Taxing Resident Trusts: Is Residency of the Beneficiary Enough?

A trust is typically considered a taxable resident when the trust beneficiaries are state residents in the current year, but the constitutionality of that rule has recently been challenged.

By Jeff Weinkle, SALT manager

Under state income tax laws, a nonresident trust is subject to tax on the portion of its income attributable to sources from the state. [1] If a trust is determined to be a resident, the state may tax it on all of its income. While the definition of a “resident trust” varies between states, a trust is typically considered a taxable resident when it meets one or more of the following conditions:

  • Trust beneficiaries are state residents in the current year;
  • The grantor is a state resident in the current year or was a state resident at the time
  • the trust was created, funded or became irrevocable;
  • The trust is formed/governed under state law;
  • The trustee is located in the state; and/or
  • The trust is administered from the state.

The constitutionality of the first of these rules has been challenged recently, and while the outcome was in favor of the taxpayer, the opinion highlights a continuing split among states. On April 23, 2015, the North Carolina Superior Court issued its opinion in Kaestner 1992 Family Trust v. North Carolina, addressing whether North Carolina could tax a trust as a resident based solely on the fact that the trust’s beneficiary was a resident. [2] The North Carolina tax code reads that trusts are taxed on the amount of income that is for the benefit of a state resident, effectively subjecting an entire trust’s income to North Carolina tax when it has North Carolina beneficiaries. [3]

In Kaestner, the court ruled that the residency of a trust’s beneficiary in North Carolina alone is not significant enough under the Constitution to subject the trust to state income tax. The court noted that the trust itself, an entity distinct and separate from its beneficiaries, did not establish contacts with North Carolina and that control of the trust remained with its trustees located outside of the state. These facts led the court to conclude that the tax failed to meet the requirements of the Due Process Clause since no purposeful activity was directed within the state and the tax levied on the trust was not rationally related to any benefits received by the trust from the state.

The tax also failed to meet the requirements of the Commerce Clause by failing the “four-prong test” established by the U.S. Supreme Court in Complete Auto Transit v. Brady. [4] In order for a tax to survive a Commerce Clause challenge, it must pass all four requirements of the Complete Auto test: (i) it must be applied to an activity that has substantial nexus with the state, (ii) it must be fairly apportioned, (iii) it cannot discriminate against interstate commerce and (iv) it must be fairly related to the services provided by the state. The North Carolina court ruled that the first and fourth tests were not met in Kaestner. Since the trust did not have the minimal contacts required under the Due Process Clause, it also did not meet the higher threshold of the substantial nexus requirement. In addition, since the trust itself engaged in no activities and had no actual presence in North Carolina, the court determined that the tax burden did not fairly represent the benefits conferred by the state since the trust did not benefit from any services or legal framework provided by the state.

While the Kaestner decision considers the unconstitutionality of a North Carolina law dictating the taxation of trusts based solely on the residence of its beneficiary, it’s also worth noting a similar case from Pennsylvania two years prior. Although not principally relied upon, the opinion in McNeil v. Commonwealth of Pennsylvania influenced the Commerce Clause analysis of Kaestner court. [5] In a parallel issue, the Pennsylvania Department of Revenue attempted to tax two trusts as residents on the grounds that the grantor was a Pennsylvania resident at the time he formed the trusts. The Pennsylvania tax code reads that trusts created by a resident of Pennsylvania are considered to be resident trusts (and thus ostensibly subject to state tax in perpetuity). [6] The McNeil court ruled that imposing tax on the trusts violated the Commerce Clause on the grounds that the trust did not have substantial nexus with the state and did not benefit from the state’s economic markets, courts or laws. With regard to the substantial nexus requirement, the court concluded that neither the grantor’s status as a resident when the trust was created nor the beneficiaries’ status as residents established physical presence for the trust in Pennsylvania.

Finally, it’s important to note that not all states currently adhere to the opinions found in North Carolina and Pennsylvania. In McCullough v. Franchise Tax Board, the California Supreme Court ruled that the state could constitutionally tax a trust on the basis of having a resident (non-contingent) beneficiary. [7] Even though the resident beneficiary was also a trustee, a fact that differentiates this case from Kaestner and McNeil and would likely survive Due Process and Commerce Clause challenges, the court noted that this fact merely reinforced the state’s independent basis for taxing the trust based on the beneficiary’s state of residence. North Carolina specifically opined in Kaestner that it did not find the McCullough opinion persuasive. Earlier this year, the California Franchise Tax Board made clear that it continues to follow the McCullough opinion when it released a Tax Information Letter clarifying that it still follows California Tax Code §17742(a), the state law which subjects to tax the entire taxable income of a trust if the non-contingent beneficiary is a resident of the state. [8]

While the outcome of these cases may signal a broader change in how states may determine trust residency and tax non-grantor trusts, they currently only affect the taxes assessed by these particular states. However, the fact that these decisions are based on constitutional law rather than state law could be viewed as persuasive to courts in other jurisdictions that may face similar issues. In any case, the existing differences in trust residency laws among the states and courts’ propensity to agree or disagree with them demonstrates the need to consider these factors when establishing new trusts.

Contact Jeff Weinkle, SALT manager, at jeff.weinkle@aprio.com or Jeff Glickman, partner-in-charge of HA&W’s SALT practice, at jeff.glickman@aprio.com for more information.

[1] This article is concerned with non-grantor trusts, which are directly taxed on the income and gains retained within the trust. The income and gains of grantor trusts, which are typically treated as disregarded entities for tax purposes, are taxed to the grantor and thus follow personal income tax rules. The portion of a trust’s income attributable to sources from the state may include pass-through entity income apportioned to the state and/or income from property located within the state.

[2] The Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, Docket No. 12 CVS 8740 (N.C. Super. Ct., April 23, 2015).

[3] North Carolina General Statutes § 105-160.2.

[4] 430 U.S. 274 (1977).

[5] Robert L. McNeil, Jr. Trust v. Commonwealth of Pennsylvania, No. 651 F.R. 2010 (Pa. Comm. Ct., May 24, 2013).

[6] 72 Pennsylvania Statutes Ann. §7301(s).

[7] Robert P. McCullough v. Franchise Tax Board, 390 P.2d 412 (Cal. 1964).

[8] California Franchise Tax Board Information Letter 2015-02, April 21, 2015.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding this matter.

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