Fifty Nifty United States: State Income Taxation of Trusts
(Originally presented at New Hampshire’s 32nd Annual Tax Forum in November 2014)
Forty-two states and the District of Columbia impose an income tax on resident trusts as well as state-sourced income of nonresident trusts. Thus, state income taxation of trusts is an area with an overabundance of rules at play. Researching and understanding the tax laws of each state with a possible connection to the trust is essential to providing complete and accurate tax return compliance.
Compliance issues: New England States
All of the New England states other than New Hampshire have a broad based income taxation regime of trusts. New Hampshire no longer taxes interest and dividends earned by non-grantor trusts though it does still have an entity level tax on business activities engaged in by the trust.
The basis for taxation as a resident trust differs in each state. While a state by state review of the specific rules is beyond the scope of this article, one must understand the importance of identifying the connections a trust has to a particular state (or multiple states) and the unique rules that each state may employ for subjecting a trust to income taxation.
In addition, each state provides its own definitions of modifications to arrive at taxable income, deductions, and credits. Most states determine the taxable amount by starting with the federal taxable amount and then making certain adjustments.
Estimated tax payments, too, come with distinct rules. For instance, Connecticut requires estimated tax payments equal to 90% of the current year tax or 100% of the prior year tax if the prior year included a full twelve month period. In the initial year of filing, the trust must remit 90% of its current year tax to avoid underestimated tax penalties. Exceptions to the estimated tax obligation include a trust that was a full year resident for the prior year but did not file because it had a zero Connecticut tax liability and a nonresident trust that had prior year Connecticut source income but did not file because it had a zero Connecticut tax liability.
Maine requires estimated tax payments equal to 90% of the current year tax or 100% of the prior year tax if the prior year included a full twelve month period. Massachusetts requires estimated tax based on the current year taxable income. Estimated tax payments must be remitted electronically if net taxable income is $50,000 or more. Rhode Island requires estimated tax payments equal to the smaller of 100% of current year tax or 100% of prior year tax. Vermont does not require trusts to make estimated tax payments.
With respect to identifying differences between federal and state taxation, of note, Massachusetts does not follow the federal 65 day election under IRC § 663(b).
States subject nonresident trusts to taxation on income sourced to that specific state. The definition of source income will vary from state to state under the applicable statutes. Generally, source income is income attributable to specific assets or business activities occurring in a state. Examples include income generated from tangible personal property or real property located within the state or an operating business with activity occurring in the state. Source income generally does not include portfolio income such as interest, dividends, and gains on intangible property.
Grantor vs. non-grantor trusts
The ordinary income and capital gains realized in a non-grantor trust are taxed either at the trust level or to the trust beneficiary in accordance with the terms of the trust instrument, beneficiary distributions, and the Distributable Net Income (DNI) rules under the Internal Revenue Code (IRC).
Income, deductions, and credits of a trust properly treatable as a grantor trust for income tax purposes under the IRC will be reportable by the grantor. Most states – but not all – recognize the federal rules of grantor trust status for income tax purposes. Of note, Alabama, Tennessee, Pennsylvania, Louisiana, and the District of Columbia do not follow in all regards federal law with respect to grantor trust taxation.
With respect to the New England states, typically if a return is filed with the IRS for a grantor trust, a return should likewise be filed with the applicable states. Maine is an exception to that general rule as it does not require the filing of a return for any grantor trust. Massachusetts requires the filing of an information return, Form 2G, with the Massachusetts Department of Revenue; however, the income, deductions, and credits will be attributable to the grantor/owner in accordance with federal rules.
ESBTs and QSSTs
Under federal law, S corporation stock may be held by only certain types of trusts without terminating a valid S election. Permitted trust shareholders include voting trusts, testamentary trusts for a two year period following receipt of the stock, grantor trusts, Qualified Subchapter S Trusts (QSSTs), and Electing Small Business Trusts (ESBTs).
To qualify for ESBT status, all beneficiaries must be individuals, estates, or certain charitable organizations; no beneficiary of the trust may acquire its interest in the trust through purchase; and a valid election must be filed.
An ESBT is bifurcated for income tax purposes into two separate shares: (1) an S portion that consists of all S corporation stock; and (2) a non-S portion that consists of all other trust assets. The non-S portion may be taxable as either grantor, simple, or complex depending upon the terms of the trust. In fact, an ESBT may have three distinct taxable portions: a non-grantor S portion, a non-grantor non-S portion, and a grantor portion (which could contain S corporation stock in its own right and any other type of asset).
The tax attributes of the S portion may not be commingled with the tax items of the non-S portion. The S portion takes into account the items of income, deductions, gains, losses, and credits reported on the S corporation Schedule K-1. In addition, state income taxes and administrative expenses must be allocated relative to the respective S portion and non-S portion. The trust pays income tax on the S portion at a flat rate using the highest marginal tax rates.
State taxation of the trust portions will vary from state to state as some states have specific state laws respecting the federal ESBT treatment whereas other states do not. Connecticut, Maine, and New York all follow federal law with respect to ESBT treatment. Under Massachusetts law, the income of the ESBT is taxed to the trust at the same rate it would be if the taxpayer were an individual. On that basis, Massachusetts allows an ESBT shareholder to be included as part of an S corporation composite return. Rhode Island provides that an ESBT with one or more beneficiaries who are Rhode Island residents, will be treated as a Rhode Island resident trust.
To qualify as a QSST, all income must be distributed at least annually to the sole current beneficiary; principal may be distributed only to that same beneficiary during his or her life; the beneficiary’s income interest must terminate at the earlier of the beneficiary’s death or termination of the trust; if the trust terminates during the beneficiary’s lifetime, all assets must be distributed to that beneficiary; and a valid election must filed.
For federal income tax purposes, QSSTs are taxed as grantor trusts with respect to the S corporation of the trust. In the case of a QSST, however, it is not the settlor but the beneficiary of the trust that is taxed as the grantor for income tax purposes. The balance of the trust is taxed as grantor, simple, or complex in accordance with the trust instrument’s provisions. To the extent that a state follows the federal rules with respect to grantor trust income taxation, the trust will not pay an entity level tax on the QSST activity. Instead, the grantor (beneficiary) will report the activity on his or her individual income tax return for both federal and state tax purposes. See above discussion with respect to grantor trust status.
Because of the variety of different ways in which states define a resident trust, it is possible that a trust could be treated as a resident trust in multiple jurisdictions. Be aware of resulting filing requirements and consider ways to limit exposure through credits and/or changing the circumstances of the trust. Depending upon the basis for state income taxation, there may be a remedy.
Understand Trust Provisions and the Law
- Always review the applicable trust instrument.
- Understand all state laws that apply. Such laws include most commonly the state’s respective version of the Uniform Principal and Income Act and the Uniform Trust Code. There are a number of other state laws that may govern aspects of the entity and its administration.
- Consider that taxable income as defined for either federal or state purposes will not necessarily be the same as trust accounting income.
- Obtain other potentially applicable documents such as gift tax returns and estate tax returns (for generation skipping transfer tax treatment, in particular).
- Coordinate with the attorney that drafted the instrument when possible.
- Be mindful of having multiple settlors of the same trust when the settlors are domiciled in different states.
- Consider carefully trustee selection.
- Consider granting to an objective third party the power to remove a trustee and appoint the successor.
- Consider the impact of all trust advisors on the trust’s residency status.
- Consider separate trusts for multiple beneficiaries to prevent taxation of the entire trust‘s income activity based on the residency of one of multiple beneficiaries.
- To the extent allowable under applicable state law, build in flexibility that will allow for changes as residency of parties could change.
- Residency based on the trustee’s location:
- Consider changing the trustee by resignation or removal.
- Evaluate physical relocation of the trustee.
- If a trustee will not resign and cannot be removed, consider adding trustees where the relative number of resident and nonresident trustees matters (California for instance).
- Residency based on the beneficiary’s location:
- For a trust that benefits multiple beneficiaries, consider whether severing the trust into a separate trust for each beneficiary is possible.
- Consider decanting the trust as a means of otherwise splitting up the trust interests. Be aware, however, that decanting or other trust modification may have federal tax implications including income, gift, and GST consequences.
- Consider physical relocation of the beneficiary
- Evaluate the pros and cons of a beneficiary’s disclaimer of an interest in trust.
- Residency based on the location of the administration of the trust:
- Consider moving administrative functions out of that state.
- How extensive is the definition of administration? Does it include simply the location of the trustee? If so, see above.
- Residency based on the settlor’s domicile:
- Have the settlor consider a change of domicile before the triggering event occurs (establishment of trust, change from revocable to irrevocable, death).
- Consider creating a new trust rather than adding to an existing trust when the settlor has changed domicile since creating the existing trust.
When or How Often to Review?
- Before the trust is finalized/funded
- When there is a change in fiduciary
- When a trust changes from being revocable to irrevocable
- Death of the settlor
- When a beneficiary’s interest changes such as at the commencement or termination of distributions
- Whenever the residency of trustee(s), beneficiary(ies), and settlor(s) change
- On an annual basis when the trust income tax returns are prepared
- Review location of tangible and real property owned by the trust
- Review location of business activities.
- Review residency of trustee(s), beneficiary(ies), and settlor(s)
- If there is any change to the situs under the terms of the governing instrument
- Upon a triggering event that changes the status of the trust from grantor to non-grantor or vice versa for income tax purposes
- Upon acquisition of real property, tangible personal property, or a business interest
- Upon sale of real property, tangible personal property, or a business interest
- When engaging a new client with existing trusts
- Consider requesting a ruling from the state taxation or revenue department when it is unclear if the trust is subject to taxation in that state.
- File tax returns with the state taking a reasonable position regarding residency and so document.
- Advise client with respect to any tax, interest, and/or penalties that may apply if either returns are not filed or a no-tax position is not upheld.
- If tax has been paid in states for which nexus or residency was incorrectly determined, apply for refunds within the statute of limitations.
- When residency changes from year to year, file final returns in the applicable state.
If you would like more information or have questions about a specific state, please feel free to contact Jean McDevitt.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.