Trust can be a valuable tool for various reasons, estate preservation and liability protection just to name a few. They are designed to protect the assets they hold and for this reason they are considered separate legal entities from the grantor and beneficiaries. Trustees serve as the fiduciary responsible for the trust assets and one of these responsibilities include the filing of the appropriate tax returns.
Trusts come in many different colors and sizes. They can be irrevocable or revocable, grantor or nongrantor and nongrantor trusts can be taxed as simple or complex trusts. Depending on many factors, a trust will not only be taxed at the federal level but also at the state level too. In fact, a trust can be taxed in various states depending on the assets held, income generated and location of its grantor, trustees or beneficiaries.
This article will focus on the factors used in several states to determine a nongrantor’ s trust status as a resident or nonresident trust. The difference between a resident and nonresident trust is that a resident trust will be taxed on all of its income no matter where sourced (or earned). A nonresident trust will only be taxed in that state on the income sourced to that state. It is possible that more than one state can deem at trust a resident trust creating income that is taxed multiple times at the state level. Careful planning can prevent this unfavorable situation.
The Factors – it depends on the state!
State taxation of trusts depends on state law, basing taxation on different factors, which inevitably complicates the analysis. However, many states do use similar factors, one or a combination of factors, to determine residency. These factors often relate to a connection to the state based on domicile or where the trust is administered. These different factors can also lead to two (or possibly more) states taxing the same trust as a resident trust resulting in double taxation.
- Testators domicile or residency: For a trust created under a will, the domicile or residency of the testator often determines residency of a trust. (e.g. AL, NJ, NY)
- Grantors domicile or residency: For a inter vivos trust (one created during life) the grantor’s; person creating and/or funding the trust, domicile or residency determines residency of the trust. (e.g. CT, IL, LA)
- Trustee(s) domicile or residency: Some states look to the residency of the trustee or trustees to determine the residency of a trust. (OR, NM, OR)
- Beneficiaries domicile or residency: Domicile or residency of beneficiaries of the trust could also be a factor in determining residency of the trust in some states. (CA, DE, HI)
- Where the trust is administered: Administration of a trust can often determine trust residency for state tax purposes. The definition of administration becomes very important and can vary from state to state. (CO, MS, UT)
- Location of trust property: In a few states the location of a trust’s property can determine residency of the trust, such as Idaho where it is one of the factors to determine sufficient contact with the state. This should not be confused with sourcing of trust property or income to determine taxation of a nonresident trust.
Each state is different and can use several factors in determining residency. While other states may only use one factor, such as where the trust is administered. And not surprisingly, the definition of administered can mean different things to different states. Some examples of administration include conducting trust activities, investing trust assets, administrative decisions, recordkeeping and preparation of tax returns and fiduciary decision making of the trust.
Can a resident trust not be taxed to the resident state?
When there is a resident trust all the income is taxable to that state no matter where derived or sourced. However, some states do offer exemptions from taxation even though a resident trust exists. This is usually because of an insufficient connection to the state. For example, NY determines residency based on the domicile of a testator for a testamentary trust or grantor when a trust becomes irrevocable. However, even if one of these factors exist, if the trust has no resident trustees, no NY sourced income or assets then the trust is exempt from taxation even though it is a resident trust (NY Tax Law § 605(b)(3)(D)). A fiduciary return is still filed with an exemption form certifying the criteria is met.
Another example of a resident trust not taxed to the state is Delaware. Delaware uses several factors to determine a resident trust status including testator, grantor and trustee residency or domicile. But like New York there is an exemption from taxation. In Delaware, no Delaware fiduciary return is required when a resident trust has not distributed or set aside for distribution of its federal taxable income to nonresident beneficiaries. (30 Del. C. § 1605(b)(1)(a)(2)).
Double Taxation Relief
When a trust is a resident trust in more than one state, some states offer relief in the form of a tax credit. California and Colorado offer such resident trust relief allowing credit for taxes paid to the other resident state. Worth noting, many states allow a nonresident tax credit for taxes paid to other states where the trust is taxed as a nonresident.
Planning Opportunities
Planning to minimize state tax exposure can be done at trust creation but also during the administration of the trust.
- Multiple settlors – avoid having multiple settlors (or grantors) to avoid exposure in more than one state. Since many trusts include residency of the grantor as a factor, having only one grantor per trust can prevent double taxation.
- Separate trust for separate beneficiaries – This can have a few benefits especially if generation skipping beneficiaries are involved but can also minimize multiple states taxing the trust.
- Grantor or nongrantor status – the focus of this article is on nongrantor trusts and their resident trust status. These rules do not apply to grantor trusts in almost all of the states (PA is an exception for trust compliance before 2025). In a grantor trust the income is taxed to the grantor only and the trust’s status as resident or nonresident is irrelevant. Careful consideration of the terms of the trust on creation must be made when grantor status is desired. In addition, a trust can have provisions to turn off the grantor trust status to tax the trust as a nongrantor trust.
Other considerations such as location of trust assets, where the trust will be administered, and the selection of trustees can all play a role in state trust taxation planning. Also to note, several states do not tax trust at all. These states include AL, FL, NV, NH, SD, TN, TX and WY, while Washington only taxes capital gains. These states can also create planning opportunities where the facts and circumstances fit.
Not all trusts are created equal. Determining and planning for state trust residency and taxation consequences is important when creating and administering the trust. Many factors can play a role in that determination such as residency of grantors, testators, beneficiaries or trustees. Location of assets, administration of the trust and the type of trust also can play a significant role depending on the state.
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship
