How Do States Determine Trust Income Tax Nexus in the Modern Era?

Families with significant wealth that will be held in multigenerational trusts may find opportunities to reduce state income tax exposure through a regular review of the income tax situs of the trusts and the types and location of their income. Ideally, a trust’s nexus review is part of the initial planning process, but nexus should also be reviewed when a trust is already in place or when there is a change in law or circumstances that could impact the nexus of the trust or its sources of income.

States may use numerous factors to establish trust nexus, including:

• The location of assets;
• The location of trustees, fiduciaries, and certain types of beneficiaries;
• The type of assets and beneficiary interests in the trust assets; and
• The location of the grantor when the trust became irrevocable.

Most trusts hold a variety of assets and allocate the responsibility for various trust duties to multiple individuals, advisors, and trust companies. Such dispersed responsibilities often prevent or complicate a trust nexus review to determine and monitor whether there may be tax obligations in multiple jurisdictions.

The cases discussed below reveal the burgeoning efforts of the states to introduce the concepts of the unitary business principle and of investee apportionment into the field of trust taxation, often resulting in conflicts between statutory provisions applicable to individuals and trusts and those applicable to corporations, as well as conflicts between long-standing principles of jurisdiction over trusts, as in Curry v. McCanless, 307 U.S. 357 (1939), and more recent principles of taxation of multistate business, as in Allied-Signal v. Dir., Div. of Taxation, 504 U.S. 768 (1992).

The unitary business principle calls for determining state apportionment of business income earned in more than one state by looking at entity unity, while investee apportionment uses apportionment factors of the entity instead of the investor taxpayer.

US Supreme Court

There is a limited number of US Supreme Court cases directly addressing when a trust has established sufficient nexus with a state for the constitutional imposition of a tax on the income to the trust based on due process. The Court’s most recent such decision, on appeal from the North Carolina Supreme Court, is North Carolina Dept. of Rev. v. The Kimberley Rice Kaestner 1992 Family Trust, 588 U.S. 262 (2018).

In Kaestner, the facts were generally taxpayer-favorable, as the trust was created by a New York resident and governed by New York law, it was no longer a grantor trust, and its sole connection to North Carolina was through discretionary beneficiary residents. The Court ruled that “the presence of in-state beneficiaries alone does not empower a State to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain to receive it” given the trustee’s discretion under the trust instrument. Id. The Court expressly limited its holding to the facts before it and did not address the constitutionality of statutes that rely solely on beneficiary residence. Interestingly, as discussed below, even California requires beneficiary nexus to be noncontingent to establish income tax nexus.

State Supreme Courts

A few state supreme courts have ruled on notable trust income tax nexus cases. While these cases are not binding on other states, when considered in conjunction with the Kaestner case, which is binding precedent for all jurisdictions, they may indicate the direction in which courts are going regarding perpetual or threadbare state tax nexus positions.

Illinois
Linn v. Dept. of Rev., 2013 IL App (4th) 121055888 (2013) dealt with an inter vivos trust created by an Illinois-domiciled individual that became irrevocable while the grantor remained domiciled in Illinois. The trust was administered by an Illinois trustee pursuant to Illinois law. Under Illinois income tax law, upon becoming irrevocable, the trust became a resident of Illinois in perpetuity, forever taxable on all its income. Illinois asserted this position when, after the trustee distributed the trust property to a new Texas trust, the trust filed its Illinois tax return as a nonresident. When the Texas trust was created, there were no noncontingent beneficiaries resident in Illinois, no trust fiduciary resident in Illinois, no trust assets in Illinois, and no mention of Illinois law in the trust documents.

The Illinois Appellate Court drew a line between the trust’s historical connections to Illinois and its contemporaneous connections to Texas in the tax year at issue, concluding that the trust now received the benefits and protections of Texas law, not Illinois law, and that Illinois lacked the constitutionally requisite due process contacts with the trust income. The court found that for a tax to comply with due process requirements and for Illinois to tax trust income: (1) a minimum connection must exist between Illinois and the person, property, or transaction it seeks to tax within the period it seeks to tax, and (2) that the income attributed to Illinois for tax purposes must be rationally related to values within Illinois. The appellate court noted that there were no Illinois resident beneficiaries in the years at issue and concluded that the grantor’s residence in Illinois was insufficient to satisfy due process.

Although Illinois did not amend its trust residency provisions in response to the Linn decision, it adheres strictly to the holding and facts in Linn, specifically, that no jurisdiction is conferred on Illinois when none of the following factors exist in Illinois:

• The trust instrument’s provisions;
• The trustees’ residence;
• The beneficiaries’ residence;
• The trust assets’ location; and
• The location where the trust’s business is conducted.

See, e.g., General Information Letter IT-22-0012 (Dec. 6, 2022).

Minnesota
One week after its decision in Kaestner, the US Supreme Court denied certiorari to Fielding v. Commissioner, 916 N.W.2d 323 (Minn. 2018), a case in which the trust’s contacts with the state were much stronger than in Kaestner. The Fielding case had a taxpayer-favorable result at the state court level, with the Minnesota Supreme Court ruling that the trust income from the sale of stock was not subject to Minnesota income tax based on a lack of due process constitutional nexus between the trust and the state of Minnesota.

In Fielding, the grantor was a Minnesota resident and, as in Kaestner, the trusts were irrevocable inter vivos trusts. In Fielding, four trusts were set up by the grantor for his children in 2009 and were taxed to the grantor for income tax purposes until December 31, 2011, when he released his grantor power. The trusts used Minnesota law and one of the beneficiaries was a Minnesota resident. The original trustee lived in California, and the successor trustee was appointed on January 1, 2012, and lived in Colorado. On July 24, 2014, a new sole trustee domiciled in Texas was appointed. Shortly after, the Minnesota S corporation stock owned by the trusts was sold. Since the stock was sold midyear, there was some Minnesota business income that was taxed to the trusts in Minnesota in 2014. The Minnesota Department of Revenue took the position that the trust was a Minnesota resident trust and therefore all gain from the sale of stock was subject to Minnesota income tax.

The court upheld the Minnesota Tax Court’s ruling in favor of the trusts, seemingly giving heavy weight to the location where decisions were made regarding trust assets and the extent of state “services, benefits, and protections” enjoyed by the taxpayer “during the year in which tax was imposed,” citing Luther v. Comm’r of Revenue, 588 N.W.2d at 509 (Minn. 1999). A series of factors—choice of law, limited beneficiary connection, grantor domicile when the trust became irrevocable, and business interests in a Minnesota S corporation—were deemed not sufficient to create tax nexus in this case.

Since Fielding, the Minnesota Department of Revenue has included several factors, in addition to the statutory provisions, to determine minimum connections to Minnesota for income tax purposes, for both irrevocable testamentary and inter vivos trusts (Minnesota Revenue Notice #23-01; Resident Trusts). The pertinent connections, established through a “facts and circumstances” analysis for each tax year at issue, include:

• The residency of trustees, fiduciaries, protectors, advisors, and custodians;
• The location of the trust’s tangible and intangible assets;
• The location of the administration of the trust (investment of trust assets, distribution of trust assets, record keeping, preparation of tax forms, undertaking of other administrative services, fiduciary functions, and the conduct of trust business, litigation, and administrative proceedings);
• The laws made applicable to the trust by the governing trust documents or the laws of Minnesota;
• The residency of the beneficiaries and whether they have some degree of possession, control, or enjoyment of the trust property;
• The domicile of the grantor, settlor, or testator;
• Whether and where the trust was probated; and
• Whether Minnesota’s courts have a continuing supervisory or other existing relationship with the trust.

Minnesota also provides a Resident Trust Questionnaire to help determine if the trust minimum connections threshold has been met. These resources provide a good outline of potential facts and circumstances to review, regardless of state, as a proactive measure to determine possible trust nexus determination factors.

New Jersey
The New Jersey Superior Court, Appellate Division, upheld the New Jersey Tax Court’s decision in Residuary Trust A U/W/O Fred E. Kassner v. Dir., Div. of Taxn, No. 0A-3636-12T1 (NJ. App. Ct. May 28, 2015) preventing the New Jersey Division of Taxation from taxing undistributed income of a trust with no tangible assets or trustees in New Jersey. The trust was a resident trust because it was created when Mr. Kassner was a New Jersey resident and the trust’s primary assets were interests in New Jersey S corporations with business income correctly apportioned between New Jersey and other state sources.

The issues in this case were “(1) whether New Jersey may properly tax the undistributed income of a testamentary trust; and (2) whether ownership of stock in a New Jersey S corporation constitutes ownership of New Jersey assets.” Residuary Trust A v. Dir., Div. of Taxn, 27 N.J. Tax at 71 (Tax 2013). The Division of Taxation argued that the presence of some New Jersey income and assets owned by a resident trust was sufficient to tax all the trust’s income. The appellate court disagreed, quoting the Tax Court’s opinion: “New Jersey cannot tax a trust’s undistributed non-New Jersey income if the trustee, assets and beneficiaries are all located outside New Jersey, because in that situation the trust lacks minimum contacts with this State (Residuary Trust A v. Dir., Div. of Taxation, 27 N.J. Tax at 72 (Tax 2013)).”

The holding essentially creates a scenario where even if the trust is a resident trust, it will not be taxed on all income perpetually if there are no tangible assets in New Jersey. Ownership in S corporations incorporated in New Jersey is not enough for the trust to be deemed to own New Jersey tangible assets. Having some New Jersey income is also not enough to be able to tax the entire trust income in New Jersey, even if the trust is defined as a resident trust. Since the court ruled that the S corporation wasn’t a tangible asset to create income tax nexus to a resident trust, this would potentially eliminate gain on the sale of the S corporation stock by the trust as well. If so, that would be consistent with the holding in the Minnesota Fielding case, discussed above.

Ohio
In Corrigan v. Testa, 149 Ohio St. 3d 18, 2016-Ohio-2805, the Ohio Supreme Court held that due process was violated when Ohio taxed capital gains of a nonresident on the sale of an interest in an LLC with Ohio activities. The court stated that “the activity at issue is a transfer of intangible property by a nonresident” and thus “Ohio’s connection is an indirect one.” Id. at ¶36. Moreover, while the pass-through income of the LLC clearly had a connection to Ohio business activity of the LLC, the “sale of his interest in [the LLC] did not avail him of Ohio’s protections and benefits in any direct way.” Id. Corrigan did not involve a trust, but it served as the reference point when the Ohio Supreme Court tackled an ostensibly similar fact pattern involving a nonresident trust.

Subsequent to Corrigan, in T. Ryan Legg Irrevocable Trust v. Testa, 149 Ohio St. 3d 376, 2016-Ohio-8418, the Ohio Supreme Court held that Ohio income tax was due on capital gain from the sale of stock of an Ohio-based S corporation by one of its nonresident shareholders, a Delaware irrevocable trust. The grantor of the trust was the founder, manager, and 50% owner of the Ohio-based S corporation, but the irrevocable trust had no contacts with Ohio. The court rejected the trust’s due process challenge premised on the Corrigan decision, finding instead that in this instance the grantor’s contacts with Ohio sufficed for due process to allow Ohio to tax the gain. The key difference between Corrigan and Legg, the court said, was that “unlike Corrigan, Legg was a founder and manager of the business of the pass-through entity” and that was a material difference, because in Corrigan there was “the absence of any assertion or finding that Corrigan’s own activities amounted to a unitary business” with that of the LLC in which he sold his interest. Id. at ¶67.

California
Under California’s personal income tax (§17952 of the Rev. and Tax’n Code), income from intangible property is sourced to a nonresident’s state of residence unless the property acquires a business situs in California. This issue was litigated by the shareholders of Pabst, an S corporation with multistate operations, including in California. The shareholders were three trusts that received a gain distribution from the S corporation upon its sale of a subsidiary.

In The 2009 Metropoulos Family Trust v. California Franchise Tax Bd., 79 Cal App. 5th 245 (2022), the California Court of Appeal held that the pass-through pro rata share of gain from the sale was characterized and sourced as business income apportionable to California by the S corporation for corporate tax purposes and thus, for the trusts’ personal income tax reporting purposes, had acquired a California situs subjecting it to tax. Further, on the alternative position that the gain was intangible goodwill sourced as income from intangible property for California personal income tax purposes, the Court of Appeal held that the goodwill had acquired a business situs in California resulting from the actions of the S corporation, rather than those of the trust.

A key distinguishing factor in this case is that the three trusts conceded that the Pabst business was a “unitary business,” and hence its business income was apportionable. The appellate court in Metropoulos found “[t]here is import to plaintiff’s concession” because business income of a unitary business “includes income from intangible property–such as the goodwill here[.]” Id. However, the appellate court also introduced a dubious rationale that relying on the personal income tax provisions applicable to nonresidents was to argue for an “exemption” from the unitary business income provisions of the Corporation Tax Law. Framing the issue in that manner, the appellate court concluded it was required to strictly construe “exemption” provisions against the taxpayer and to favor the California Franchise Tax Board. The decision opens the door for a similar argument that, for instance, when the Personal Income Tax Law generates a higher tax for California (e.g., income of a resident) than under the Corporation Tax Law (nonbusiness income of an S corporation), the latter could then be viewed as an exemption to the former.

California and New York
California and New York have long been known as progressive income tax jurisdictions: both have high income tax rates and neither one allows incomplete gift non-grantor trusts (INGs) to prevent grantors from escaping income tax on trust assets. Interestingly, while California does not currently have a state estate tax, New York has a cliff estate tax, whereby once the decedent’s assets exceed the threshold amount, the entire estate is subject to New York estate tax (except as apportioned by residency or other state estate taxes).

Another similarity between California’s and New York’s tax regimes is that they both impose a resident trust beneficiary throwback income tax. In this context, a throwback tax is imposed if the trust’s income does not meet the nexus requirements to be currently taxed in a state, but there are contingent beneficiaries in that state. When a contingent beneficiary receives a distribution in excess of trust income for a given year, there may be a discrepancy between what the state receives as tax from income for that year and the distributions that include accumulated income for prior years to a resident beneficiary.

In California, if there is a noncontingent resident beneficiary, the trust will be deemed to have nexus and be subject to California income tax. If a trust is not taxed in California and there are California contingent beneficiaries, then a throwback tax may be applied to distributions of trust income made to California beneficiaries in the year distributed based on the amount of accumulated — but undistributed — trust income for years when the contingent beneficiary was a California resident.

For example, Trust is not considered a California trust, but it has a contingent California resident beneficiary. In Year 1, Trust has income of $1 million but makes no distributions to the California beneficiary. If in Year 2 Trust has zero income, but makes a $500,000 distribution to the California beneficiary, then that $500,000 is subject to California income tax based on Year 1 undistributed income.

New York has enacted a similar statute to prevent accumulated distributable net income of New York exempt resident trusts from being pushed out to New York beneficiaries as principal distributions not subject to New York income tax. New York exempt resident trusts are resident trusts, because they were created by New York grantors, but do not have trustees, assets, or income in New York. When these trusts have discretionary New York beneficiaries, an inconsistency between New York taxable income and the distribution may arise.

In both states, the forms and calculations may be complex, so planning and documentation by professionals is advisable.

New York provides some exceptions to the application of the throwback tax, specifically when:

• The trust’s income has already been subject to New York tax;
• The income was earned before Jan. 1, 2014;
• The income was earned during a period when the beneficiary was not a New York resident; and
• The income was earned before the beneficiary turned 21.

While these exceptions are hard to plan around, if a taxpayer has younger children or grandchildren, there may be opportunities to accumulate significant income before the beneficiaries reach 21 years of age. Of course, sprinkle trusts may create complications for beneficiaries with various ages. Overall, throwback taxes further complicate planning and trust state income tax computations.

Finally, while several states consider trustee residency for trust income tax nexus purposes, another unique factor of California’s trust income tax rules is that California will tax pro rata based on the location of the trust fiduciaries, if there is more than one fiduciary (California R&TC §17743). California’s definition of fiduciary “includes a trustee of a trust including a qualified settlement fund, or an executor, administrator, or person in possession of property of a decedent’s estate,” which is broader than the appointed executor, personal representative, or trustee (Ca. Fid. Inc. 541 Tax Booklet).

Takeaways

State laws vary significantly on which factors to consider to determine trust income tax nexus, and how those factors will apply, with considerations for the location of the grantor, beneficiaries, fiduciaries, and assets that likely change over the duration of the trust. Additionally, states regularly revise their statutes, regulations, guidance, and court decisions may continually change this landscape. Courts currently appear to be trending in the direction of disallowing perpetual trust income tax nexus based on grantor location when the trust became irrevocable. For states that have not litigated the issue, or if taxpayer facts deviate from judicial precedent, the audit and litigation risks of discontinuing trust tax filings should be considered.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Abbie M.B. Everist, JD, LLM, MBA, MA, is a principal at BDO National Tax Office, Private Client Services. Michael J. Wynne, JD, is of counsel at Jones Day.