The taxation of trusts often raises questions. Trusts are a separate legal entity that are taxed at the federal level. States can also tax trusts but laws vary by state. This article will address the taxation of trusts in New York State (NYS) and the corresponding compliance requirements.
What is a trust?
A trust is a relationship in which one person holds title to property (trustee), subject to an obligation to keep or use the property for the benefit of another (beneficiary). A trust is formed under state law. Just like individuals and corporations, NYS imposes income taxes on trusts. In fact, most states have some way of taxing trusts, while some states do not tax trusts at all. It should be no surprise to those familiar with state taxation, that each state’s rules for taxing trusts differs; including what constitutes a resident trust, tax rates and filing requirements.
Resident versus nonresident Trusts
Resident and nonresident trust status taxes are similar to resident and nonresident individuals, where residents are taxed on all income and nonresidents are taxed on income sourced to the state. As with most states, NYS taxes all of the undistributed income of a resident trust regardless of where sourced. Therefore, it is important for those creating trusts (and their planners) to understand that definition. Definitions of resident trust can vary from state to state but usually hinge on where the grantor created the trust, residency of the trustee(s), asset location and sourcing of income. Other factors such as situs of the trust, beneficiary residency and administration of trust can also be important.
New York defines resident trusts as those created by a grantor who was a resident of NYS at the time the trust became irrevocable or when a testamentary trust was created by a decedent who was a resident of NYS at the time of death. A nonresident trust is a trust that is not a resident trust for any part of the year. As stated earlier, resident trusts are taxed on all of its taxable income regardless of where it is sourced. One thing to note: trust income is taxed at the trust level only on taxable income that is not distributed to its beneficiaries. Beneficiaries are taxed on reportable income distributed to them. In addition, trusts taxed as grantor trusts are not subject to these rules as the income is directly taxed to the grantor individual and no entity level taxation applies.
In 1964, a NYS court ruled in Mercantile Safe Deposit and Trust Company vs. Murphy that the resident trust definition was not constitutional and did not create sufficient nexus to tax the income from the trust as a full resident. As a result, NYS modified its taxation of resident trusts. A NYS resident trust will not be taxed on its income if all the following conditions are met (NYS Tax Law, Article 22, §605(b)(3)(D):
- All the trustees are domiciled in a state other than New York;
- The entire corpus of the trust, including real and tangible personal property, is located outside of NYS (it is the Tax Department’s position that intangibles located in the state but that are not employed in a business carried on in the state are not deemed to be located in the state for purposes of this rule); and
- All income and gains of the trust are derived from, or connected with, sources outside of NYS, determined as if the trust were a nonresident trust.
Therefore, a resident trust would be taxed as a full resident if it failed any of those three conditions. Since trustees can change, or sourcing and asset location can change at any given time taxation as a resident trust can change during the year. If this is the case, the trust would be taxed as a part-year resident trust.
NYS resident and nonresident trusts must report their income on Form IT-205, Fiduciary Income Tax Return. A nonresident trust must only file Form IT-205 if the trust (1) had income derived from NYS sources; (2) is subject to a separate tax on lump-sum distributions; or (3) incurred a NYS net operating loss for the tax year without incurring a federal net operating loss.
Income from NYS sources includes, but is not limited to:
- Income attributable to the ownership of any interest in real property located in NYS or tangible personal property located in NYS;
- Income attributable to the ownership of any interest in intangible personal property to the extent that it is used in a business, trade, profession, or occupation carried on in NYS;
- Income attributable to a business, trade, profession, or occupation carried on in NYS.
It does not include annuities, interest, dividends, or gains from the sale or exchange of intangible personal property, unless they are part of the income from a business, trade, profession, or occupation carried on in NYS.
If a resident trust meets the three conditions to exempt its income retained in the trust from taxation, the trust should file Form IT-205 with Form IT-205-C, New York State Resident Trust Nontaxable Certification.
Similar rules apply to New York City and Yonkers trusts, therefore resident trust status must be determined by substituting NYC or Yonkers for NYS in the analysis. The fiduciary of a New York City or Yonkers resident trust or part-year resident trust who is required to file a NYS fiduciary return must file a New York City or Yonkers fiduciary return for the trust on the same NYS form on which the NYS tax liability is reported.
Needless to say, taxation of NYS trusts can be complicated. Understanding whether the trust is taxed as a resident trust, nonresident trust or part-year resident trust is important. This determination must be made every year by analyzing the source of income derived by the trust, location of trust assets and residency of the trustee(s). Proper evaluation and planning can save the trust from being incorrectly taxed at the state level and save trust tax dollars which can be invested for current and future beneficiaries.
The Bonadio Group’s Estate & Trust team has years’ of advisory and tax experience. Please do not hesitate to reach out to our trusted experts 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.