Residency rules and state trust taxation – beware the traps

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.

Example

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:

• a person domiciled in this state at the time such property was transferred to the trust, if such trust or portion of a trust was then irrevocable, or if it was then revocable and has not subsequently become irrevocable, or
• a person domiciled in this state at the time such trust, or portion of a trust, became irrevocable, if it was revocable when such property was transferred to the trust but has subsequently become irrevocable.

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: