Just like a resident individual, a New York resident trust is subject to New York income tax on all of its income. And just like a nonresident individual, a nonresident trust is subject to income tax only on its New York source income. But the world of New York fiduciary income taxation creates a third category not applicable to individuals – the exempt resident. Understanding when a trust falls into the category of resident, exempt resident, or nonresident is the threshold to any New York fiduciary income tax analysis. However, if a trust is a “grantor trust” for federal income tax purposes, the residency of the trust is not determinative. Rather, all of the trust’s income is reported directly on the trust creator’s individual income tax return.
N.Y. Tax Law § 605 sets forth the rules for determining the residency of a trust. It begins with determining when property was transferred to the trust; if property was transferred to the trust under the will of a person domiciled in New York at death, then the portion of the trust passing under the will is a resident trust. In a typical situation, a trust is wholly funded by assets passing under such a will, meaning that the trust would be a wholly resident trust; however, if a will directs that assets be added to an existing trust that is otherwise nonresident, the trust might have dual residency. In that case, the portion of the trust funded by the New York decedent’s will is New York resident, and the portion of the trust that existed prior to funding is nonresident.
If property was transferred to a trust during the transferor’s lifetime, the trust is a resident trust if the transferor was domiciled in New York at the time of the transfer, and if the trust was either (i) irrevocable at the time of the transfer or (ii) revocable at the time of the transfer and remains revocable. Or, if an individual transfers property to a revocable trust, and the trust becomes irrevocable while the individual is domiciled in New York, the trust will also be considered a New York resident trust.
Just like a trust under a will, a trust created during an individual’s lifetime can have both a resident portion and a nonresident portion. Consider the fairly common situation of a grandmother who creates an irrevocable trust for her grandchild. The grandmother is a lifelong New Yorker. Every year she makes annual exclusion gifts to the trust. Eventually, she grows tired of the cold New York winters and moves to Florida. Always generous, she continues to make gifts to the irrevocable trust after her death. In TSB-A-11(4)I, the Department of Taxation and Finance indicated that the portion of the trust that was funded while the transferor was domiciled in New York is treated as a New York resident trust, while the portion of the trust funded after the move to Florida is treated as a nonresident trust.
The definition of a nonresident trust found in N.Y. Tax Law § 605 is much more clear-cut: Any trust that is not a resident trust is a nonresident trust. As stated above, whereas a resident trust is subject to New York income tax on all of its income, a nonresident trust is taxed only on its New York source income.
A trust (or a portion of a trust) becomes resident or nonresident on day one, and so it remains until the trust terminates. Unlike the generous grandmother, a trust cannot move to Florida and become a nonresident, but a resident trust can become exempt from taxation if it meets the three-prong test set forth in N.Y. Tax Law § 605(b)(3)(D). To satisfy the test, all of the trustees must be domiciled outside of New York, all of the trust property must be located outside of New York and, finally, the trust cannot receive any New York source income, which is determined as if the trust were a nonresident trust. Each of the three prongs has its own nuances.
When reviewing the first prong, consider not only the individuals who have the title of “trustee,” but also other individuals who may have powers over the trust. For instance, trusts formed in Delaware may have a corporate Delaware trustee, but they may also have an “investment advisor,” who has the absolute right to direct how the trustee invests the trust assets, and a “distribution advisor,” who has the absolute right to direct when the trustee distributes assets to the beneficiaries. In TSB-A-04(7)I, the Department of Taxation and Finance 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. Depending on the terms of the trust agreement, a distribution advisor domiciled in New York could potentially be deemed to be a trustee, causing the trust to fail the first prong of the exemption test.
To meet the second prong, the resident trust cannot have any New York situs assets. This test is the most straightforward of the three: Real property and tangible property is sitused where they are actually located. If a trust owns a house and a car located in the Adirondacks, it has New York situs assets. Intangible property is deemed to be sitused in the jurisdiction where the trustee is domiciled. If the trustee is domiciled in Maine, for example, the stocks and bonds in the trust’s brokerage account are deemed to be sitused in Maine.
Finally, in order for a resident trust to be exempt from New York income taxation, it cannot receive any New York source income. The third prong of the test is perhaps the most difficult to police, and the most treacherous. For instance, a trustee who is attempting to qualify a resident trust as exempt may believe that because the trust only owns a brokerage account, the trust is not deemed to receive New York source income. Unbeknownst to the trustee, however, the investment advisor invested a sliver of the brokerage account in a publicly traded partnership that generates a K-1 showing $100 of New York source income. That $100 of New York source income could jeopardize the trust’s exempt status for the year.
Because a resident trust that meets the three-prong test is exempt from New York income tax, savvy trustees and beneficiaries of resident trusts actively take steps to satisfy the three prong test. The New York trustee may resign in favor of the named successor who lives in New Jersey, or the trust may sell the house and car in the Adirondacks. The Department of Taxation and Finance has taken the position in TSB-A-10(4)I that when a change of trustees occurs mid-year, it is possible for a trust to be taxed as a resident trust for the first part of the year, but exempt from New York taxation during the remainder of the year. The same analysis will presumably apply if a trust disposes of its New York situs assets mid-year, or ceases to receive New York source income mid-year.
The New York legislature has recently taken steps to capture the tax dollars that are lost when a resident trust becomes exempt. The first step is a new policing effort: Effective Jan. 1, 2014, a resident trust claiming to meet the three-prong exemption must file a New York income tax return and Form IT-205-C to certify its exempt status. Failure to file will result in a monthly $150 penalty, not to exceed $1,500 for a given year, even when no tax is due.
In addition, New York enacted an accumulation distribution regime for distributions from exempt resident trusts, which can be found in N.Y. Tax Law § 612(b)(4). Under the federal fiduciary income tax rules applicable to U.S. domestic trusts, each trust’s tax year stands alone. Put simply, if a trust earns income in year one and distributes the income to a beneficiary, the beneficiary receives a K-1 and must report that income on his or her personal tax return. If the trust does not make any distributions in year one, but rather adds the income to principal, then the trust pays tax on the income and the income will never carry-out to the beneficiaries. This summary is an oversimplification of the federal scheme, but a discussion of a trust’s distributable net income is beyond the scope of this article.
New York’s accumulation distribution regime has tossed out the federal rule. Now, if a New York resident receives a distribution from an exempt resident trust, the distribution may carry out the prior year’s undistributed income to the beneficiary. 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 Jan. 1, 2014; the income was earned during a period when the beneficiary was not a New York resident; or the income was earned before the beneficiary turned 21. Generally, income for these purposes will include interest and dividends, but not capital gains.
If a New York resident beneficiary receives an accumulation distribution, the beneficiary may be allowed a credit for the beneficiary’s share of New York income tax already paid by the trust on the income, and on any income tax imposed on the trust by another state on income sourced to that other state. The credit cannot be more than a percentage of tax due, which is determined by dividing the portion of the income taxable to the trust in the other jurisdiction and taxable to the beneficiary in New York by the beneficiary’s total income.
Determining whether a trust is subject to New York taxation in a given year is only the first step. The fifty states have varying rules for determining whether a trust is resident in that state, and it is possible that a trust may be considered resident in more than one state. An analysis must be completed to determine if income tax returns must be filed in other jurisdictions where the trust has connections, and care must be taken to avoid the potential of taxation in multiple jurisdictions. Planning for a trust’s income tax residency is certainly not an easy task, but the fruits of careful planning are worth the effort.
Catherine Eberl, JD, regularly advises clients on all aspects of estate planning, including estate, gift, and fiduciary income tax planning; cross-border estate planning; charitable giving; and family business succession planning. Catherine regularly practices in Surrogate’s Court and counsels both fiduciaries and beneficiaries with respect to the administration of trusts and estates. She also advises both private foundations and public charities on governance issues and on satisfying IRS operational requirements.