Where does your trust live? It depends on who’s asking and the purpose of the question.
If the context is state trust law, a trust’s place of residence is its situs or principal place of administration. The Uniform Trust Code (UTC) doesn’t explicitly define “principal place of administration”—probably because the term appears to be largely self-defining. A trust’s principal place of administration would seem to be the place where most of the trust’s administrative acts are carried out, which in most cases (at least those involving an individual sole trustee or a predominant individual co-trustee) would be where the trustee resides.1 Other relevant factors include the place where the trust records are kept or trust assets held or, in the case of an institutional trustee, the place where the trust officer responsible for supervising the account is located.2 UTC Section 108 allows the terms of a trust to designate the principal place of administration if a trustee’s principal place of business is located in, or a trustee is a resident of, the designated jurisdiction or all or part of the administration occurs in the designated jurisdiction.
If, however, the context is state income tax law, the status of a nongrantor trust as a resident, or not, of a given state may have nothing to do with where it’s administered or where the trustee resides. To assume otherwise could be a potentially serious mistake. In those relatively few states whose laws don’t impose income tax on nongrantor trusts,3 the concept of a trust’s residency for income tax purposes is meaningless. Regarding the remaining states, whether a nongrantor trust is treated as a resident for income tax purposes often determines whether the trust’s undistributed income and realized capital gains will be subject to income tax in one or more of such states and generally depends on the presence of one or more of the following factors:
• If the trust was established by will, whether the testator resided in the state at his death (the testator residence test);
• If the trust was established by an inter vivos instrument, whether the settlor resided in the state at the time the trust was established (if the trust was irrevocable from the moment of establishment) or at the time the trust became irrevocable (if the trust, at the time of establishment, was revocable) (the settlor residence test);
• The location of the trust property;
• Whether the trust is administered in the state (the place of administration test);
• Where the trustee resides (the trustee residence test);
• Where the beneficiaries reside (the beneficiary residence test); and
• Whether the trust instrument provides that the trust is to be governed by the laws of the state.
Possible State Tax Outcomes
There’s a dizzying array of possible state income tax outcomes for nongrantor trusts depending on the subject trust’s facts and circumstances. For example:
• If the trust was established by the will of a testator who resided in a state whose laws impose the testator residence test (State A), or if the trust, irrevocable from the moment of establishment, was established, by an inter vivos instrument, by a settlor who resided in a state whose laws impose the settlor residence test, the trust will be considered a resident of that state and so will be subject to that state’s income tax regime, indefinitely, regardless of the presence (or lack thereof) of any other factors.4
• If the trust is administered in a state whose laws impose the place of administration test (State B), the trust will be considered a resident of that state and so will be subject to that state’s income tax regime, for as long as the trust continues to be administered in that state, regardless of the presence (or lack thereof) of any other factors.5
• If the trust has one or more beneficiaries residing in a state whose laws impose the beneficiary residence test (State C), the trust will be considered a resident of that state and so will be subject to that state’s income tax regime, for as long as one or more beneficiaries continue to reside in that state, regardless of the presence (or lack thereof) of any other factors.6
• If the trust is considered a resident of a given state because of the testator residence test or the settlor residence test, but no trust beneficiaries reside in the state, the state’s laws don’t impose income tax on the undistributed income and realized capital gains of the trust.7
• If the trust was established by a testator or settlor who resided in State A, is administered in State B and has one or more beneficiaries residing in State C, the trust will be subject to the income tax regimes of all three states! Depending on the identity of State A, State B and State C, there may be credits under the laws of one or two of the states that would partially offset the income tax required to be paid to the other state or states.
• If the trust was established by a testator or settlor who resided in State B, the trust is administered in State A and no beneficiary of the trust resides in State C, the trust isn’t subject to the income tax regime of any state, notwithstanding that each such state has a statutory scheme that imposes income tax on the undistributed income and realized capital gains of resident nongrantor trusts.
There are other issues that add still further complexity. First, while an irrevocable grantor trust, because it doesn’t have a separate existence and isn’t recognized as a separate taxpayer for income tax purposes,8 would seem not to be within the scope of this discussion,9 grantor trust status inevitably ends, most often because of the death of the grantor, which may occur unexpectedly. At that juncture, depending on the presence of one or more of the factors listed above, the trust’s income tax posture could be surprising and unwelcome. Second, income of a nongrantor trust whose “source” is deemed to be in a given state where the trust isn’t considered a tax resident will frequently be subject to tax under the laws of that state.10 Third, there’s a growing trend among state courts to strike down as unconstitutional state laws that purport to categorize nongrantor trusts as state tax residents solely because of connections to the state that are judged to be tangential or irrelevant to the question of whether the state provides a benefit to the trust that reasonably justifies that state’s assessment of tax on the trust’s income.11
Designing Irrevocable Trusts
State income tax issues deserve careful focus by estate planners when designing irrevocable trusts and by trustees when administering them. In the planning phase, it’s important to identify those circumstances in which it may be possible to structure a nongrantor trust so that its undistributed income and realized capital gains generate no or only a small amount of state income tax. If the client doesn’t reside in a state whose laws impose the testator residence test or the settlor residence test, the opportunity to design the trust to avoid or minimize state income tax shouldn’t be overlooked. Of course, the client may decide that non-tax factors, such as where the preferred trustee happens to reside, dictate setting up the trust in a manner in which otherwise avoidable state income tax will be imposed.
Change in Place of Administration
At the outset of or during administration of a nongrantor trust, the trustee may wish to think about whether a change in the place of administration (which will often require replacement of the existing trustee) could enable the trust to avoid or minimize state income tax. In some cases involving nongrantor trusts, state income tax is nothing more than a wasted trust expenditure. In other cases, the trustee may conclude that, even if a change in the place of administration could enable the trust to avoid or minimize state income tax, there are real, meaningful, countervailing non-tax benefits, such as the trustee’s long-standing familiarity with and proximity to the beneficiaries or the trustee’s special skills in dealing with unique trust assets, arising from retaining the trust’s current place of administration. Moreover, if the trust was established by a testator or settlor who resided in a state whose laws impose the testator residence test or the settlor residence test, avoidance or minimization of state income tax may not be possible in any event.
Estate-planning professionals and fiduciaries should be aware of the opportunities to design, change and move nongrantor trusts in ways that could eliminate or minimize state income tax and evaluate whether such opportunities should be implemented.
1. Uniform Trust Code Section 108, Comment.
3. Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington and Wyoming.
4. See, for example, Me. Rev. Stat. Ann. Tit. 36, Section 5102(4)(B),(C); Neb. Rev. Stat. Section 77-2714.01(6)(b),(c).
5. See, for example, Colo. Rev. Stat. Section 39-22-103(10); S.C. Code Ann. Section 12-6-30(5).
6. See, for example, Tenn. Code Ann. Section 67-2-110(a).
7. See, for example, Del. Code Ann. Section 1636; Section 143.331, RSMo.
8. All items of a grantor trust’s income, deduction and credit are attributed to and reported on the individual income tax returns of the grantor as if the trust property were owned directly and unqualifiedly by the grantor. See Revenue Ruling 85-13.
9. But at least one state, Pennsylvania, doesn’t recognize the concept of a grantor trust.
10. See, for example, Section 143.381.1, RSMo.
11. See, for example, Linn v. Department of Revenue, 2 N.E.3d 1203 (Ill. App. Ct. 2013); Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, 12 CVS 8740 (N.C. Super. Ct. April 23, 2015).