When are states permitted to tax undistributed trust income?

As I am researching another precedent-setting trust case for an upcoming virtual continuing education panelist discussion for IICLE (Illinois Institute for Continuing Education), it’s hard to ignore the trend we see regarding trust taxation.

In 2018, we closely followed the Fielding case’s trajectory with our business development director, Jouko Sipila, living in Minnesota and company president, Greg Crawford, gaining his graduate degree at the University of Minnesota. We watched as Fielding won in Minnesota’s Supreme Court and as the case landed on the steps of the Supreme Court of the United States.

Also, on the SCOTUS steps at the time was the Kaestner case out of North Carolina. As many of us are very aware, SCOTUS denied hearing Fielding but argued Kaestner, and the rest is history.

We discussed the Kaestner and Fielding cases in detail last year.

Linn v. Illinois Department of Revenue

Linn, Kaestner, and Fielding all have nuanced differences, but they share the same issue: When is a state allowed to tax a trust’s undistributed income? The three cases argued over their states’ nexus with the trusts and turned to the U.S. Constitution’s Due Process Clause in courts.

The Illinois Department of Revenue founded their argument on an Illinois statute stating that a “‘resident” means: An irrevocable trust, the grantor of which was domiciled in this State at the time such trust became irrevocable.” But, as stated above, there must be nexus between a state and the taxable entity. Otherwise, it is unconstitutional for a state to tax the entity even if a state’s statute looks to support such taxation.

Like Minnesota, Illinois taxed the undistributed income of an irrevocable trust based solely on a grantor’s residence when the grantor established the trust. As Illinois argued the case, there were no IL precedents, and the courts sourced out-of-state trust case precedents to find direction.

Before the Illinois Fourth District Appellate Court decided on the Linn case, Illinois partly relied on establishing nexus, particularly with irrevocable trusts, if the grantor’s residence was Illinois when the trust was established.

Essentially, before the Linn case, Illinois believed that once an irrevocable trust was established in Illinois, that trust would always be an Illinois trust.

Linn Facts

A.N. Pritzker established an inter vivos trust–not a will, nor testamentary trust– in Illinois in 1961 with Illinois trustees named. 40+ years later, in 2002, the trustee distributed property from the IL trust to a new trust in Texas. At this time, the trust was primarily administered in TX, with some of the trust provisions remaining under IL law. In 2005, a TX court modified the TX trust removing all references to IL law.

As of 2006, after the Texas court modification to the trust instrument:

  • No beneficiaries lived in IL;
  • No trustees lived in IL;
  • IL had no custody of assets in the TX trust;
  • No mention of Illinois in the trust document.

However, the Illinois Department of Revenue (IDR) argued that in 2006, the trust was, in fact, a resident of IL because the TX trust came from the IL trust. Without the IL trust, there is no TX trust.

The Texas trustee argued that the IDR violated the due process and commerce clauses.

I reached out to an Illinois private wealth attorney for comment.

Jeffrey Glickman of Katten Muchin Rosenman commented:

“The facts in Linn were overwhelmingly in the taxpayer’s favor – there was no fiduciary in Illinois, there was no beneficiary in Illinois, there were no assets in Illinois, and now there was no mention of Illinois in the trust instrument – and so not only was this short of a minimum connection with Illinois, it was arguably no connection at all. 

The Department of Revenue was trying to essentially argue that ‘if it doesn’t look like a duck, and if it doesn’t quack like a duck, it’s still a duck if it was born here.’ 

The strong facts are likely what led the trustee and beneficiaries to push back on the Department of Revenue – doubtfully, were they motivated to act to recover the $2,729 tax deficiency – but instead, here was a clear case to show that the arcane Illinois statute was no longer workable in a more modern trust administration landscape.”

Once again, we see the issue of nexus with a trust established initially in one state where circumstances of residencies involved within the trust changed drastically.

Like Kaestner and Fielding, the Illinois Fourth District Appellate Court concluded that for the tax year of 2006, “what happened historically with the trust in Illinois courts and under Illinois law has no bearing” and that the trust is receiving benefits from Texas, not Illinois.

Linn wins.

Take-Aways

We continue to see a trend towards the “high courts,” deciding that a significant and existing nexus between a state and an entity must exist for the state to tax the entity constitutionally. Historical facts that have since changed may not stand up in court. But, historical facts continue to give states a leg to stand on when deciding to tax entities.

Thus, when migrating a trust or assets to a state with trust laws suited for your needs, it seems prudent to explore strategies that support such moves in states’ eyes too. For example, decanting a trust and moving only the high-value assets to a state with better tax advantages removes the taxable assets from the original state, placing the assets in a new trust domiciled out-of-state.

Also, the residences of those you or your client appoint with trust roles can significantly impact the taxability of a trust. Furthermore, understanding the governing laws in all states involved with a trust is imperative when migrating a trust and assets.

Again and again, we see the value of utilizing experienced and knowledgeable estate planning professionals (e.g., attorneys, trustees, advisors, CPAs) when hoping to make a clean transition from one state to another. We can only imagine how many tax bills are paid without question.

While seeing precedents being made across the country supporting trust jurisdictions like Nevada does not hurt our feelings, please contact us for more information on trustee services or with any other estate planning questions you may have.

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