View PDF of Article in Tax News & Comment — October 2012
INCOME TAX PLANNING FOR NEW YORK TRUSTS
I. Taxation of Resident Trusts
“Resident” New York trusts which are not “grantor”” trusts must pay New York State fiduciary income tax on all income and gains at rates which approach 9 percent for New York residents and 13 percent for New York City residents.
[Income earned by grantor trusts is taxed directly to the grantor at the grantor’s income tax rate. Most states, including New York, adopt the federal definition of what constitutes a grantor trust. The grantor trust rules reside in Sections 671 through 679 of the Internal Revenue Code. IRC Sections 164(a)(3) and 641(b) also provide that state income tax is deductible for federal income tax purposes, although the benefit of the deduction for capital gains, which are now taxed at only 15 percent at the federal level, is paltry.]
Most states impose fiduciary income tax on “resident” nongrantor trusts at various rates, although some states impose no tax. Not surprisingly, New York and California impose relatively high rates of income tax on fiduciaries of resident trusts. Seven states: Alaska, Florida, Nevada, Washington, South Dakota, Wyoming and Texas, impose no income tax on fiduciaries of resident trusts.
Step One: Determining Whether The Trust is a Resident New York Trust
In analyzing whether and to what extent a trust is taxable in New York, one must first determine whether the trust is a New York resident trust. If the trust is not a New York resident trust, the trust (a “Nonresident Trust”) could still be subject to New York income tax, but in that case (see below) only on its New York source income.
States generally utilize five criteria in determining whether a trust constitutes a “resident” trust:
(i) whether the trust is a testametary trust created under the will of a resident;
(ii) whether the trust is an inter vivos trust created by a resident;
(iii) whether the trust is administered within the state;
(iv) whether the trustee is a resident of the state; and
(v), whether a noncontingent beneficiary is a resident of the state.
New York employs only the first two criteria in determining whether the trust is a New York resident trust. Thus, in general, a New York “resident trust” is (i) any trust created under the will of a New York domiciliary or (ii) any revocable or irrevocable inter vivos trust created by a New York domiciliary. Although one can only speculate as to why the legislature chose not to consider factors considered by many other states, Wall Street and the New York banking industry may have been considerations. The rationale for this conclusion is that an out of state resident, for example, from Florida, which imposes no fiduciary income tax, who never visited New York, would avoid choosing a New York trustee or a New York administrator if doing so resulted in the trust income being taxed in New York.
Exceptions to Trust Taxation
Having stated the requirements for a New York resident trust, it is important to emphasize that not all New York resident trusts are subject to New York income tax, mainly for Constitutional reasons. The Third Department, in Taylor v. State Tax Commission, 445 NYS2d 648 (3rd Dept. 1981), found that income from a testamentary trust of a New York resident whose assets consisted of land in Florida managed by Florida trustees, could not be subject to New York taxation. The Appellate Division reasoned that the “only substantive contact with the property was that New York was the domicile of the settlor of the trust, thus creating a resident trust.”
The Third Department concluded that “[t]he fact that the former owner of the property in question died while being domiciled in New York making the trust a resident trust under New York tax law, is insufficient to establish a basis for jurisdiction.” The authority cited was the Fourteenth Amendment, which provides that a state may not impose a tax on an entity unless that state has a sufficient nexus with the entity. Following the decision in Taylor, the exemption for some resident trusts was codified in Tax Law §605(b)(3)(D)(i).
In deference to the Fourteenth Amendment (and possibly also to wealthy New Yorkers who might otherwise leave the state) Tax Law §605(b)(3)(D)(i) provides for a generous safe harbor under which a Resident Trust is not subject to New York. The safe harbor applies if
(i) all of the trustees are domiciled in another state;
(ii) the entire trust corpus is located out of state; and
(iii) all income and gains are derived from out of state sources.
For purposes of (i), TSB-A-10(4) may imply, but does not explicitly state, that the removal of a New York trustee during the tax year might satisfy the statutory requirement of all trustees being domiciled in another state.
For purposes of (ii), the requirement that the “entire corpus [be] located out of state” is less exacting than it might appear. Article XVI of the New York Constitution provides that “money, securities and intangible property not employed in carrying on any business in the state is deemed to be located at the domicile of the owner for purposes of taxation, and, if held in trust, shall not be deemed to be located in [New York] for purposes of taxation [by reason of] the trustee being domiciled in this state.”
For purposes of (iii), it is thought that even a small amount of New York source income will taint all trust income and render the entire trust income subject to New York tax, i.e., the ““one dollar” rule.
In 2010, Governor Patterson introduced legislation intended to eliminate the three-part exemption test provided by Tax Law §605(b)(3)(D)(i). However, the proposal was opposed by the New York Bar Association, and was subsequently tabled by the Senate and Assembly.
However, an unfortunate consequence of the failed legislative attempt to repeal the exemption appears to be that Albany has shown new interest in monitoring fiduciaries who claim the exemption by implementing new reporting requirements. In 2011, the Department promulgated TSB-A-11(4), which provides that “[as] of tax year 2010, even though the Trusts meet the conditions set forth in Tax Law §605(b)(3)(D), they are required to file Form IT-205 Fiduciary Income Tax Return and attach Form IT-205-C New York Resident Trust Nontaxable Certification to Form IT-205.””
Additionally, Tax Law §685(c)(6) now requires that trustees make estimated income tax payments.
II. Taxation of Nonresident Trusts
Some trusts created by nondomiciliaries may still be subject to New York income tax. Tax Law §605(b)(4) succinctly defines “Nonresident Trusts” as trusts which are not “Resident Trusts.” In contrast to Resident Trusts, which are taxed on all income regardless of source, Nonresident Trusts are taxed only on New York source income or gains. New York source income includes income from (i) real or intangible personal property located in New York; (ii) a trade or business operating in New York; (iii) services performed in New York; (iv) lottery winnings from the NYS lottery in excess of $5,000; and (v) the sale or transfer of shares of stock in a New York coop.
Since New York defines a Nonresident Trust as any trust that is not a Resident Trust, the existence of a New York trustee would not alone cause a nonresident trust to be taxed in New York provided the trust had no New York source income. The reason for this is that although the domicile of the trustee is important in determining whether the exemption from taxation for resident trusts under Tax Law 605(b)(3)(D)(i) is applicable, New York does not consider the domicile of the trustee in determining whether the trust is a New York resident trust.
Pursuant to Tax Law § 605(b)(3)(D)(i), if (i) the entire corpus of a trust is located out of New York, (ii) there are no New York trustees, and (iii) the trust has absolutely no New York source income, then a New York Resident Trust will not be subject to New York income tax.
If the existence of a New York trustee is the only cause of the New York resident trust being taxed in New York, the trust could provide a mechanism whereby the beneficiaries could substitute another out of state trustee. If the trust does not so provide, and also in other situations, the approval of the Surrogate might be required. However, since the trustee is charged with a fiduciary obligation to reduce taxes, the Surrogate would likely be favorably inclined to issue an order granting a request to remove a New York trustee which is causing the trust to be taxed in New York.
As a proviso, it must be noted that every judge has a unique temperament and there is no way of predicting in advance how a particular judge or Surrogate may view the request to change the situs of a trust. Therefore, if court involvement can be avoided, that is the preferable route.
The assets of a trust subject to New York State income tax may also be decanted into another trust not considered a New York Resident Trust.
Similarly, if the New York Resident trust fails the exemption test by reason of the ownership by the trust of New York real property or the existence of any tangible property in the state, the sale of the real property or the removal of the tangible property to out of New York might well cure that defect.
Under the “one dollar” rule, even a small amount of New York source income will render New York Resident Trusts taxable on all income and gains. It is therefore important that the fiduciary ensure that no errant K-1s arrive showing New York source income, if the requirements for the exemption are to be met. It has been argued that the “one dollar” rule does not accord with Due Process, as articulated by the Court of Appeals in Mercantile-Safe Deposit & Trust Co. v. Commissioner, 15 NY2d 579 (1964). However, in this regard as in others, it is probably best not to tempt fate.
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Estate tax and estate planning considerations may also inform the decision of a New York resident of where to situs a trust. Those considerations range from choosing a state with favorable asset protection laws, such as Nevada, Delaware, South Dakota, Wyoming, Tennessee, Utah, Oklahoma, Colorado, Missouri, Rhode Island and New Hampshire, to choosing one of the many states (of which New York is not one) which has either abolished the Rule Against Perpetuities or limited its application.