has allowed the states to define property and property rights. One example is the rule against perpetuities (RAP), dealing with the duration of a trust. Many states have non-long term or perpetual duration statutes or have tweaked their RAP statutes, while other states follow the Uniform Statutory Rule Against Perpetuities and the common law. A second example is how the states have defined a “discretionary interest” in trusts.19 Many of the modern boutique trust states (for example, Alaska, Delaware, Nevada, New Hampshire, South Dakota, Tennessee and Wyoming) have codified the common law and Restatement (Second) of Trusts, which state that a beneficiary’s discretionary interest in a trust isn’t a property interest or an entitlement.20 Many of these statutes also include distributions based on health, education, maintenance and support as discretionary, provided the decision is in the sole and absolute discretion of the trustee.21 Therefore, if a beneficiary has no property, by definition, how would a wealth tax apply to them? In addition to these state discretionary interest statutes, a recent U.S. Supreme Court case, Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust,22 could raise more questions as to how a wealth tax would apply to a trust. In Kaestner, the Supreme Court held that an in-state beneficiary of a discretionary trust was an insufficient contact for North Carolina to tax the trust. The Supreme Court focused on the fact that the trust was discretionary, and consequently, the beneficiary wasn’t entitled to demand distributions nor did she have a right to income or any control over the trust assets. Additionally, the beneficiary couldn’t be taxed unless she received a distribution. Consequently, Kaestner may also help prohibit the imposition of a state wealth tax on a discretionary trust.
Would the wealth tax require the settlor to pay the tax? In the case of an irrevocable non-grantor discretionary trust, in which the settlor has relinquished dominion and control, how could that requirement be enforced? Instead, would the trust need to pay its own state wealth tax? What if the trust was sitused in a state without a wealth tax? Much of the reasoning doesn’t fit into the traditional norms of the legal relationship of trust taxation, settlor, trustee and beneficiary.23 Also, if discretionary trusts are formed prior to the wealth tax, they may be grandfathered.24
State Income Taxes
Many of the states looking to pass wealth taxes have or are also looking to pass higher income tax rates for wealthy taxpayers. In many instances, this has resulted in clients and their businesses fleeing those states to lower or no income tax states.25 Both California and New York are great examples of this trend.26 Alternatively, Governor Ned Lamont of Connecticut indicated that he’s more interested in increasing taxpayers versus taxes.27 Gov. Lamont recently passed tax cuts for the middle class. That being said, Connecticut legislators are exploring a wide range of tax hike proposals, including one that would create a top individual income tax rate of 10.65% on ordinary income and 15.65% on capital gains income, raise the corporate income tax to 13.8% (including a permanent “surcharge”) and establish a new statewide property tax on commercial or residential property valued at more than $1.5 million.28 In November 2022,29 Massachusetts approved an additional 4% tax on state residents with annual income over $1 million. Combined with the state’s existing 5% income tax rate, it raises Massachusetts’ top rate to 9%.30 It applies to both ordinary income and capital gains taxes. It’s already had a negative affect on Massachusetts by causing many wealthy residents to move to more tax-friendly states.31 New Jersey also previously introduced a millionaires tax raising its top tax bracket to 10.75% along with dropping the threshold of their top income tax bracket from $5 million to $1 million.32 California also previously proposed legislation raising their top state income tax rate to 16.8%.33 California’s top income tax rate is currently 12.3%. An additional 1% tax rate is added for income over $1 million for a top tax rate of 13.3%.34 California also proposed an exit tax designed to continue to tax those who leave the state.35 The exit tax would allow California to recap the funds it invested to assist with the development of the wealth exiting. The California investment to be recouped would include tax breaks, financial incentives and infrastructure support.36 This exit tax raises several potential constitutional issues.37 A pending proposal in New York would increase capital gains taxes by 30%, that is, higher than the 20% federal tax on long-term capital gains so that the combined federal and New York City rate would exceed 70%.38 Many people and businesses are looking for more tax-friendly states as a result of all of these tax increases on the wealthy.
Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming are no-income tax states.39 Many of these states attract retirees, businesses and trusts. They also have the top limited liability company (LLC), trust and asset protection laws.40 Consequently, many wealthy families situs their trusts in these states. Many of these no-income tax states have withstood trust state income tax battles with high income tax states where trust grantors live.41 One exception is the incomplete gift non-grantor (ING) trusts.42
ING trusts are non-grantor irrevocable trusts sitused in a no-income tax trust state, thus allowing a taxpayer to avoid state income taxes so long as the ING trust doesn’t have a resident trustee in a client’s high income tax resident state. The trust grantor generally has limited rights over the principal and income of the trust. Additionally, because the ING trust is an incomplete gift trust, it won’t be considered a taxable gift for federal gift tax purposes. As mentioned, ING trusts are generally sitused in no-income tax trust states; consequently, they’re named AKING (Alaska), DING (Delaware), NING (Nevada), SDING (South Dakota) and WING (Wyoming). New York passed legislation in 2014 to treat ING trusts as grantor trusts,43 thus eliminating the state income tax savings on ING trusts for New York residents. California recently passed retroactive legislation on July 10, 202344 to treat ING trusts as grantor trusts, thereby eliminating the ability of a California resident to save California state income taxes.
Insurance Premium Taxes
State premium taxes are paid on all life insurance premiums in the United States.45 These premium taxes vary dramatically among the states. Alaska, Delaware, South Dakota and Wyoming all have some of the lowest premium taxes in the United States. See “Selected State Premium Taxes,” p. 13.
Competitive state premium taxes and modern domestic trust laws, as well as improved domestic regulatory costs and state consumer laws for insurance policies, have resulted in much larger life insurance contracts being issued onshore versus the traditional route offshore.46
Generally, state premium taxes are imposed on premiums paid for the life insurance by the state where the applicant for the insurance policy is resident, domiciled or sitused.47 The insured’s resident state doesn’t generally levy a premium tax on the premium paid for the life insurance policy purchased by a trust or an LLC sitused in one of these low premium tax states.48 This is generally the case with private placement life insurance (PPLI) policies.49 Many of these low premium tax states also have very favorable LLC, trust, lending and insurance statutes.50
In many situations, there are existing trusts in the client’s resident state with high premium taxes, and the client wants to purchase insurance in these trusts to take advantage of the lower premium tax in states such as Alaska, South Dakota or Wyoming. To do this, the client can form an Alaska, South Dakota or Wyoming LLC, established with an Alaska, South Dakota or Wyoming co-managing member to purchase insurance within the LLC and allocate the units to the out-of-state trusts.51 This generally applies to most large PPLI policies but may also apply to standard fixed, variable and universal policies on a case-by-case basis depending on the size of the policy and the insurance company.52 Thus, state premium tax recognition by the insurance companies may influence which insurance companies or products are selected.53
Monitor State Trends
Sometimes clients don’t have a choice about moving to a tax-friendly state. They either want to be a resident of a particular state for non-tax reasons or need to be a resident of a particular state. Other clients can move to no-income tax states as a result of the ability to work remotely; others will wait until retirement. Trusts frequently change situs to no-income tax states or establish situs in no-income tax states both during lifetime and at death. These tax savings can be substantial, particularly for a family establishing an unlimited or a long-term duration family dynasty trust. This is also the case with business interests. Clients can choose to establish LLCs in states with favorable LLC laws and taxes. Consequently, state taxing trends need to be monitored for many reasons, all of which could have a dramatic effect on a client’s estate planning.
Endnotes
1. BNY Wealth Management, “New State Wealth Taxes in the Cards for 2023?” BNY Wealth Management (2023), www.bnymellonwealth.com/insights/new-state-wealth-taxes-in-the-cards-for-2023.html.
2. Janelle Fritts, “Does Your State Have an Estate or Inheritance Tax?” Tax Foundation (June 21, 2022), https://taxfoundation.org/state-estate-tax-inheritance-tax-2022/.
3. Ibid.
4. Biden Administration Fiscal Year 2023 Greenbook, at pp. 34-36.
5. Jack Salmon,“Taxing Unrealized Gains Is Unconstitutional: Moore v. United States,” Philanthropy Roundtable(June 15, 2023), www.philanthropyroundtable.org/resource/taxing-unrealized-gains-is-unconstitutional-moore-v-united-states/.
6. Moore v. United States, Buckeye Institute in Support of Petitioners amicus curiae brief (March 27, 2023), www.buckeyeinstitute.org/library/docLib/2023-03-27-The-Buckeye-Institute-Amicus-Brief-in-Moore-v-United-Statesamicus-brief.pdf.
7. Kate Dore, “President Biden’s proposed 2024 budget calls for top 39.6% tax rate,” CNBC (March 9, 2023), www.cnbc.com/2023/03/09/president-bidens-proposed-2024-budget-calls-for-top-39point6percent-tax-rate.html#:~:text=President%20Biden%E2%80%99s%20proposed%202024%20budget%20calls%20for%20top,to%20pass%20in%20the%20Republican-controlled%20House%20of%20Representatives.
8. See supra note1. Laura Mahoney, Donna Borak and Michael J. Bologna,“Tax-the-Rich Blue States Want to Leave Wealthy ‘Nowhere to Hide,’” Bloomberg Tax (Jan. 19, 2023), https://news.bloombergtax.com/daily-tax-report-state/tax-the-rich-blue-states-want-to-leave-wealthy-nowhere-to-hide. See Senator Bernie Sanders’ campaign, https://berniesanders.com/issues/tax-extreme-wealth/ and Senator Elizabeth Warren’s campaign,https://elizabethwarren.com/plans/ultra-millionaire-tax.
9. Ibid.
10. Daniel Bunn, “What the U.S. Can Learn from the Adoption (and Repeal) of Wealth Taxes in the OECD,” Tax Foundation (Jan. 18, 2022), https://taxfoundation.org/wealth-taxes-in-the-oecd/. Al W. King III, “Is a Wealth Tax in Our Future?” Trusts & Estates (December 2020).
11. See supra notes 1 and 8.
12. Ibid.
13. Seesupra note 8.
14. Jared Walczak, “Wealth Tax Proposals Are Back as States Take Aim at Investment,” Tax Foundation (Jan. 17, 2023), https://taxfoundation.org/state-wealth-tax-proposals/.
15. Daniel Hemel and Rebecca Kysar, “The Big Problem With Wealth Taxes,” New York Times (Nov. 7, 2019),www.nytimes.com/2019/11/07/opinion/wealth-tax-constitution.html(“the wealth tax rate in West Virginia — the poorest state per capita — would need to be roughly 10 times the rate in more affluent California and more than 20 times the rate in prosperous Connecticut”).
16. Seesupra note 10.
17. See supra note 8.
18. Greg Leiserson, “Tackling the Tax Code: Efficient and Equitable Ways to Raise Revenue,” The Brookings Institution (January 2020), www.brookings.edu/wp-content/uploads/2020/01/TaxBookforWeb_12320.pdf, at p. 89.
19. Al W. King III, “An Update on Third-Party Discretionary Trusts With Spendthrift Provisions,” Trusts & Estates (October 2019).
20. Ibid.; Restatement (Second) of Trusts, Section 155(1) and comment 1(b); See also Dan Worthington and Mark Merric, “Best Situs for DAPTs in 2023,” Trusts & Estates (December 2022).
21. Seesupra note 19. Seealso Al W. King III, “The Spendthrift Provision-Does it Really Protect?” Trusts & Estates (December 2016).
22. Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, 139 S. Ct. 2213 (2019). See also Al W. King III, “Trust Designs in Light of Kaestner And Other Trends” Trusts & Estates (June 2019).
23. Seesupra note 10.
24. Ibid.
25. Katelyn Washington, “Low Tax States Gain Residents from California and New York,” Kiplinger (May 4, 2023), www.kiplinger.com/taxes/low-tax-states-gain-residents-from-california-and-new-york#:~:text=More%20than%2084%2C000%20New%20Yorkers,Yorkers%20relocated%20to%20the%20Carolina.
26. Ibid.
27. Keith M. Phaneuf, “CT Tax Cuts Are Likely, But Fierce Debate Expected Over Who Benefits,” CT Public (Jan. 26, 2023), www.ctpublic.org/news/2023-01-26/ct-tax-cuts-are-likely-but-fierce-debate-expected-over-who-benefits.
28. Jared Walczak, “New York, Oregon, and Other States Eye Much Higher Taxes on High Earners,” Tax Foundation (Feb. 15, 2023), https://taxfoundation.org/blog/state-capital-gains-tax-estate-tax-proposals/.
29. See supra note 1.
30. Ibid.
31. David S. Bernstein, “Will the ‘Millionaires’ Tax’ Hobble the Massachusetts Economy?” Boston Magazine (April 17, 2023), www.bostonmagazine.com/news/2023/04/17/millionaires-tax-massachusetts/.
32. “New Jersey Increases Tax Rate on Millionaires,” Grant Thornton (Oct. 28, 2020), www.grantthornton.com/insights/alerts/tax/2020/salt/k-o/nj-increases-tax-rate-on-millionaires-10-28#:~:text=Assembly%20Bill%2010%20increases%20the,%245%20million%20in%20annual%20income.&text=Prior%20to%20the%20bill%27s%20enactment,1%2C%202020.
33. Rob Frank, “Tax hike on California Millionaires would create 54% tax rate,” CNBC (July 30, 2020), www.cnbc.com/2020/07/30/tax-hike-on-california-millionaires-would-create-54percent-tax-rate.html.
34. Tina Orem, “California State Income Tax: Rates, Brackets and Who Pays What in 2022-2023,” NerdWallet (July 20, 2023), www.nerdwallet.com/article/taxes/california-state-tax.
35. Sam Brotman, “California Exit Tax & Wealth Tax: What Is It & How It Applies To You,” Brotman Law (Dec. 2, 2022), www.sambrotman.com/blog/california-exit-tax.
36. Ibid.
37. See supra note 35.
38. Jared Walczak, supra note 28.
39. See Wolters Kluwer CCH, 2023 State Tax Handbook (2023).
40. See supra note 22; Al W. King III, “Key Federal & State Considerations and Opportunities in 2021,” Trusts & Estates Webinar (Jan. 12, 2021), https://planning2021forum.wealthmanagement.com/#link-wmtekey.
41. Ibid.
42. The incomplete non-grantor trust is an irrevocable non-grantor trust for income tax purposes (that is, the trust is responsible for tax liabilities) while also deemed an incomplete gift for transfer-tax purposes (that is, the trust remains in the grantor’s estate). See generally Jordan D. Veurink, Christine Quigley and Kelly Perez, “Where are we now? The current state of DINGs, NINGs, SDINGs and other thINGS,” ABA Section of Real Property (Aug. 7, 2018).
43. New York Tax Law Section 612(b)(41); Michael Lum and William Grady, “State Income Tax Planning with ING Trusts,” Baker Tilly
(April 7, 2023), www.bakertilly.com/insights/state-income-tax-planning-with-ing-trusts.
44. Cal. Rev. & Tax. Code Section 17082; Justin T. Miller, “California Says No to NINGs and Don’t to DINGs” (Aug. 2, 2023), www.wealthmanagement.com/estate-planning/california-says-no-nings-and-don-t-dings.
45. Al W. King III and Pierce H. McDowell III, “Zero Tax Trusts,” Trusts & Estates (September 2021).
46. Ibid.
47. See supra note 45.
48. Ibid.
49. Ibid.; Al W. King III and Pierce H. McDowell III, “Powerful Private Placement Life Insurance Strategies With Trusts,” Trusts & Estates (April 2016).
50. Ibid.
51. See supra note 49.
52. Ibid.; See supra note 45.
53. See supra note 45.