CSG Law Alert: What to Know About State Income Taxation of Non-Grantor Trusts
State tax residency and filing requirements can be a complicated issue for non- grantor trusts. Unlike a grantor trust, where the grantor is the deemed owner of trust assets for income tax purposes, a non-grantor trust is a separate tax entity from the grantor with its own filing requirements. Each state has different elements to determine a trust’s tax residency, filing requirements and tax liability, and these different elements often lead to erroneous or missed trust tax filings.
A state’s authority to tax a trust is contingent on the trust’s nexus to the state. Under the Due Process Clause, a trust must have requisite minimum connection with a state to justify taxation. In a 2019 decision, the Supreme Court held that North Carolina’s taxation of a trust based only on the trust beneficiary’s residence exceeded the state’s power to tax a trust under the Constitution.1 Many state taxing authorities have since issued guidance for the application of such states’ tax codes pertaining to trusts to conform with the Supreme Court’s 2019 ruling.
New Jersey and New York both classify trusts as resident or non-resident trusts for income taxation. Under New Jersey and New York statutes, a resident trust is generally (i) a trust that was created under the Will of a New Jersey or New York resident decedent, (ii) a revocable trust that became irrevocable when the grantor was a New Jersey or New York resident or (iii) an irrevocable trust that was created and funded by a New Jersey or New York resident.2 In other words, New Jersey and New York look to the residency of the creator of the trust to determine if the trust is a resident trust. All other trusts are categorized as non-resident trusts.
While resident trusts have a filing requirement for New Jersey and New York, not all resident trusts are subject to state income tax. To avoid infringing on the Due Process Clause and infringing on the Due Process Clause and engaging in unconstitutional state taxation, both New Jersey and New York have the concept of an exempt resident trust. For an exempt resident trust, the trust meets the definition of a resident trust under state tax code but is not subject to state income taxes because the trust lacks minimum connection to the state. For New Jersey and New York, a resident trust will be considered an exempt trust if it has (i) no trustee domiciled in the state, (ii) no trust corpus held in the state and (iii) no source income to the state (discussed below).3 If these three elements are established, the trust has a state filing requirement, but does not pay New York or New Jersey state income taxes on trust income.
Resident trusts that are non-exempt have tax filing requirements to New Jersey and New York, and, generally, all the income of the resident trust is taxed to such state, regardless of where the income is sourced.
Another important concept to state trust taxation is source income. Both resident and non-resident trusts are subject to state taxation on income sourced in such state. For trusts, state source income includes the following income derived from in-state: net income from a business; rents or royalties from real property or business activities; net distributive share of partnership income; and S corp income. Dividends and sales of public stock are typically not sourced to a state for trust taxation.
For example, if a New Jersey non-resident trust sells a home in New Jersey, the trust will have a tax liability to New Jersey for the income it recognizes on the sale. Similarly, if a New York non-resident trust receives partnership distributions from a New York partnership, the trust will have a tax liability to New York on its partnership distributions. Alternatively, a non-resident New Jersey trust would not be considered as receiving source New Jersey income from dividends received from the trust’s ownership in Johnson & Johnson stock.
While not formally approved by New Jersey or New York, there may be certain resident trusts that are only subject to state income tax on source income. When a trust would be an exempt resident trust, except that it receives state source income, such trust may only be subject to state income taxes on the income sourced from the state, as opposed to all the trust’s income. Neither New Jersey nor New York taxing authorities appear to have formally recognized this tax position; however, at least for New Jersey trusts, it is consistent with the ruling of Residuary Trust A (Kassner) v. Director.4 In Kassner, the New Jersey Tax Court held New Jersey could not tax income derived from out of state sources where a resident trust had no New Jersey trustees, assets or current beneficiaries.
As a matter of best practice, tax preparers need to inquire into the particulars of each trust when preparing annual state income tax returns. As discussed above, various fluid factors can determine the state filing requirements and tax imposition, which can change year to year.
1 North Carolina Dep’t of Rev. v. Kimberley Rice Kaestner 1992 Family Trust, 139 U.S. 2213 (2019).
2 20 CRR-NY 105.23(a); N.J.S.A. 54A:1-2(o)(1)
3 20 CRR-NY 105.23(c); Estates and Trusts Understanding Income Tax, Bulletin GIT-12 (Jan. 2023)
4 Kassner Residuary Trust A v. Director, 27 NJ Tax 68 (Tax 2013)