THE STATE INCOME TAXATION OF TRUSTS AND estates has become an increasingly complicated and challenging task for trustees and their tax advisers. 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-1, many of which include pages of supplemental state tax information. In turn, it has become common for trusts to have filing obligations in several states.
Last year this column addressed some of the challenges and issues facing trusts that file nonresident state income tax returns. (1) This column complements that column and discusses the credit that a resident trust can claim for taxes paid in the nonresident states.
Similar to the income taxation of resident individuals, most states tax a resident trust on all its income and tax a nonresident trust on income sourced to the state. To avoid double taxation, most states allow a resident trust to claim a credit for taxes paid in the nonresident states. The credit is usually limited to the resident state's tax on the income subject to double taxation or the resident state's tax on income earned in other states (using the resident state's sourcing rules). Some states may even allow the credit when the taxpayer is considered a resident of more than one state.
Many of the same factors that complicate the calculation of the trust's nonresident state income tax also create issues and challenges for computing the credit. Some of these challenges are inherent in the nature of trusts. For example, 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. This dichotomy can result in interesting situations, examples of which are provided below. Further, differences in the rules from state to state cause some of the challenges. This column provides examples of these differences as well.
This column discusses (1) the state income tax add-back and how it affects the calculation of the credit; (2) how the allocation of income between the trust and beneficiaries can make it difficult to determine who deducted the state income taxes and who is the actual taxpayer; (3) how dual-resident trusts complicate the calculation of the credit; and (4) how state throwback rules affect the credit.
State Income Tax Add-Back
Most states do not allow the same tax to be deducted and claimed as a credit For example, the Illinois statute states "[t]he credit provided by this paragraph shall not be allowed if any creditable tax was deducted in determining base income for the taxable year." (2) For individuals, this is usually not an issue because many states either add back all state income taxes or start with federal adjusted gross income (AGI). Trusts, however, usually deduct state income taxes in computing federal taxable income.
In Illinois this created an issue because, for tax years prior to 1989, the Illinois statute did not provide a modification for the non-Illinois state income taxes to be added back. In Zunamon v. Zehnder, a trustee added back the state income taxes for tax years prior to the law change. (3) The Illinois Department of Revenue denied the credit for taxes paid to other states, which in Illinois is called the foreign tax credit. The state took the position that "the trusts were not permitted to add back the federal deduction taken for source state taxes to their Illinois base income in order to preserve their ability to take the foreign tax credit. " (4)
Although the Illinois statute had been amended in 1988 to allow such an addition modification, the legislation was specific in terms of the change's effective date. The statute states, "For taxable years ending on or after January 1, 1989, an amount equal to the tax deducted pursuant to Section 164 of the Internal Revenue Code if the trust or estate is claiming the same tax for purposes of the Illinois foreign tax credit under Section 601 of this Act." (5) The appellate court held for the taxpayer:
The absence of any indication in the statutory language that the legislature previously intended to limit a trust's ability to take advantage of the foreign tax credit, and the policy choice of making this credit available to all resident taxpayers, make it impossible to reconcile and give meaning to the date restriction. This leads us to conclude that the inclusion of the same was an oversight. Thus, in order to harmonize the various statutory provisions and give effect...