The state income taxation of trusts and estates has become an increasingly complicated and challenging task for trustees and their tax advisers. Trust portfolios have moved from traditional “stock and bond” allocations to investments in real estate, private equity, venture capital, and hedge funds. This migration toward more sophisticated investment holdings has increased the complexity of federal and state income taxation and related tax return preparation. Simple investment statements and Forms 1099 have been replaced with complicated Schedules K-1, many of which include pages of supplemental state tax information. In turn, it has become common for trusts to have filing obligations in several states.
Last year this column addressed some of the challenges and issues facing trusts that file nonresident state income tax returns. 1 This column complements that column and discusses the credit that a resident trust can claim for taxes paid in the nonresident states.
Similar to the income taxation of resident individuals, most states tax a resident trust on all its income and tax a nonresident trust on income sourced to the state. To avoid double taxation, most states allow a resident trust to claim a credit for taxes paid in the nonresident states. The credit is usually limited to the resident state’s tax on the income subject to double taxation or the resident state’s tax on income earned in other states (using the resident state’s sourcing rules). Some states may even allow the credit when the taxpayer is considered a resident of more than one state.
Many of the same factors that complicate the calculation of the trust’s nonresident state income tax also create issues and challenges for computing the credit. Some of these challenges are inherent in the nature of trusts. For example, for income tax purposes, trusts operate as flowthrough entities to the extent that current distributions are made to beneficiaries, and as separate taxpayers with regard to undistributed amounts retained at the trust level. This dichotomy can result in interesting situations, examples of which are provided below. Further, differences in the rules from state to state cause some of the challenges. This column provides examples of these differences as well.
This column discusses (1) the state income tax add-back and how it affects the calculation of the credit; (2) how the allocation of income between the trust and beneficiaries can make it difficult to determine who deducted the state income taxes and who is the actual taxpayer; (3) how dual-resident trusts complicate the calculation of the credit; and (4) how state throwback rules affect the credit.
State Income Tax Add-Back
Most states do not allow the same tax to be deducted and claimed as a credit. For example, the Illinois statute states “[t]he credit provided by this paragraph shall not be allowed if any creditable tax was deducted in determining base income for the taxable year.” 2 For individuals, this is usually not an issue because many states either add back all state income taxes or start with federal adjusted gross income (AGI). Trusts, however, usually deduct state income taxes in computing federal taxable income.
In Illinois this created an issue because, for tax years prior to 1989, the Illinois statute did not provide a modification for the non-Illinois state income taxes to be added back. In Zunamon v. Zehnder, a trustee added back the state income taxes for tax years prior to the law change. 3 The Illinois Department of Revenue denied the credit for taxes paid to other states, which in Illinois is called the foreign tax credit. The state took the position that “the trusts were not permitted to add back the federal deduction taken for source state taxes to their Illinois base income in order to preserve their ability to take the foreign tax credit.” 4
Although the Illinois statute had been amended in 1988 to allow such an addition modification, the legislation was specific in terms of the change’s effective date. The statute states, “For taxable years ending on or after January 1, 1989, an amount equal to the tax deducted pursuant to Section 164 of the Internal Revenue Code if the trust or estate is claiming the same tax for purposes of the Illinois foreign tax credit under Section 601 of this Act.” 5 The appellate court held for the taxpayer:
The absence of any indication in the statutory language that the legislature previously intended to limit a trust’s ability to take advantage of the foreign tax credit, and the policy choice of making this credit available to all resident taxpayers, make it impossible to reconcile and give meaning to the date restriction. This leads us to conclude that the inclusion of the same was an oversight. Thus, in order to harmonize the various statutory provisions and give effect to the true intent of the legislature, we now delete from section 203(c)(2)(F) of the act the phrase, “For taxable years ending on or after January 1, 1989.” 6
The appellate court rejected the department’s position that prior to the law change a resident trust was required to choose between claiming a federal deduction and the Illinois credit. Instead, the court found that the prior law allowed a trust to choose between taking an Illinois deduction for income taxes paid to other states or claiming the Illinois credit, thus preventing the trust from receiving a double benefit.
In concept this sounds fairly simple—claim a deduction or a credit, but not both. However, relatively straightforward concepts can become complicated issues when they are applied to trusts. Most states follow the federal tax treatment of trusts. In many states, the adoption of the federal system is built in because the state uses federal taxable income as the starting point for the state tax calculation.
For federal income tax purposes, depending on the terms of the governing instrument and/or the trustee’s actions, nongrantor trusts’ income may be taxed to:
- The trust on its income tax return (Form 1041, U.S. Income Tax Return for Estates and Trusts);
- The beneficiary on his or her personal income tax return (Form 1040, U.S. Individual Income Tax Return); or
- Some combination of both.
This potential shifting of the liability for the tax payment results from the allowance of an income distribution deduction (IDD) under Sec. 661(a) when a trust distributes income to its beneficiaries. Most states follow federal tax treatment and allow the trust an IDD. Likewise, most states tax beneficiaries on the income associated with the IDD.
Who Deducted the State Tax?
This potential shifting of the liability can make it difficult to determine who received the deduction for the state income tax. Part of the difficulty is the flexibility of the federal rules. Regs. Sec. 1.652(b)-3(c) lists state income tax as an example of an expense that is not directly attributable to a class of income. As a result, the deduction for the tax may not be allocated the same as the income that caused the tax liability. For example, in Rev. Rul. 74-257 a trust paid state income tax as a result of a capital gain retained by the trust. The trust deducted the state income tax in arriving at the IDD. In other words, the deduction for state income tax was allocated to the beneficiary even though the state income tax was paid by the trust as a result of income retained by the trust.
Layering the state issues on top of the federal tax treatment can result in further complications. For example, what happens if the capital gain from Rev. Rul. 74-257 is from the sale of real estate located in a state where the trust is a nonresident? The trust likely is taxed on the gain in the state where the real estate is located. The trust likely is also taxed on the gain in the trust’s resident state. Most states allow a resident trust to claim the credit for at least a part of the tax paid to the nonresident state. However, as discussed above, for the trust to claim the credit, most states require the trust to add back the state taxes. Should the add-back be allocated to the trust that was subject to the tax and is claiming the credit, or should the add-back be allocated to the beneficiary who was allocated the state income tax deduction? In other words, does the trust have to add back the state income taxes it deducted in computing the IDD or can the add-back be allocated to the beneficiary?
In General Information Letter IT 02-0052, the Illinois Department of Revenue indicated that a trust could allocate the state income tax addition modification to the beneficiary and claim the credit for the tax. 7 In the letter the Department of Revenue conceded that its 2001 instructions to Form IL-1041, Fiduciary Income and Replacement Tax Return, were incorrect when they indicated that the addition modification for state income taxes must be allocated to the trust. Therefore, the Illinois Department of Revenue allowed the trust to claim the credit even though the addition modification for the state tax was allocated to the beneficiary. Can an argument be made that if the tax is allocated to the beneficiary, then the beneficiary should be able to claim the credit?
In some states, such as California, the statute specifically allows a resident beneficiary who is taxable on income from a trust to claim the credit for taxes paid by the trust to another state on such income. 8 Most states do not have statutory provisions specifically allowing the beneficiary to claim the credit for tax paid by the trust. However, there may be a position in some of these states for the beneficiary to claim the credit.
In Matter of Smith, 9 the beneficiary claimed the credit for taxes imposed on and paid by the trust. The New York State Tax Commission took the position that the beneficiary could not claim the credit for the fiduciary income tax paid by the trust to Massachusetts. The Appellate Division ruled in favor of the taxpayer, noting that the taxes were added back to the beneficiary’s AGI. “Having so borne the burden of the income taxes paid to Massachusetts, petitioners [the beneficiary and her husband] have constructively paid ‘income tax imposed for the taxable year by another state’ and are thus entitled to a credit . . .” 10
It can become difficult to determine who should claim the credit for taxes paid to other states in complex situations where the trust and the beneficiary each are taxed on portions of the income. Layers of complexity can be added when the trust has income and losses from several different nonresident states or when the trust and beneficiaries are resident in different states. One can query whether the court in Matter of Smith would have come to the same conclusion if the trust had claimed the credit for the tax in its resident state. It is probably safe to assume that New York does not allow both the trust and the beneficiary to claim the credit for the same tax.
In certain situations, taxpayers may be able to avoid the issue raised by the New York Tax Commission in the Matter of Smith (i.e., that the beneficiary was not the taxpayer that paid the tax in the nonresident state). Last year’s column discussed some of the complications caused by the IDD when a trust has income and losses from several states. It was pointed out that in many situations it can be unclear if the trust or the beneficiary is subject to tax on the income earned in a particular state. In states where the beneficiary cannot claim the credit for taxes imposed on the trust, the credit issues can influence the taxpayer’s position on who is taxed in the state.
The credit issues can also influence the trust’s decision to be included in a composite return. Often partnerships and other flowthrough entities offer to file composite tax returns on behalf of the nonresident owners. In many states they can include owners that are trusts. However, inclusion in a composite return may create a potential issue because the trust is listed as the taxpayer. If the beneficiary pays tax on the income in his or her resident state, there may be an issue claiming the credit for tax on the composite return in states that do not allow the beneficiary to claim a credit for tax paid by the trust.
The credit issue may be avoided if the beneficiary files individual tax returns in all of the states. Unfortunately, filing individual returns for the beneficiary can dramatically increase the compliance burden because in most states the trust and the beneficiary are required to file nonresident tax returns. If the beneficiary is a resident of a state that does not allow beneficiaries to claim the credit for taxes paid by the trust, then the compliance costs need to be balanced against the potentially lost credit.
Even in states where the beneficiary can claim the credit for taxes paid by the trust, the beneficiary may not be able to claim the credit for taxes paid by the trust on income from intangible assets. In In re Mallinckrodt 11 the New York resident beneficiary was not allowed to claim the credit for taxes paid to Missouri because the income was not sourced to Missouri under New York law. In this case the trust was subject to Missouri tax on all of its income because it was a Missouri resident trust. The income was interest and dividends from intangible assets that were not employed in a business, trade, or profession carried on in Missouri. The beneficiary was a New York resident who was taxed on all of her income by New York. She attempted to claim a credit for the taxes paid to Missouri. The New York Division of Taxation disallowed the credit because the income was not derived from Missouri sources. The New York Division of Tax Appeals ruled against the taxpayer and did not allow the credit. This is a common problem in states that limit the credit to income sourced to another state, similar to the rule in New York. This issue can be a very expensive problem when more than one state considers the trust to be a resident of its state.
It is fairly common for a trust to be considered a resident of more than one state. Often this is a result of differences between the states in the rules for defining where a trust is a resident (e.g., one state defines a resident trust based on where the grantor is located and another state based on where the fiduciary is located). Most states tax a resident trust on all of its income and not just the income sourced to the state. As discussed above, many states limit the credit to the tax paid on income sourced to another state. This can result in the same income being taxed twice without any offsetting credits.
To prevent this problem, some states, such as California 12 and Colorado, 13 have developed special rules for dual-resident trusts to claim the credit for tax paid to another state. California simply allows a credit for the tax paid to the other state. However, in Colorado the credit is computed by multiplying the Colorado tax “by a percentage equal to the other state’s income tax rate for the income tax year divided by the sum of the income tax rates of Colorado and the other state for the income tax year.” 14 If the trust is a resident of more than two states, then the numerator is the sum of non-Colorado state income tax rates, and the denominator is the sum of the Colorado income tax plus all of the other state income tax rates. In Colorado the dual-resident credit is “in lieu of the credit granted in section 39-22-108(1),” which is the normal credit for taxes paid to other states. 15 As one might expect, it can become very complicated trying to compute the various state credits for a dual-resident trust that also pays tax in nonresident states on income and losses sourced to several different states.
Illinois Replacement Tax Issue
One issue that is specific to Illinois was the second issue addressed in the Zunamon case discussed above. In Illinois, trusts are subject to the income tax, which currently is 5%, and the replacement tax, which currently is 1.5%. Trusts report both taxes on the same tax form (Form IL-1041) and compute them on the same tax base. The trust in Zunamon claimed the credit for taxes paid to other states against both the income tax and the replacement tax. The court held that “Section 601 provides that the foreign tax ‘shall be credited against the tax imposed by section 201(a) and (b)’ Ill. Rev. Stat. 1987, ch. 120, par. 6-601(b)(3). Thus by its express terms, application of the foreign tax credit does not apply to the replacement tax found at section 201(c).” 16 The taxpayer argued that not allowing the credit against the replacement tax “subjects the trusts to double taxation, which runs afoul of the uniformity clause of the Illinois Constitution and the due process and commerce clauses of the United States Constitution.” 17 The court rejected both arguments, pointing out that the “due process clause does not prohibit a state from taxing all of its residents’ income, even income earned in another state . . .” and “the commerce clause is not intended ‘to protect state residents from their own state taxes.’” 18
State Throwback Rules
Some states, such as California, seek to tax resident beneficiaries on distributed taxable income on which the trust has not paid tax to their state. The California throwback rule requires a beneficiary who is a California resident to pay tax on income if the trust did not pay the tax. 19 Section 17745(b) of the statute states, “If no taxes have been paid on the current or accumulated income of the trust because the resident beneficiary’s interest in the trust was contingent such income shall be taxable to the beneficiary when distributed or distributable to him or her.” Section 17745(d) provides,
The tax attributable to the inclusion of that income in the gross income of that beneficiary for the year that income is distributed or distributable under subdivision (b) shall be the aggregate of the taxes which would have been attributable to that income had it been included in the gross income of that beneficiary ratably for the year of distribution and the five preceding taxable years, or for the period that the trust accumulated or acquired income for that contingent beneficiary, whichever period is the shorter.
In other words, the California throwback provision calculates the additional tax that the beneficiary would have paid if the trust had distributed the income ratably over the shorter of the actual accumulation or the past six years.
As discussed above, California allows resident beneficiaries to claim the credit for taxes paid by the trust. 20 When the throwback rule applies, the beneficiary can claim the credit for taxes paid in prior years. In Legal Ruling 375 the California beneficiary received a distribution of accumulated income in 1972. 21 The trust had not filed a California tax return or paid any California tax for any of the years of accumulation. The beneficiary became a California resident in 1963. The trust had filed and paid tax to the state of Minnesota for the tax years 1963 to 1972.
The California Franchise Tax Board held that:
subject to the limitation set forth in Section 18005(b), the credit shall be based upon the tax on the income accumulated by the trust since the taxpayers became California residents until the date of distribution. One-sixth of that amount shall be added to the taxpayers’ income for the year of distribution and for each of the five preceding years to determine the California tax attributable to the trust income. The credit shall be computed for each year and the total allowed in the year of distribution. 22
Thus, the California Franchise Tax Board allowed the beneficiary to claim the credit for the Minnesota tax paid by the trust in the prior years.
This column reviews some of the state income tax issues for trusts and their beneficiaries in claiming the credit for taxes paid to other states. These issues become more complicated as trusts and their investments become more diverse and sophisticated. Similar to most issues in state taxation, this is an area where the tax rules are evolving and changing as a result of marketplace, legislative, and regulatory activity. Trustees and tax practitioners are well advised to give special attention to the state income tax matters for trusts and their beneficiaries.
This article does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation. Copyright © 2012 Deloitte Development LLC. All rights reserved.
1 Bergmann and Johnson, “Selected Issues Concerning the State Income Taxation of Nonresident Trusts and Estates,” 42 The Tax Adviser 622 (September 2011).
2 35 Ill. Comp. Stat. 5/601.
3 Zunamon v. Zehnder, 719 N.E.2d 130 (Ill. App. Ct. 1999), app. denied, 724 N.E.2d 1275 (Ill. 2000).
5 35 Ill. Comp. Stat. 5/203(c)(2)(F).
6 Zunamon, 719 N.E.2d at 135–6.
7 Illinois Dep’t of Rev., IT 02-0052-GIL (11/22/02).
8 Cal. Rev. & Tax. Code §18005.
9 Matter of Smith, 503 N.Y.S.2d 169 (N.Y. App. Div. 1986).
10 Id., 503 N.Y.S.2d at 171.
11 In re Mallinckrodt, DTA 807553 (N.Y. Div. Tax App. 11/12/92).
12 Cal. Rev. & Tax. Code §18004.
13 Colo. Rev. Stat. §39-22-108.5.
16 Zunamon, 719 N.E.2d at 136.
18 Id., 719 N.E.2d at 137, quoting Goldberg v. Sweet, 488 U.S. 252, 266 (1989).
19 Cal. Rev. & Tax. Code §17745.
20 Cal. Rev. & Tax. Code §18005.
21 Cal. Franchise Tax Bd., Legal Ruling 375 (11/19/74).
Jamie Yesnowitz is a principal for State and Local Taxes with Grant Thornton LLP in Washington, D.C. Gregory A. Bergmann is a Multistate Tax Services partner in the Chicago office of Deloitte Tax LLP. Eric L. Johnson is a Private Company Services partner in the Chicago office of Deloitte Tax LLP. Mr. Yesnowitz is chair and Mr. Bergmann is a member of the AICPA State & Local Tax Technical Resource Panel. Mr. Johnson is vice chair of the AICPA Trust, Estate & Gift Tax Technical Resource Panel. For more information about this column, contact Mr. Bergmann at email@example.com.