Editor: Kevin D. Anderson, CPA, J.D.
Whether you have an existing trust or are creating a new trust, location matters. The total tax owed by a trust can be significantly affected by the location of grantors, beneficiaries, trustees, and even trust assets. This is especially true for tax years 2020 and 2021, when most people have been working remotely and could do so from anywhere or are quarantining somewhere other than their usual residence. Trustees and planners can no longer ignore the ever-expanding reach of states in their pursuit of state and local tax (SALT) revenue.
A trust can be taxed as a resident trust in multiple states or in no states. A single characteristic may classify a trust as a resident trust in some states, while in other states, a combination of factors is required. Currently, eight states — Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington, and Wyoming — do not tax the income of nongrantor trusts. The remaining states tax a trust based on a number of factors: (1) residency of the testator or the trustor; (2) administration of the trust; (3) residency of the trustee; and(4) residency of the beneficiary.
Residency of testator or trustor
Numerous states tax a testamentary trust based on whether the testator lived in the state at the time of death. Numerous states also tax an inter vivos trust based on whether the trustor resided in the state. Illinois, Maine, Maryland, Michigan, Pennsylvania, Vermont, and Virginia are some of the states that rely solely on the residency of the testator or trustor. The reach of this state residency factor leads to a trust that is tainted from creation (a forever tainted trust) and that cannot seem to escape taxation by the original resident state of the trustor, regardless of how long the trustor has been gone from the state.
Some of these states, however, have been forced to consider more than just the residency of the trustor in determining whether the state has an ongoing right to tax a resident trust. Michigan faced a federal constitutional challenge and Pennsylvania faced state and federal constitutional challenges addressing trust residency based on the trustor and can no longer rely solely on the residency of the trustor if the trust does not have ongoing connections to the state (Blue v. Michigan Dep't of Treasury, 462 N.W.2d 762 (Mich. Ct. App. 1990); McNeil, Jr. Trust v. Pennsylvania, 67 A.3d 185 (Pa. Commw. Ct. 2013)). Thus, courts have created a third trust classification when they have not permitted a state to tax a trust based on the state's residency definition. States with such jurisprudence now have nonresident trusts, resident trusts, and nontaxable resident trusts because the courts, while allowing the state's residency definition to stand, have held that the application of the residency definition to a trust with a given fact pattern was unconstitutional.
Defective trusts that are irrevocable but treated as grantor trusts for income tax purposes are problematic and create a unique issue under this state residency factor. Suppose a Michigan-domiciled grantor creates a defective trust in 2008, the grantor moves to Illinois in 2015, and in 2020, the defective trust becomes a nongrantor trust. Under a Michigan statute, Mich. Comp. Laws Section 206.18(1)(c), a resident trust is "any trust created by, or consisting of property of, a person domiciled in this state, at the time the trust becomes irrevocable." Under Illinois statute, 35 ILCS 5/1501(a)(20)(D), a resident trust is "[a]n irrevocable trust, the grantor of which was domiciled in this State at the time such trust became irrevocable. For the purpose of this subparagraph, a trust shall be considered irrevocable to the extent that the grantor is not treated as the owner thereof under Sections 671 through 678 of the Internal Revenue Code."
The trust in the above example becomes a resident of Illinois in 2020 because the grantor, while a resident of Illinois, toggled off the grantor trust powers under the irrevocable (nongrantor) trust in 2020, such that the grantor was not treated as the owner of the trust under Secs. 671 through 678. The trust also is a resident of Michigan because the grantor in 2008, while a resident of Michigan, created an irrevocable defective (grantor) trust. With this slight variation in the definition of a resident trust, the trust is defined to be a resident trust in both Illinois and Michigan, which will complicate the trust's tax situation, as both states will attempt to tax the same income. However, the trust may not be taxable under Blue if the trust does not have any ongoing connections with Michigan (e.g., if the trustee, assets, administration, and beneficiaries are all outside of Michigan). With the subtle differences in the residency definitions and the constitutional framework that overlays all state taxes, a trust may be a resident of multiple states, yet taxable in none or all states depending on the trust's ongoing connections to each state.
Administration of the trust
Numerous states tax a trust based on whether it is administered in the state. These states include Colorado, Kansas, Maryland, New Mexico, Oregon, South Carolina, and Virginia. Administration of the trust is a factor that can be managed and avoided. For example, if a corporate trustee is administering the trust, the state of administration can be changed by transferring the duties and decision-making to an office in another state.
Some states provide guidance regarding when a trust is being administered within the state. Virginia's Department of Taxation has held on three occasions that a trust was not administered in the state when the trust was administered by a committee not operated or controlled in Virginia that had a Virginia resident member, but control over the trust could only be exercised by a majority or consensus of the committee and not by a committee member individually (Va. Dep't Tax., P.D. 02-101 (2002); P.D. 07-164 (2007); P.D. 13-18 (2013)).
Residency of the trustee
Several states — including Arizona, California, Montana, Oregon, and Virginia — tax a trust if one or more trustees reside in the state. Trust advisers and protectors who act in a fiduciary manner may be considered co-trustees, potentially exposing a trust to additional state tax jurisdictions. California, for example, applies a broad definition of fiduciary, which includes "any person ... acting in a fiduciary capacity" (Cal. Rev. & Tax. Code §17006). The individual need not be named a trustee or adviser or protector; he or she need only to act in a fiduciary manner to fall within the California definition. Residency of the trustee is a factor that can be mitigated by appointing nonresident trustees or obtaining the resignation of the resident co-trustee, if the other co-trustees are nonresidents.
Residency of the beneficiary
California, Georgia, Montana, North Carolina, North Dakota, and Tennessee tax a trust if it has one or more resident beneficiaries. Generally, only income attributable to the resident beneficiary is taxed by the state. Some states, such as California, will tax accumulated trust income when distributed or distributable to the resident beneficiary (McCulloch v. Franchise Tax Bd., 61 Cal. 2d 186 (1964)). Also, states may differ in their definition of beneficiaries. Beneficiaries may include mandatory beneficiaries, discretionary beneficiaries, and contingent remainder beneficiaries. Massachusetts, for example, includes unborn and unascertained persons, as well as persons with uncertain interests, in its definition of resident beneficiaries (Mass. Gen. Laws. Ch. 62, §10(a)).
The most recent U.S. Supreme Court decision dealing with a state's right to tax a trust involved a state's trust residency definition that was based on the residency of the beneficiaries. North Carolina's attempt to tax a trust based solely on the residency of the beneficiary was addressed in North Carolina Dep't of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, where the Court held that the mere presence of in-state beneficiaries did not meet the minimum connection required to impose state tax because the beneficiaries had not received any trust income nor exercised control over trust income or assets (139 S. Ct. 2213 (2019), aff'g 814 S.E.2d 43 (N.C. 2018), aff'g 789 S.E.2d 645 (N.C. Ct. App. 2016), aff'g 2015 NCBC 36 (N.C. Sup. Ct. (Bus.) 2015)). Along with court challenges that scrutinize the taxation of a trust based solely on the residency of the trustor, Kaestner creates uncertainty in states that have trust residency definitions that look to something other than the residency of the trustor.
There is no objective rule for determining the residency of a beneficiary. Residency is a question of fact and circumstances, including the intentions of beneficiaries and their conduct and declarations. The residency of a beneficiary is a factor that is difficult to mitigate because beneficiaries relocate for a multitude of reasons, least of which is trust tax planning.
Avoid inadvertent SALT consequences
Trusts can end up paying a considerable amount of SALT, especially trusts that accumulate income and have large capital gains. The movement of beneficiaries, the appointment of a co-trustee, and even the toggling of a grantor power can have unintended tax consequences. The utmost vigilance, including ongoing dialogues with the testator, beneficiaries, and trustees, is necessary to ensure that inadvertent trust tax consequences do not arise. Whether you are creating a new trust or managing an existing trust, remember to minimize the SALT.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Contributors are members of or associated with BDO USA LLP.