A recent case out of Pennsylvania has catalyzed a debate on state taxation practices on trusts. An article by WealthManagement, an online resource for estate planning and financial professionals, addressed the debate, noting that the case likely highlights an upcoming evolution of the way states tax the income of trusts.
Taxes and trusts: The basics.
Trusts are viewed as separate legal entities. In addition to federal taxes, state taxes can also apply. The laws governing these taxes vary with each state. Pennsylvania state law applies a trust tax to most trusts in two different ways: once to the trust itself and once to the beneficiary. The first is applied to the income or gains of the trust that was not distributed or credited to the beneficiaries and the second is based on the income of the beneficiary.
Taxes and trusts: Recent cases.
In the past, courts often upheld the application of state income taxes on the income of trusts. Three cases decided in 2013 have moved away from this standard, likely because the nature of finances for this generation often extends beyond state lines.
One of the cases making headlines comes from Pennsylvania. The case involved a taxpayer and two trusts that were created inter vivos by a Pennsylvania resident. Inter vivos trusts are created during the lifetime of the creator as opposed to testamentary trusts, created by a will at the death of the creator. Aside from the creator being a resident of Pennsylvania, there were very few ties to the state. The trustees were not within the state, administration occurred outside of the state, even the source income was outside of Pennsylvania. However, the beneficiaries were residents of Pennsylvania.
One beneficiary received a discretionary payment from the trust and argued that Pennsylvania state income tax should not apply. Ultimately, the court sided with the beneficiary for a number of reasons. One of the more notable justifications was the fact that the trust lacked a substantial nexus with the state. Essentially, in order for a state to validate taxing this income the trust must be sufficiently connected to the state.
Taxes and trusts: Importance of legal counsel.
This case is just one of many that underscore the complex nature of trusts. As a result, those who are looking to establish or update their trusts are wise to seek the counsel of an experienced estate and trust tax planning attorney. This legal professional can review your situation and help better ensure the creation of a trust that not only meets your needs but also makes the most of available tax planning benefits.