State & local taxes: selected issues concerning the state income taxation of nonresident trusts and estates.

• Author: Bergmann, Gregory A.

Trusts have played a significant role in serving affluent families for centuries, and the basic federal statutory landscape for taxing trusts and their beneficiaries has remained relatively intact for about the past 50 years. However, the state income taxation of trusts has become an increasingly complicated and challenging task for trustees and their tax advisers in carrying out their responsibilities to both trust settlors and beneficiaries.

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Some of these challenges are simply inherent in the nature of trusts. For example, at least two aspects of trusts make them distinctive from other taxpayers. First, for income tax purposes, trusts operate as flowthrough entities to the extent that current distributions are made to beneficiaries and as separate taxpayers with regard to undistributed amounts retained at the trust level. Second, a lack of integration exists between the two principal conventions governing the operations of trusts: fiduciary accounting and income taxation.

Other challenges have arisen due to changes in societal and marketplace conditions. Financial markets have dramatically evolved, and there are more investment products and strategies available than ever before. Trust portfolios have moved from traditional "stock and bond" allocations to investments in real estate, private equity, venture capital, and hedge funds. This migration toward more sophisticated investment holdings has increased the complexity of federal and state income taxation and related tax return preparation. Simple investment statements and Forms 1099 have been replaced with complicated Schedules K-l, many of which include pages of supplemental state tax information.

Coincidentally, and particularly noticeable over the past five years, the federal tax compliance environment for taxpayers (including trusts) has become increasingly complex, mainly as a direct result of legislative and regulatory actions taken to address the use of tax shelters, improve disclosures of foreign holdings, and increase overall transparency. Not to be outdone, many states have initiated their own reporting requirements as well.

Finally, the aftermath of the recent financial crisis has left many states with a significant budget shortfall. Consequently, many states are now ramping up efforts to increase tax revenue by enacting new legislation mandating higher taxes or increasing enforcement and collection efforts. Many trustees have noticed increased correspondence and assessments from state tax authorities, particularly as it relates to nonresident state tax compliance.

The convergence of these factors has resulted in the perfect storm for trustees and their tax advisers: Never before has there been as much complexity combined with the heightened risk associated with potential noncompliance. This column attempts to identify, although may not necessarily resolve, selected state income tax issues for nonresident trusts that are a direct result of these recent challenges.

Settlors,Trustees, Beneficiaries

To provide a background for the discussion that follows, this column begins with a brief overview of certain terms particular to the world of trusts and estates. A trust is an arrangement under which one person (the settlor or grantor) transfers title to specific property to another (the trustee or fiduciary), who agrees to hold or manage the property for the benefit of a third person (the beneficiary).(1) The beneficiary may receive income or principal distributions from the trust. Income for this purpose is trust accounting income (sometimes called fiduciary income), which is determined under the terms of the trust agreement and applicable local law.(2) Trust accounting income is a separate concept from taxable income.(3)

In the case of an estate, the decedent is the person who died and thereby created the estate; the executor or personal representative is the person (or organization) responsible for administering the estate; and the beneficiary or heir is the person who will inherit assets from the estate.

Because the income tax treatment of trusts and estates is generally consistent, this column will use the term "trust" to refer to both trusts and estates, unless otherwise noted. In addition, it is not uncommon for government forms and instructions to refer to the trust itself as the fiduciary, and that reference has been used in certain examples that follow.

State Income Taxation of Nonresident Trusts

Similar to the taxation of resident individuals, most states tax a resident trust on all its income and tax a nonresident trust on income sourced to that state. Much has been written about the various state rules for determining when a trust is a resident trust. This column will not specifically review those issues but will instead focus on selected topics relevant to nonresident trusts, including (I) the allocation of state-sourced income between the trust and beneficiaries, (2) passive activity loss rules, (3) net operating loss rules, (4) "throwback" rules, (5) grantor trusts, (6) reportable transaction disclosure requirements, and (7) estimated state tax payments and withholding.

Allocation of State-Sourced Income Between Trust and Beneficiaries

The federal income tax deduction for distributions to beneficiaries makes trusts unique taxpayers.(4) Depending upon the terms of the governing instrument and/or the trustee's actions, trust income may be taxed to:

* The trust on its income tax return (Form 1041, U.S. Income Tax Return for Estates and Trusts);

* The beneficiary on his or her personal income tax return (Form 1040, U.S. Individual Income Tax Return); or

* Some combination of both.

This potential shifting of the liability for the tax payment is accomplished by the trust's distributing income to its beneficiaries and the allowance of an income distribution deduction (IDD).(5) Most states follow federal tax treatment and allow the trust an IDD. Likewise, most states tax beneficiaries on the income associated with the IDD. In many states, the adoption of the federal system is built in because the state uses federal adjusted gross income or federal taxable income as the starting point for the state tax calculation.

However, most states tax nonresident trusts and nonresident beneficiaries only on the income sourced to the state. Most states also allow a nonresident trust an IDD in computing taxable income. California Code Regs. Section 17742 is fairly typical and provides a simple illustration.

B is the executor of the estate of A, who was a nonresident of [California] at the time of death. All the beneficiaries are likewise nonresidents. During the year 1980, the gross income of the estate from all sources amounted to $100,000, $50,000 of which was derived from real and personal property located, and from business transacted, in this state. The losses, depreciation, and depletion sustained with respect to the property in California, and the taxes, licenses, expenses, and bad debts, etc., properly deductible from the California income amounted to $40,000. Thus, the income from California sources, prior to deducting amounts distributed to beneficiaries, amounted to...