How States Treat Taxation of Trusts

By Mary Kay Foss
Trusts are taxed by a state based on residency, determined by either:

Federal Guidance
The Supreme Court weighed in on the issue twice in the 1920s. The renowned Justice Oliver Wendell Holmes wrote the opinion in Brooke v. City of Norfolk (1928) and wrote a dissenting opinion in Safe Deposit & Trust Co. v. Commonwealth (1929). A state can’t tax its resident beneficiary for trust assets she never received (Brooke, 1928). A state can’t tax a nonresident trustee just because a trust beneficiary is a resident (Safe Deposit, 1929). Of course, a state can tax its resident for trust income actually received, and a state can tax its resident trustee for property actually owned.

The U.S. Constitution 14th Amendment states, “No state shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any state deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws.”

The Supreme Court clarified due process in International Shoe (1945): “Due process requires only that in order to subject a defendant to a judgment in personam, if he be not present within the territory of the forum, he have certain minimum contacts with it such that the maintenance of the suit does not offend traditional notions of fair play and substantial justice.”

International Shoe was not a tax case, but the Supreme Court of the United States cited it in Quill Corp. v. North Dakota in 1992: “The Due Process Clause requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax, and that the income attributed to the State for tax purposes must be rationally related to ‘values connected with the taxing State.”

In South Dakota v. Wayfair, Inc., [138 SCt 2080 (2018)], the Supreme Court held that the physical presence standard for out-of-state sellers of goods under Quill was “unsound and incorrect.” Under Wayfair, a state may impose a state sales tax on an in-state consumer, notwithstanding the lack of the seller’s physical presence in that state. This holding, however, does not seem to impact state fiduciary taxation. So, we’re still looking for some “minimum connection rationally related.”

What States Are Doing
California subjects a trust to tax based on the residence of the trustee and a noncontingent beneficiary, while 14 other states base fiduciary income tax on the residence of the trustee. Arizona, Hawaii and Oregon are the closest states using the trustee as the determining factor.

Georgia, North Carolina, North Dakota, Pennsylvania and Tennessee also taxi a fiduciary based on the residence of the current beneficiary. Trusts created by a living resident (inter vivos) are taxable as residents in 25 states. The residence of the decedent creating the trust is the factor in 27 states. Virginia is the only state that seeks to tax fiduciaries based on four of the five criteria used for taxation. The residence of the beneficiary is the only one they don’t use.

Recent Court Cases
In North Carolina Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S. June 21, 2019), the Supreme Court held that North Carolina violated the “due process” clause in taxing the trust based on the residence of a contingent, discretionary beneficiary of the trust. The contingent beneficiary moved to North Carolina after the trust was created by a New York resident. All trust assets, the settlor and the trustee were located outside of North Carolina.

William Fielding, Trustee v. Comm. of Revenue (Minnesota Supreme Court, No. A17-1177, July 18, 2018) held that an inter vivos trust created in Minnesota that became irrevocable when the grantor was a Minnesota resident was not a resident trust when the beneficiaries, trustee and administration of the trust were outside of Minnesota. The state considered the facts that the trust was written in Minnesota, that the drafting attorneys retained a copy of it in Minnesota, the agreement cited Minnesota law and it was initially funded with shares of a Minnesota S corp as sufficient to treat it forever as a Minnesota resident trust. The U.S. Supreme Court denied hearing an appeal.

What Does California Law Say?
In California, the tax is imposed on “the entire taxable income of a trust if the fiduciary or beneficiary (other than a beneficiary whose interest in such trust is contingent) is a resident, regardless of the residence of the settlor” [California Revenue and Taxation Code (CRTC) Sec. 17742(a)]. There is a two-tier system of applying the law when not all beneficiaries and trustees are resident in the state per FTB Notice 98-12. 

First, income is apportioned by looking at the number of trustees in California (CRTC Sec. 17743); second, you look to the number of non-contingent beneficiaries in the state. 

In Paula Trust v. California Franchise Tax Board, a trust with one of two trustees residing outside California pursued a refund claim for half of the income derived by the trust. It owned an interest in a California LLC that sold an interest in a California business in 2007. There were no distributions in that year to the beneficiary. In 2018, the Superior Court for the County of San Francisco held that the trust was entitled to a refund.

FTB appealed the case (now called Alan Steuer as Trustee v. Franchise Tax Board) based on regulations which state that a trust is taxable on its California source income (derived from real and tangible property in California and businesses conducted in California), and on the proportion of “all net income … from all other sources which eventually is to be distributed to the non-contingent beneficiaries who are residents of this State” (18 Cal. Code Regs. Sec. 17744). The Appeals Court agreed with FTB that only income that is not California source income is allocated based on the resident status of trustees. The LLC income was California source and the trust was taxable in the state just as a nonresident individual would be. The case also clarified that the beneficiary was a contingent beneficiary in 2007 because she received no income from the trust even though she resided in the state.

For a state-by-state comparison of how trusts are taxed see the Aug. 14, 2019, ACTEC.org article “Bases of State Income Taxation of. Nongrantor Trusts for 2018” by Richard W. Nenno, Esq. (Wilmington Trust).

Mary Kay Foss, CPA is an instructor for the CalCPA Education Foundation and a member of the CalCPA Estate Planning Committee and Committee on Taxation.