Case law opens options for trusts looking to minimize state income taxes.

• Author: Schwartz, Jonathan

A handful of 2013 cases involving the taxation and administration of trusts should grab the attention of tax professionals looking to reduce the state income tax liabilities of their testamentary and inter vivos trust clients. Armed with two planning strategies derived from these recent cases, tax advisers can take steps to alleviate the state tax burden on undistributed trust income.

Using the first of these approaches, a taxpayer could fight a state's assertion of nexus. This would involve making a case to the state that, even though a trust falls under a technical definition of a "resident trust," insufficient connections exist between the trust and the state to constitutionally subject the trust to taxation on its out-of-state income. Depending on the laws of the resident state, a second option may be to change the situs of the trust to a more taxpayer-friendly jurisdiction.

When Does the State Lack Authority to Tax a "Resident Trust" on Out-of-State Income?

The trusts at issue in McNeil v. Commonwealth, 67 A.3d 185 (Pa. Commw. Ct. 2013); Residuary Trust v. Director, Division of Taxation, 27 N.J. Tax 68 (2013); and Linn v. Department of Revenue, No. 4-12-1055 (111. App. Ct. 12/18/13), were all classified as resident trusts by the states in which the petitioners sought relief. As the common thread among the cases, each trust retained minimal connections with those states in the years that followed their creation, despite having been created by residents of the respective states.

In McNeil, resident discretionary beneficiaries represented the only additional connection to the state. Deciding the case under the U.S. Constitution's Commerce Clause, the court found that the "substantial nexus to the taxing jurisdiction" necessary to satisfy the first prong of the Commerce Clause standard in Complete Auto Transit v. Brady, 430 U.S. 274 (1977), could not be sustained based on the residency of discretionary beneficiaries alone. The court also noted that, according to the state's own regulations, "for residency purposes of a trust, '[t]he residence of ... the beneficiaries of the trust shall be immaterial'" (McNeil, 67 A.3d at 194). That left the settlor's residency in Pennsylvania as the lone connection to the state. The court held that "to rely on Settlor's residence in Pennsylvania approximately [48] years before [the year] in question to establish the Trusts' physical presence in Pennsylvania ... would be the equivalent of applying the slightest presence standard rejected by the U.S. Supreme Court in Quill [504 U.S. 298 (1992)]" (McNeil, 67A.3d at 195).

Residuary Trust and Linn were decided under the U.S. Constitution's Due Process Clause. In Residuary Trust, a New Jersey Tax Court decision, the only additional connections between the state and the plaintiff trust were the trust's ownership of S corporation stock in a company that conducted business in New Jersey and the trust's use of...