Trusts, like individuals, must live somewhere – maybe not in a house, but at least in a state. State residency can subject a trust to a particular state’s income tax, if the state imposes one. In addition, a trust may have ties to other states through the location of its grantors, trustees, assets, managers, and sometimes beneficiaries, all or some of which may also subject the trust to a particular state’s income tax regime. The result can be different jurisdictions competing to tax a trust’s income, or competing states claiming the trust as a resident in order to tax all of its income.
Reading through a few recent decisions by state courts, it becomes clear that the states can vary radically in whom they tax, how they define whom they tax, what they tax, and how they calculate the tax. The variety of requirements for taxation means that each trust must navigate a different set of criteria to determine whether the trust, or part of its income, is subject to that state’s tax. Recent budgetary constraints and legislation mean that states need to produce revenue from sources already available to them. However, many attempts to use existing statutes have conflicted with both the U.S. and state constitutions. Each state must meet the Due Process requirements under that state’s or the United States Constitution. The criteria courts use to evaluate the constitutionality of a state statute include: (i) some definite link, some minimum connection, between a state and a trust, property, or transaction it seeks to tax, generally by looking to see if the connections are substantial enough to justify the state’s exercise of power over the trust (generally by the trust availing itself of the forum state’s benefits of an economic market; and (ii) an evaluation of whether the income attributed to the state for tax purposes is rationally related to assets connected with the taxing state (generally by examining whether the taxing power exerted by the state bears a fiscal relationship to protection, opportunities, and benefits the state provides).
In the case of The Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, North Carolina attempted to tax the income of a New York trust. The trust was located in New York and had assets located in Massachusetts. However, North Carolina attempted to tax the trust based solely on the trust having a North Carolina noncontingent beneficiary. North Carolina attempted to tax this trust despite the fact that the trust made no income distributions to the North Carolina beneficiary and had no North Carolina assets. The North Carolina Department of Revenue relied on N.C. Gen. Stat. §105-160.2, which states in pertinent part:
The tax imposed by this part applies to the taxable income of estates and trusts as determined under the provisions of the Code … The tax is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of this State ….[Emphasis added]
In affirming lower court decisions, the North Carolina Supreme Court held that the statute was unconstitutional as applied to the Kaestner trust because the revenue office conflated the beneficiary and the trust. The court also clearly set the limits to its ruling, stating “[n]either the Code nor Chapter 105 conflates the income of the trust with the income of a beneficiary.” Thus N.C. Gen. Stat. §105-160.2 still stands, but with case law limiting its reach. Trusts similar situated can now claim refunds.
In Linn v. Department of Revenue, the Illinois Appellate Court, Fourth District, determined that Illinois’ attempt to tax a Texas trust through an Illinois statute was unconstitutional as applied. In Linn, an Illinois resident created an Illinois trust, with an Illinois trustee, and Illinois situated assets. The trust was created to benefit the settlor’s granddaughter. After the grantor passed away as an Illinois resident, the trustee distributed the trust’s assets to a Texas trust to be administered in Texas. All of the beneficiaries of the Texas trust, including the granddaughter, resided in Texas. The Illinois Department of Revenue relied on 35 ILCS/1501(A)(2)(D), which defines a resident, in pertinent part, as “an irrevocable trust the grantor of which was domiciled in this State at the time such trust became irrevocable.” [Emphasis added] The court in this case cited Connecticut case law to note the difference between an inter vivos trust and a testamentary trust. According to the court, an inter vivos trust is not created through probate of a decedent’s will in state court. Further, an irrevocable inter vivos trust “does not owe its existence to the laws and courts of the state of the grantor” as does a testamentary trust. In addition, the court noted that Michigan and New York courts have found that the grantor’s state residency was insufficient to establish the minimum connections needed to satisfy the Due Process requirements.
The court also noted that the Texas trust resulted from the exercise of a limited power of appointment that was exercised under the terms of the Illinois irrevocable trust, i.e., the Texas trust did not owe its existence to Illinois law. Further, according to the court, income taxation is examined for the tax year in question. Thus, the court concluded, “what happened historically with the trust in Illinois courts and under Illinois law has no bearing on the 2006 tax year.” The plaintiff asserted that the Illinois income tax on the Texas trust was unconstitutional as applied. Thus, 35 ILCS/1501(A)(2)(D) still stands, but is now limited by the Linn holding.
Neither of these cases address unusual facts – trusts are formed, funded, decanted, and moved all the time; grantors, trustees, beneficiaries, and assets move around as well. These trusts requested relief from income taxation under Due Process provisions (both state and federal), as applied to the facts of that particular case, rather than requesting that the court declare unconstitutional on its face the underlying statute. This is an important distinction because of the standard of proof required. A trust/taxpayer asking for relief based upon its own particular set of facts need only show that the statute, as applied to the particular trust, is unconstitutional beyond a reasonable doubt. Alternatively, a trust seeking to invalidate the statute as a whole on constitutional grounds must show that no set of circumstances exists under which the act would be valid. While the occasional challenge by protesting trusts may have outweighed the additional revenue in the past, continuous challenges are expensive for both the trusts and the states. Most of these statutes were drafted and adopted at a time where there was less movement of trusts, people, and assets. States should consider whether the potential additional revenue outweighs the litigation cost, especially in light of the fact that more and more state courts are ruling against the requisite state nexus for taxation. Perhaps states should further evaluate the criteria a particular statute applies and evaluate it against holdings in other states on similar statutory criteria. This is particularly relevant as trust stakeholders become more informed and may look to form or move the trusts to tax-friendly jurisdictions.
For everything necessary to research, plan, and implement strategies for maximizing your clients’ control while minimizing taxes, take a free trial to the Estates, Gifts and Trusts Portfolios Library .
 Linn v. Dep’t of Revenue, 2 N.E.3d 1203 (Ill. App. Ct. 2013); Fielding v. Comm’r of Revenue, No. 8911-R, 2017 BL 194423 (Minn. Tax Ct. May 31, 2017); The Kimberley Rice Kaestner 1992 Family Tr. v. North Carolina Dep’t of Revenue, No. 307PA15-2, 2018 BL 202913 (N.C. June 8, 2018); T. Ryan Legg Irrevocable Tr. v. Testa, 75 N.E. 3d 184 (Ohio 2016).
 The statute has since been amended twice, but only to cross-references that were changed.
 Chase Manhattan Bank v. Gavin, 733 A.2d 783 (Conn. 1999), cited by both sides, and by the North Carolina Department of Revenue in Kaestner.
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