Trusts can be a valuable tool for estate preservation, liability protection, and more. They are designed to protect the assets they hold and are therefore considered separate legal entities from the grantor and beneficiaries. Trustees serve as the fiduciaries responsible for managing the trust’s assets, including the responsibility to file the appropriate tax returns.
Trusts come in many different colors and sizes. They can be irrevocable or revocable, and categorized as either grantor or nongrantor trusts. Nongrantor trusts are subject to additional classification for tax purposes and may be treated as simple or complex trusts depending on how income is managed and distributed. While all trusts are subject to federal taxation, many are also taxed at the state level. In fact, a trust can be taxed in multiple 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 trust’s status as a resident or nonresident trust. The difference between a resident and nonresident trust lies in how income is taxed. A resident trust is taxed on all of its income, regardless of where it is sourced or earned. In contrast, a nonresident trust is only taxed on income that is sourced to that specific state. It is possible that more than one state can deem a trust as 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, which inevitably complicates the analysis. However, many states use similar factors to determine residency. Common considerations include the following:
- Testator’s 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).
- Grantor’s domicile or residency: For an inter vivos trust created during the grantor’s lifetime, the trust’s residency is typically determined by the grantor’s domicile or state of residence (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 (e.g. OR, NM).
- 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 (e.g. 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 is very important and varies from state to state (e.g. CO, MS, UT).
- Location of trust property: In a few states, the location of a trust’s property can determine residency of the trust (e.g. ID). This should not be confused with sourcing of trust property or income to determine taxation of a nonresident trust.
Each state is different and may use a singular factor or a combination of factors in determining residency. And not surprisingly, the definition of these considerations can mean different things to different states. For example, administration can include conducting trust activities, investing trust assets, making administrative decisions, recordkeeping and preparation of tax returns, or fiduciary decision making of the trust in varying states.
Exemptions to State Taxation for Resident Trusts
When a trust is considered a resident trust, all of its income is taxable to that state, regardless of where it is derived or sourced. However, some states offer exemptions from taxation even though a resident trust exists. This is usually because of an insufficient connection to the state. For example, New York 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 exists, a trust with neither resident trustees nor New York-sourced income or assets is exempt from taxation, even though it is classified as a resident trust (NY Tax Law § 605(b)(3)(D)). A fiduciary return still must be filed with an exemption form certifying that the criteria is met.
Another example of a resident trust not taxed to the state is in Delaware, which 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. Delaware fiduciary returns are not required when a resident trust has neither distributed nor set aside its federal taxable income for nonresident beneficiaries (30 Del. C. § 1605(b)(1)(a)(2)).
Double Taxation Relief
When a trust is considered 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 trusts relief, allowing credit for taxes paid to the other resident state. It’s worth noting that many states offer a nonresident tax credit for taxes paid to other states where the trust is also taxed as a nonresident.
Planning Opportunities
Planning to minimize state tax exposure can be done at the time of trust creation and administration.
- Multiple settlors: Avoid having multiple settlors or grantors to mitigate exposure in more than one state. Since many trusts include residency of the grantor as a factor, opting for only one grantor per trust can prevent double taxation.
- Separate trusts for separate beneficiaries: Creating separate trusts yields several benefits, especially if generation-skipping beneficiaries are involved, and can also minimize the risk of multiple states taxing the trust.
- Grantor or nongrantor status: The focus of this article is nongrantor trusts and their resident trust status. These rules are not applicable to grantor trusts in most states (e.g. PA is an exception for trust compliance before 2025). In a grantor trust, all income is taxed solely to the grantor, warranting the trust’s status as resident or nonresident irrelevant. Careful consideration of the trust’s terms upon creation is essential when grantor status is desired. In addition, a trust can include provisions to turn off the grantor trust status, allowing it to be taxed as a nongrantor trust instead.
Additional 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. Keep in mind that several states do not tax trusts at all, including AL, FL, NV, NH, SD, TN, TX and WY, while WA only taxes capital gains. These states may 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 are important when creating and administering the trust. Many factors can play a role in that determination, including residency of grantors, testators, beneficiaries, or trustees, location of assets, administration of the trust, and the type of trust.
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.
