In recent years, there have been numerous state tax cases around the country highlighting the different tax treatments and definitions of resident trusts. Trust residency is defined differently by each state. Even though the particular state rules may not be applicable to a taxpayer at the present time, it is important to be aware of the differences. Trustees, beneficiaries and grantors move constantly, and the fluidity can cause unexpected tax results. In California, even if the trust was created as a resident trust of another state, trusts are considered resident in California if there is a trustee or a beneficiary residing there. Last year, the Supreme Court addressed state taxation of a trust and the determination of residency in North Carolina. Although the specific case only affects North Carolina, the statute in effect made the trust taxable there because of beneficiary residence.
Earlier this year, a New York Advisory Opinion caused a great deal of discussion by ruling that a trust was subject to tax in New York because it failed the statutory exemption to taxation. In making that determination, the New York State Department of Taxation and Finance’s Office of Counsel looked through a mutual fund to determine source income of exempt bond interest. Although this is a New York ruling and is only applicable to New York trusts, combined with other rulings across the country, it does serve as an alarm for trustees. They need to be aware of the movement of beneficiaries (and of their own relocation) and the effect that can have on the taxation of the trusts.
In February, the Office of Counsel ruled that the trust in question was a New York state resident trust and did not qualify for the exemption from tax.
New York state tax law defines a resident trust as a trust, or portion of a trust, consisting of property of:
There was no question that the trust met the definition of a resident trust, but New York has a statutory exception to the taxation of a resident trust if there is insufficient nexus to tax the trust. However, in order for a resident trust to qualify for the exemption the law, three conditions must be met:
The trust that is the subject of the ruling met the first two exceptions, but the counsel ruled that it failed the third point.
The corpus of the trust includes two types of intangible investments. Approximately 15% is invested in a tax-exempt municipal bond fund. Approximately 15% of the total income generated by the bond fund is from New York tax-exempt bonds. The approximately 85% remaining corpus consists of a limited partnership interest in a publicly traded partnership. Less than 1% of the partnership's income is New York source income. Thus, in the aggregate, New York source income accounts for less than 5% of the trust's total income. All the income of the trust has been retained, and no distributions have been made to the trust beneficiaries.
The interpretation that “all” means all is a harsh result and should serve as a caution to trustees of trusts that are resident New York trusts relying on the statutory exemption. In this instance, New York tax-exempt bond income served as the hook to tax the entire trust — income that would not even be taxable in New York.
Although this ruling is for a New York trust, it should serve as a warning to all trustees. With Trustees and beneficiaries moving from state to state, review of trust residency and taxation should become part of an annual checklist. Even the smallest infraction of a state’s residency rules can cause unexpected tax results.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.