State Income Taxation Of Trusts
Jeanne L. Newlon
A.Overview Of The Federal Income Taxation Of
Complex Trusts
1.There are three types of trusts for federal income tax purposes: (1) simple trusts; (2) complex trusts; and (3) grantor
trusts.
2.A simple trust is a trust in which the income is taxable to
the beneficiary. To qualify as a simple trust, three requirements must be met:
Jeanne L. Newlon
is a Partner with the law firm of Venable LLP in
Washington, DC. Her practice involves advising individuals of significant means on estate
and gift planning issues, including business
succession, charitable planning, and planning with life insurance. Jeanne received her
J.D. from The George Washington University
with High Honors, her L.L.M. in Taxation from
Georgetown University, and her B.S.B.A. with
a degree in Finance from the University of
Florida. Jeanne is a member of the District of
Columbia Estate Planning Council, Co-Editor
of the Council’s newsletter, Co-Chair of the
Communications Committee, and a mem­ber
of the Council’s Board of Directors. She also
was named as a 2005-2006 John S. Nolan Fellow by the American Bar Association Section
of Taxation and is the Chair of the Fiduciary
Income Tax Committee of the ABA Section of
Taxation. Jeanne is licensed to practice in the
District of Columbia, Maryland, Florida, and
Virginia.
a.The trust agreement must require that all of the trust’s
income be distributed currently. Internal Revenue
Code §651(a)(1). (Unless otherwise indicated, all section references are to the Code.)
b.The trust agreement must not provide that any
amounts are to be paid, permanently set aside, or used
for charitable purposes. §651(a)(2).
c.The trust must not distribute any amounts other than
the required income distribution. Id.
3.A complex trust is any trust that is not a simple trust.
Thus, if income is required to be accumulated or the
trustee has the discretion to accumulate income, even if
the trustee actually distributes all of the income, the trust
is a complex trust. A trust will also be a complex trust in
any year in which a distribution of principal is made and
in any year in which the trust makes a charitable contribution.
4.A grantor trust is a trust in which the grantor or another
person is treated as the owner of the trust assets for federal income tax purposes. See §671(a).
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5. This outline deals with complex trusts.
6.Many of the rules relating to the federal income taxation of individuals apply to the federal income
taxation of complex trusts, but many of these rules have some alterations. For example, the brackets
for trusts are very compressed. The 2009 tax rates for trusts are as follows:
If taxable income is:
The tax is:
of the amount
over - $
$2,300
$5,350
$345.00 + 25%
$2,300
$5,350
$8,200
$1,107.50 + 28%
$5,350
$8,200
$11,150
$1,905.50 + 33%
$8,200
$11,150
. . . . .
$2,879.00 + 35%
$11,150
0
but not over -
$2,300
over -
15%
$0
7.In addition, a complex trust will receive a deduction for the income that it distributes to the trust
beneficiaries. §661(a). The deduction, however, is limited to the trust’s distributable net income (DNI).
§661(b). DNI is equal to the taxable income of the trust computed with the following modifications:
a. The distribution deduction under section 661 is not taken into account. §643(a)(1).
b. The personal exemption under section 642(b) is not taken into account. §643(a)(2).
c.Capital gains are not included unless included in fiduciary accounting income under applicable
state law or the trust agreement or paid, credited, or required to be distributed to a beneficiary or
paid or set aside for charitable purposes. §643(a)(3).
d.Capital losses are not taken into account, except to the extent that they reduce capital gains actually paid or credited to the beneficiaries of the trust. Id.
e.The partial exclusion of gain on the sale of certain small business stock set forth in section 1202 is
not taken into account. Id.
f.Tax-exempt interest is included, but reduced by any disallowed deductions attributable to it. §643(a)
(5).
8.Another unique aspect of the income taxation of complex trusts is that the trustee can make a discretionary distribution of income within the first 65 days of Year 2 but treat the distribution as having
been made on the last day of Year 1. §663(b).
B. State Income Taxation Of Trusts–In General
1.Forty-three states and the District of Columbia impose a tax on the income generated by trusts. The
seven states that do not impose an income tax on trusts are Alaska, Florida, Nevada, South Dakota,
Texas, Washington, and Wyoming. However, just because the grantor created a trust under the laws
of one of these states does not mean that there will not be a state tax on the income of the trust. Many
State Income Taxation Of Trusts | 7
of the other f43 states have rules that may cause the trust to be subject to income tax in one or more
of those states. For an excellent discussion on constitutionality and other issues regarding the state income taxation of trusts, see Richard W. Nenno, “Planning to Minimize or Avoid State Income Taxes
on Trusts,” presented on September 26, 2009, at the 2009 Joint Fall CLE Meeting of the Sections of
Taxation and Real Property, Probate and Trust Law of the American Bar Association.
2.It is important to note that, although a trust is a grantor trust for federal income tax purposes, it may
not be for state income tax purposes. Most states do follow the grantor trust rules of the Internal Revenue Code. However, neither Pennsylvania nor Tennessee recognizes grantor trust status. Therefore,
those dealing with grantor trusts that are taxed under the laws of either state need to be aware of the
separate treatment.
3.Although each state has its own rules about whether a trust will be subject to its income tax, there are
specific rules that help make the determination. They are as follows:
a.If the trust was created under the will of a decedent who was a resident of the state, the trust may
be taxed in that state.
b. If a resident of the state creates an inter vivos trust, it may be taxed in that state.
c. If the trust is administered in the state, it may be taxed in that state.
d. If a trustee of the trust is a resident of the state, the trust may be taxed in that state.
e. If a current beneficiary of the trust is a resident of the state, the trust may be taxed in that state.
4.In some states, there may only be one basis for taxation; other states may use more than one. The
remainder of this outline focuses on the taxation of trusts in California, the District of Columbia,
Maryland, New York, and Virginia.
C. Taxation Of Trusts In California
1. Trusts are subject to income taxation in the State of California if any of the following are present:
a. Any of the trustees are residents of the State of California
b. Any of the noncontingent beneficiaries of the trust are residents of the State of California
c. The trust has California-source income
2.If the trustee or the beneficiary (other than any beneficiary whose interest in the trust is contingent)
is a resident of California, the trust is considered a resident of California so that all income earned
by the trust is taxable in California. Cal. Rev. & Tax Code §17742(a). An individual is considered a
resident of California if he or she is in the state for “other than a temporary or transitory purpose”
or is domiciled in the state but is outside the state for a temporary or transitory purpose. Cal. Rev. &
Tax Code §17014(a). Once residency is established, it continues even during temporary absences from
California. Cal. Rev. & Tax Code §17014(c). If the individual is outside of California for at least 546
consecutive days under an employment-related contract, that individual will be considered outside
of California for other than a temporary or transitory purpose and, therefore, not a resident of Cali
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fornia. Cal. Rev. & Tax Code §17014(d). Any trips back to California totaling not more than 45 days
during the taxable year are disregarded for purposes of calculating the 546-day period. Cal. Rev. &
Tax Code §17014(d)(1).
3.Alternatively, if the individual is domiciled in California but is absent to hold an elective office of the
United States government, to work on the staff of an elective officer in the legislative branch of the
United States government, or to hold an office in the executive branch of the United States government appointed by the President of the United States and subject to confirmation by the Senate and
whose tenure is at the pleasure of the President of the United States, that individual will continue to
be considered a resident of California during the absence. Cal. Rev. & Tax Code §17014(b).
4.If the trust has two or more trustees and not all of the trustees are residents of California, the income
tax attributable to the trust will be apportioned according to the number of trustees who are residents
of California. Cal. Rev. & Trust Code §17743. More specifically, if the trust has two or more trustees
and one or more, but not all, of the trustees are residents of California, and there are no beneficiaries
who are California residents, all of the California-source income plus that proportion of the nonCalifornia source income that the number of California-resident trustees bears to the total number of
trustees will be taxed in California. Cal. Code Regs. tit. 18, §17743. The California Code of Regulations provides the following examples:
Example (1). B, a resident, and C, a nonresident of [California], are the Trustees of a trust created by A. All the beneficiaries are nonresidents. During the year 1980, the trust received $60,000 as rent from real and tangible personal property
located in, and from business carried on in [California], from which expenses of $10,000 were deducted, and $100,200
[sic] income from stocks and bonds, none of which had a business or taxable situs in [California]. None of the income was
paid or credited to the beneficiaries during the year. The $50,000 income from real and personal property located in, and
business transacted in [California] is taxable. Since there are two fiduciaries, one of which is a resident of [California],
one-half of the balance of the income of the trust is likewise taxable to the trust. Thus, the taxable income amounts to
$100,100 ($50,000 from property located in this State, plus one-half of $100,200 which is the remainder of the trust’s
income).
Example (2). E, a resident, and F and G, nonresidents of [California], are the trustees of a trust created by D. All of the
beneficiaries are nonresidents. The corpus of the trust consists entirely of stocks and bonds and property located outside
[California]. One-third of the income taxable under Section 17742 (i.e., net income less the deductions allowed under
Article 1 of Chapter 9), which is the proportion of total income taxable which the number of fiduciaries who are residents
of [California] bears to the total number of fiduciaries, is taxable to the trust.
Id.
5.If there are no resident trustees and there is more than one beneficiary, at least one of whom is a
resident of California, the income tax of the trust, other than on California-source income, is “apportioned according to the number and interest of the beneficiaries resident in [California].” Cal.
Rev. & Trust Code §17744. Specifically, the portion of the non-California source income taxable in
California is equal to that proportion of the net income that “eventually is to be distributed to the
noncontingent beneficiaries who are residents of [California].” Cal. Code Regs. tit. 18, §17744. A
noncontingent beneficiary is one whose interest is not subject to a condition precedent. Cal. Code
Regs. tit. 18, §17742. To illustrate:
State Income Taxation Of Trusts | 9
Example (1). A transferred property located outside [California] in trust to pay equal shares of the income to B, a resident,
and C, a nonresident of [California]. The beneficiaries have noncontingent interests. The fiduciaries of the trust are nonresidents. During the year 1980, the trust realized $50,000 from real and tangible personal property located, and business
carried on, within [California], $50,000 from real and tangible personal property located, and business carried on, outside
[California], and $50,000 from stocks and bonds, none of which had a business or taxable situs in [California]. None of
the income was paid or credited to the beneficiaries during the year. The trust is taxable upon the $50,000 realized from
real and tangible personal property located, and business carried on, within [California]. The trust is also taxable upon
one-half of the balance of the income since one-half of such income will eventually be distributed to B, a resident of
[California].
Example (2). A transferred stocks and bonds and real and personal property located outside [California] in trust to B, a
nonresident of [California]. Under the terms of the trust, the income from the intangible personal property is to be accumulated for a number of years and then distributed to C, a resident of [California] with a noncontingent interest. The
balance of the income is to be distributed to certain named beneficiaries who are nonresidents of [California]. The trust is
taxable upon all the income from the intangible personal property, i.e., the stocks and bonds, but is not taxable upon any
of the income from the remainder of the trust property.
Cal. Code Regs. tit. 18, Section 17744.
6.Once it is established that California can tax some or all of the trust’s income, the next issue is when
a return must be filed. In California, a trustee must file Form 541 for a trust if:
a.The gross income for the taxable year is greater than $10,000, regardless of the net income of the
trust;
b. The trust’s net income for the taxable year is greater than $100; or
c.There is alternative minimum tax liability. See page 3 of California Forms and Instructions for
Form 541.
7.Form 541 must be filed by the 15th day of the 4th month following the close of the trust’s taxable
year. Cal. Rev. & Tax Code §18566. Thus, for calendar year trusts, the return must be filed by April
15 of the year following the taxable year at issue. The trust is granted an automatic six-month extension if the return cannot be filed by the due date, but the taxes must be paid by the due date to avoid
any penalties. Cal. Rev. & Tax Code §18567. A late-filing penalty equal to five percent of the tax will
be added to the tax for each month or fraction of a month between the due date and the actual filing
of the return, with the total penalty limited to 25 percent of the tax liability. Cal. Rev. & Tax Code
§19131(a). If the return is filed more than 60 days after the extended due date, unless it is shown that
the failure to file is due to reasonable cause and not due to willful neglect, a penalty equal to the lesser
of $100 or 100 percent of the tax liability will be imposed. Cal. Rev. & Tax Code §19131(b).
8.If the tax is not paid on the due date, a penalty equal to five percent of the unpaid tax is imposed, plus
one-half of one percent for each month, or part of a month, that the tax is late, up to a total penalty
of 25 percent of the tax liability, unless reasonable cause is shown. Cal. Rev. & Tax Code §19132. The
penalty can be waived if at least 90 percent of the tax was paid by the due date.
9.The 2009 California tax schedule is as follows (Cal. Rev. & Tax Code §17041(a)(1) and (a)(2)(A)):