In general, trusts are fiduciary taxable entities which can be utilized as powerful estate, investment, tax, and financial planning tools. The basic objective of a trust is to hold and invest money or property for the benefit of the beneficiaries, while potentially saving estate taxes, avoiding probate, and protecting assets for future generations. Although most advisors who recommend trusts to their clients understand the federal income tax implications and benefits of establishing a trust, the state tax implications can vary widely creating potential pitfalls and unpredictability in planning.
As with partners in a partnership, beneficiaries in certain types of trusts (e.g., simple trusts) are responsible for reporting the income earned by the trust on their personal federal and state income tax returns. Alternatively, other types of trusts (e.g., complex trusts) do not “pass-through” the income to the beneficiaries but are instead required to file and pay the applicable federal and state income taxes. While it is the responsibility of the trustee to ensure all trust taxes are paid, it is becoming increasingly difficult for both trustees and their advisors determining the state(s) in which the trust is required to file and pay taxes. Failure to comply in filing the required state tax returns can result in significant penalties to the trust and breach of a trustee’s fiduciary responsibilities.
Resident v. Nonresident Trusts
The criteria states use for determining if a trust is a resident trust for purposes of their jurisdiction’s income tax can vary widely and can include several factors. Similar to the same principles that apply to individuals, if a state deems a trust as a resident trust, its tax will apply to all of the trust’s undistributed taxable income. If a state deems a trust a nonresident trust, its tax will be applied only against undistributed income derived from sources within the state’s jurisdiction.
When a client contemplates establishing a trust, he or she is likely aware that it may be more advantageous to establish the trust in a state that does not impose a personal income tax, or one in which the assets would be shielded from creditors. However, there are several other factors states can use to assert that they are entitled to impose tax against all of the trust’s income which can undermine this basic planning. Some of these factors cannot be contemplated when the trust is created, and these issues can be further compounded when a trust has ties to several states, each of which is claiming the trust as a resident trust based on different factors.
Most states use a combination of the following factors to determine if a trust can become subject to its income tax:
- The trust was created under the will of a testator who was domiciled or lived in the state
- An inter vivos trust was created or funded by a grantor who was domiciled or lived in the state
- The trust is administered in the state
- Location of the trust’s assets
- Residence of the trustee
- Residence of the beneficiary
The wide range of trust residency rules among the states creates inconsistencies often difficult to navigate and plan for. A seemingly simple change of residency of trustee or beneficiary can either subject a trust to additional filing requirements and tax or remove those factors. Even trusts that are intentionally created in no-tax or low tax states can become subject to tax in other states when factors of the trust change. These can include the location of trust assets, residency of a trustee, residency of a beneficiary, use of the taxing state’s governing law in the trust document, and where the trust is being administered. While some factors are more controllable than others, it is important to advise clients of the potential exposure to state income taxes before the trust invests in fixed assets outside of its resident state, and when a trustee, beneficiary, or the administration of the trust changes domicile.
It is important to note that once a trust has been established, the state residency of a testator or grantor is a factor that cannot be changed. However, even in situations where a trust cannot change its state of residency, there may be an opportunity to minimize or eliminate a trust’s state tax liability. For example, New Jersey considers a trust to be a resident if the grantor is a New Jersey resident at the time the trust becomes irrevocable. However, New Jersey tax law also provides that a resident trust cannot be taxed on its income if the trustees and trust assets are located outside the State and the trust has no New Jersey source income. This is an example of just one planning opportunity where a trust can avoid paying significant state taxes simply by changing a trust factor that was not otherwise important to the trustee or beneficiaries, such as location of trust assets.
Finally, despite each state’s statutory definition of a trust, taxpayers have successfully used constitutional principles to challenge the application of a state’s ability to tax a trust. In a June 2019 U.S. Supreme Court Case, (North Carolina v. Kaestner), North Carolina Department of Revenue argued that under its statutes, any trust income that “is for the benefit of” a North Carolina resident is subject to its state income tax. However, the Supreme Court ruled that North Carolina could not tax this trust since it failed to satisfy the requirements of the Due Process Clause under the 14th Amendment – requiring there be some minimum connection between a state and the person, property, or transaction it is seeking to tax. In this case, prohibiting North Carolina from taxing a trust based solely on the in-state residency of a trust beneficiary when the beneficiary did not have a right to, nor received, any distributions, nor did the trust have any investments, real property or physical presence in North Carolina. Trustees and advisors should keep this case on their radar, as questions of constitutionality are likely to continue and are necessary in order to get the states to revisit their residency rules – perhaps laying the groundwork for a more standardized and streamlined basis for the state taxation of trusts.
