Income and losses generated within a trust must be reported, but the entity or person required to report such income or losses depends on what kind of trust it is. If a trust is a “grantor trust,” the grantor (i.e. the person who funded the trust) is responsible for the reporting and payment of tax. If a trust is a “non-grantor trust,” it is taxed as its own entity separate and apart from the grantor. Just like with individuals, non-grantor trusts are subject to federal income tax and income tax in the state (or states) where the trust is considered a resident.
In a previous advisory, Navigating Trust Taxation: State Income Tax, we explored state income taxation of non-grantor trusts and provided an overview of (i) what qualifies a New York trust as resident or nonresident, and (ii) what qualifies a resident trust as exempt or nonexempt from New York income tax. Here, we’ll dive deeper into what makes a New York trust an “exempt resident trust,” able to wholly escape New York income taxation, and the intricacies involved.
While the definition of a “resident trust” differs by state, at a minimum a state’s authority to tax a trust is contingent on the trust’s nexus to the state. A trust must have a sufficient minimum connection with a state to justify taxation. To determine whether a New York trust could be considered an exempt resident trust, we must first determine whether the trust is a New York resident.
Determining New York Trust Residency
New York looks at the residency of the trust creator (often referred to as the “grantor” or “settlor”) to determine if the trust is a resident trust. A trust is a New York resident trust if any of the following are true:
- The trust is a testamentary trust created under the Will of a New York resident decedent;
- The trust is an irrevocable trust funded by a New York resident;
- The trust is a revocable trust that was funded by a New York resident; or
- The trust was a revocable trust that became irrevocable when the grantor was a New York resident.[1]
Residency is determined at the time property is transferred to the trust. Because a trust may be funded over the course of different years, this means a trust can have portions of it that are resident, nonresident, or part-year resident, depending on the time of the transfer and the residency of the transferor (if, for example, the transferor moves states). Of note, the resident status of the trustee does not affect the resident status of a trust; it does, however, come into play when determining whether a resident trust could be exempt from New York tax.
A New York resident trust is taxed on all of its undistributed income regardless of the source (whereas a nonresident trust is taxed only on its undistributed New York source income). Income that is distributed to a trust beneficiary is taxed to the beneficiary, and not to the trust. While a trust cannot change its New York residency status, if a New York resident trust lacks sufficient nexus with New York, then it may be exempt from New York state income tax.
Determining New York Resident Exempt Trust Status
In Mercantile-Safe Deposit & Trust Co. v. Murphy, 15 N.Y.2d 579 (1964), the New York Court of Appeals invalidated provisions of the New York Tax Law that imposed tax on the accumulated (undistributed) income of resident trusts, because such taxation unconstitutionally extended the taxing power of the state beyond its borders.[2] As a result of this case, New York now has a statutory exception to the taxation of a resident trust if there is insufficient nexus to the state. A New York resident trust can escape New York income taxation if a three-prong test is satisfied:
- All trustees are domiciled outside of New York;
- All trust property is located outside of New York; and
- All income and gains of the trust are derived from or connected with sources outside of New York, determined as if the trust were a nonresident trust. [3]
The determination of whether a trust is a New York exempt resident trust must be made every year by analyzing the residency of the trustees, location of trust assets and source of income derived from the trust. While this might seem straightforward, each requirement involves nuances and unique considerations that Trustees need to be aware of if they are attempting to secure New York exempt resident trust status.
Prong 1: No New York Trustees.
Prong 1 is fairly straightforward: no trustee of the trust can be a domiciliary of New York. If the trustee is an individual, domicile is the place where an individual intends to be such individual’s permanent home. However, there are situations where one’s domicile is not clear. Domicile is a subjective test in that it relies on what an individual perceives as his or her home. Yet, determining one’s domicile is done by evaluating external factors like where the individual spends more time or where the individual’s close contacts/doctors/club memberships are located.
If the trustee is a bank or trust company, the domicile is the principal place from which the trade or business of the bank or trust company is directed or managed. Further, a trustee that is a bank or trust company domiciled outside of New York at the time it becomes a trustee will be deemed to remain a trustee domiciled outside of New York even if the bank or trust company is thereafter acquired by or becomes an office or branch of a corporate trustee domiciled within New York.[4]
Another possible complication to this otherwise clear rule relates to determining what is considered a trustee for this purpose. Individuals other than those referred to as “trustee” may have powers under the trust agreement that could give rise to a trustee relationship. New York has indicated that it will scrutinize individuals who have trustee-like powers – such as the ability to direct investments and distributions – and that they may be treated as trustees for purposes of prong 1 of the exemption test.[5] Thus, depending on the terms of the trust agreement, an investment or distribution advisor domiciled in New York could potentially be deemed to be a trustee for purposes of the exemption trust and cause the trust to fail prong 1, subjecting all of the trust’s income to New York income tax.
Prong 2: No New York Situs Assets.
Prong 2 is also straightforward: the trust cannot have any New York situs assets. Real and tangible property is sitused where it is actually located. If a trust owns a home in Shelter Island or has a safe-deposit box with cash and jewelry at a bank in Schenectady, it has New York situs assets.
Intangible property is deemed to be located in New York if one or more of the trustees are domiciled in New York; in other words, intangible property is deemed to be sitused in the jurisdiction where the trustee is domiciled. If the trustee is a resident of Massachusetts, stocks and bonds in the trust’s brokerage account are considered to be sitused in Massachusetts. As long as there are no New York trustees, there will not be any New York intangible property.
Prong 3. No New York Source Income.
Prong 3 is where many trusts can fail the exemption test: the trust cannot have any New York source income. A resident trust that receives even $1.00 of New York source income will fail this prong of the exemption test.
In an effort to assist taxpayers, New York released a tax bulletin[6] with a list of items of income that are included in New York source income, and a list of such items that are not included in New York source income.
New York source income includes any income the trust receives from:
- The ownership of any interest in real or tangible property located in the state
- The transfer of shares of stock in a cooperative housing corporation, when the real property comprising the units of the cooperative housing corporation is located in the state (including the ownership interests in certain entities that own shares in such cooperative housing corporation)
- The ownership of any interest in intangible property, to the extent it is used in a business, trade, profession, or occupation carried on in the state
- A business, trade, profession or occupation carried on in the state
- A New York S corporation in which the trust is a shareholder
- The distributive share of a New York partnership in which the trust has in interest
New York source income does not include income the trust receives from:
- The transfer of intangible personal property (unless they are part of the income from a business, trade, profession, or occupation carried on in the state)
- Certain pension plans;
- Annuities, unless the annuity is employed or used as an asset of a business, trade, profession, or occupation carried on in the state
- A New York C corporation in which the trust is a shareholder
Note that dividends and sales of public stock are typically not sourced to a state for trust taxation purposes.
Beware of the Throwback Tax
As explained above, a New York exempt resident trust will not pay income tax to New York state on its undistributed income. In an attempt to capture tax dollars that would otherwise be lost when a trust qualifies as an exempt resident trust, New York has implemented a “throwback tax.” This is an income tax on distributions of prior years’ taxable income from a New York resident exempt trust to a New York resident beneficiary. Prior to implementation, a New York resident exempt trust could accumulate income and then distribute the accumulated income to a New York resident beneficiary in a subsequent year, effectively escaping New York income tax. New York’s accumulation distribution rule[7] eliminated this loophole.
Under the federal rule, a trust’s tax year stands alone. If the trust earns income in year 1 and distributes income to a beneficiary, the income is reported on the beneficiary’s income tax return, and the beneficiary pays the tax. If the trust does not distribute income to the beneficiary in year 1 and adds the income to principal (i.e. accumulates it), then the trust pays the tax.
Under New York’s accumulation distribution rule, if a trust beneficiary is a New York resident and receives a distribution from an exempt resident trust, the distribution will carry out to the beneficiary income from the year in which the distribution is made and any income accumulated (undistributed) in prior years (generally, income for this purpose will include interest and dividends, but not capital gains). However, the distribution will not be subject to tax if one of the following exemptions apply:
- The trust’s income has already been subject to New York tax
- The income was earned before January 1, 2014
- The income was earned during a period when the beneficiary was not a New York resident
- The income was earned before the beneficiary turned age twenty-one (21).
Example: In year 1, a New York exempt resident trust earns $1,000 of interest, which is accumulated and added to principal. In year 2, the trust earns another $1,000, also added to principal. In year 3, the trust earns $200. In year 3, the New York beneficiary of the trust receives a distribution of $500. Under the accumulation distribution rule, the entire $500 is subject to New York income tax when received by the beneficiary ($200 for Year 3 and the remaining $300 is treated as a distribution of the prior years’ accumulated income).
Filing Requirements
Generally, all New York resident trusts, including exempt resident trusts, must file a Form IT-205, Fiduciary Income Tax Return each tax year it is required to file a federal income tax return for the tax year.[8]
New York exempt resident trusts should also file Form IT-205-C, New York State Resident Trust Nontaxable Certification. In addition, every exempt resident trust must file a Schedule J to Form IT-205 for any tax year in which the trust makes an accumulation distribution to a beneficiary who is a New York resident. Failure to meet these necessary filing requirements will cause the trust to incur penalties, even if no tax is due.
Conclusion
There are clear advantages to being a New York exempt resident trust, but it is not necessarily an option for each client. If you are a grantor or a beneficiary of a trust currently paying New York income tax, please reach out to your Wiggin and Dana attorney to determine if there is a way to characterize your trust as a New York exempt resident trust.
[1] N.Y. Tax Law § 605(b)(3)
[2] New York Advisory Opinion TSB-A-20(2)I
[3] N.Y. Tax Law § 605(b)(3)(D)
[4] N.Y. Tax Law § 605(b)(3)(D)(iii)
[5] New York Advisory Opinion TSB-A-04(7)I
[6] Tax Bulletin TB-IT-615 and Technical Memorandum TSB-M-18(1)I
[7] N.Y. Tax Law § 612(b)(40)
[8] Instructions for Form IT-205, Fiduciary Income Tax Return