Recently, I have had several conversations with clients regarding the residency of their trusts and the uncertainty surrounding their determination. Estate planning typically utilizes various types of trusts as the vehicle to achieve the efficient transfer of wealth to the intended beneficiaries of the grantor or settlor. While the transfer of wealth has always been the primary purpose of estate planning, the minimization of taxes, both federal and state, has also been a consideration when determining the type of trust created and the situs and residency of the trust. Below, I will address the factors influencing where a trust may be resident for purposes of state taxation.
When creating trusts as part of their estate planning, most individuals think locally by creating a trust that is governed by the laws of the state where they reside. They also look to local banking relationships or other trusted business advisors when selecting fiduciaries to oversee the administration of the trust. The situs (the technical term for where a trust is located for legal purposes) of trust assets generally follows the fiduciary administering the trust. These factors could influence the determination of the state where the trust is resident. Taking these items into consideration at the time the trust is created could avoid costly state tax ramifications in the future.
The residency of a trust determines where the income of the trust will be subject to state taxation. The rules governing the residency of the trust can be different from state to state. For example, some states will look to the residency of the grantor or settlor at the time that the trust was created to determine whether the trust is a resident trust. Other states will look to the location of the fiduciary and administration of the trust to determine residency.
The issue of where a trust is resident has been the subject of recent litigation that has altered the landscape of determining a trust’s residency. For example, Delaware, New Jersey, New York, and Pennsylvania are among the states that look to the residency of the grantor/settlor creating the trust to determine the residency. However, even within these states there are differences to determining residency. While New Jersey and New York look to the location of the trustee and trust assets to determine the taxability of a resident trust, this is no longer the case for Pennsylvania.
Prior to the McNeil decision by the Pennsylvania Commonwealth Court in 2013, the residency of the grantor/settlor was the sole driving force in determining the residency of a trust for Pennsylvania personal income tax purposes. In McNeil, the Court looked to other factors to determine residency. The Court noted that because the trust lacked sufficient contact with Pennsylvania, other than the residency of the grantor at the time the trust was created, Pennsylvania did not have the authority to subject the income of the trust to the personal income tax.
When creating a trust, consider which state laws it will be governed by, as well as the location and type (intangible investments versus an interest in a pass-through operating business) of the assets. It is also important to note that it may be possible to change the residency of an existing trust to a more favorable state depending on the state rules for determining residency as well as the type of asset held by the trust. For example, income generated from a pass-through business owned by a trust will be subject to state income tax in the state where the business is located and doing business.
Grantors are no longer restricted from creating trusts that have a different residency than their own. As a result of the McNeil decision, Pennsylvania grantors/settlors must be aware of the factors that can now influence the outcome of where their trusts are resident as a means of minimizing state income taxes paid by either the trust or its beneficiaries. The residency of a trust can matter and requires proper consideration at the time the trust is created to avoid unnecessary state tax implications in the future.
Estate planning can often be a difficult path to navigate, and state and local tax considerations can add an additional layer of complexity. Please reach out if you have questions or would like assistance with your estate planning matters.
Thomas M. Frascella can be reached at Email or 215.441.4600.
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