By Lynne Howard, Tax Senior Manager | Family, Executive & Entrepreneur Advisory Services team
What you need to know about estate and trust income taxation
Non-grantor trusts are taxed on income not distributed to a beneficiary. Income distributed to a beneficiary passes out on a schedule K-1 and is reported on the beneficiary’s personal income tax return (form 1040). Capital gains are generally taxed to the trust even if the associated cash is distributed to the beneficiary.
Just like individuals and businesses, trusts have to file state income tax returns and must determine residency. A non-resident trust can only be taxed by that state on income “sourced” to that state, whereas a state taxes a “resident” trust on all income of the trust including both “source” and “non-source” income. “Sourced” income is connected to the state generally through physical location, such as rental income from property located in the state. The “resident” state gets a credit for taxes paid to a non-resident state on “sourced” income.
The focus of this article will be the criteria that states currently use to determine if the non-grantor trust is a “resident” trust and will therefore be taxed on all of the trust’s income, including the trusts non-source income.
What qualifies the trust as a resident of a state?
Determination of what state a trust could produce a potential income liability requires an analysis of the laws of the each state in which the settlor(s), beneficiary(ies) and trustee(s) reside. Because each state has its own residency definition for estates and trusts a non-grantor trust can be a resident of more than one state or it can be a resident of none. The various criteria used to determine residency, and which states consider each factor, are as follows:
- Trust created by will of domiciliary resident – Alabama(1), Arkansas(1), Connecticut, Delaware(1), District of Columbia, Idaho(1), Illinois, Louisiana, Maine, Maryland(1), Massachusetts(1), Michigan, Minnesota(1), Missouri(1), Montana(1), Nebraska, New Jersey(1), New York(1), New York City(1), Ohio, Oklahoma, Pennsylvania(1), Rhode Island(1), Utah(1), Vermont, Virginia, West Virginia, Wisconsin
- Inter Vivos trust created by domiciliary resident – Alabama (1), Arkansas(1), Connecticut(1), Delaware(1), District of Columbia, Idaho(1), Illinois, Maine, Maryland(1), Massachusetts(1), Michigan, Minnesota(1), Missouri(1), Montana(1), Nebraska, New Jersey(1), New York(1), New York City(1), Ohio(1), Oklahoma, Pennsylvania(1), Rhode Island(1), Vermont, Virginia, West Virginia, Wisconsin(1)
- Trust administered in state – Colorado, Hawaii(1), Idaho(1), Indiana, Iowa(1), Kansas, Louisiana(1), Maryland(1), Minnesota(1), Mississippi, Montana(1), New Mexico, North Dakota(1), Oregon, South Carolina, Utah(1), Virginia(1,2), Wisconsin(1)
- Trust with resident Trustee/Fiduciary – Arizona, California, Delaware(1), Hawaii(1), Idaho(1), Iowa(1), Kentucky(1), Montana(1), New Mexico, North Dakota(1), Oregon
- Trust with resident beneficiary – California(1), Georgia(1), Montana(1), North Carolina(1), North Dakota(1), Tennessee
- Additional factors apply
- Eliminated by new legislation effective July 1, 2019
It should be noted that states look very differently at the factors and may not even consider some factors. And of course the states have varying tax rates. There are seven states with no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. New Hampshire does not impose an income tax on non-grantor trusts.
Virginia Residency Definition for Estates and Trusts
On November 22, 2019, the Virginia Department of Taxation issued Tax Bulletin 19-7 revising the definition of “resident estate or trust”. Under prior law, a “resident estate or trust” was defined as:
- Estate of a decedent who at his death was domiciled in Virginia;
- Trust created by will of a decedent who at his death was domiciled in Virginia;
- Trust created by or consisting of property of a person domiciled in Virginia; or
- Trust or estate which is being administered in Virginia
The new legislation changed the definition to exclude estates or trusts which are only being administered in Virginia. This legislation is effective July 1, 2019, so taxpayers whose fiscal year starts before, but ends after, the effective date will be required to apply both the old and new definitions to portions of their taxable year.
North Carolina Department of Revenue vs. Kimberly Rice Kaestner 1992 Family Trust
Trust state taxation has always been a consideration but has gained attention recently due to the Kaestner case handed down by the Supreme Court of North Carolina on June 8, 2018; North Carolina Department of Revenue vs. Kimberly Rice Kaestner 1992 Family Trust. In this case all the activities of administering the trust and the location where the trust assets were held occurred outside of North Carolina, but North Carolina claimed nexus because the beneficiary was a domiciliary resident of North Carolina. The states attempt to tax the trust based solely on the residency of a beneficiary was held to violate both the North Carolina and the U.S. Constitution’s due process requirements. This can be viewed as a win for trusts in that it may help to limit the reach of states ability to tax trust income.
State trust taxation is complicated and often overlooked, but should be an important part of trust planning and administration. Because the laws related to state trust taxation vary widely from state to state a trust could be considered a resident trust and taxed on the non-source income by more than one state. It may be possible to get a credit in one state for the taxes paid to another state, but that may not always be the case, or it’s not always clear how to claim such tax credit. On the flip side within some instances and with proper planning it may be possible for the trust to avoid being subject to state income taxes entirely. This could create significant savings in a year that property is sold resulting in large capital gains. New trusts should be drafted with flexibility to respond to the changing nature of trust income taxation. Existing trusts should consider how changes in residency of the trustee and beneficiaries, and changes in where the trust is administered, effects which states can tax non-source income.
Additional Estate and Trust Planning Resources
- Funding a Living or Revocable Trust
- The Importance of an Annual Estate Plan Checkup
- Tax Cuts and Jobs Act: What You Need to Know About the Estate, Gift, and Trust Provisions
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.