Grantor Trusts and State Income Tax

A broad, theoretical overview - with bonus materials for subscribers

Table of Contents

1. Video Summary

2. Objective

3. Background and Recap

4. State Grantor Trust Rules

5. Rev. Rul. 85-13 – A Redux

6. Conflicts Between States

7. Conclusion

8. Bonus Materials

   1. Sales and Use Taxes

   2. Ad Valorem Taxes

   3. SALT Deduction and Pass-Through Entity Tax

Video Summary

Objective

Before diving into this material, note that it deals with state laws that can vary. Because of this, it is difficult to write an article that leads to conclusions and answers on many of the issues that arise or can arise when exploring the interaction of grantor trusts with state tax laws. This article takes a more theoretical frame or tone in many areas. So, my ask of you is that you read this article not with the intent of seeking answers, but instead with the intent of becoming a better issue-spotter. From there, you can seek answers based on what specific states’ laws might apply to a trust taxation situation.

Background and Recap

In the prior article in this series, we introduced the concept of the grantor trust. To recap, this is an income tax status for a trust through which a deemed owner – usually a grantor (anyone making a “gratuitous transfer” to a trust), or if not a grantor, a beneficiary holding or having modified or partially released an unrestricted power to withdraw income and/or corpus – is taxed on the trust or portion thereof they are “deemed” to own under the grantor trust rules. While we have not covered these rules in great detail yet, they typically arise in situations where a deemed owner has retained some power over the income and/or corpus (principal)[1] of a trust.

The outcome of this “deemed ownership” dynamic is that a trust is disregarded, in full or in part, for income tax purposes. This holds true even for income that is distributed to a beneficiary, denying the grantor trust (or its deemed owner who is taxed on trust income) the deduction for the distribution of “distributable net income.” The original purpose of these rules was to prevent the shifting of income from a grantor to a controlled trust in a manner that allowed two bites at (once identical) progressive tax brackets that applied to both individuals and trusts. However, with the compression and reduction of tax brackets of trusts compared to individuals, grantor trusts now usually create lower effective income tax rates than if income were to be shifted to the trust.

The grantor trust rules are largely a creature of federal income tax. However, trusts can also be subject to state income tax based on a variety of factors under which a state establishes a sufficient “nexus” with the trust or parties thereto to justify taxing distributed or undistributed trust income. While this article is not designed to be a survey of all 50 states, the following are some common factors which determine nexus depending on the state:

• The state in which a fiduciary administers a trust (sometimes with variations on the amount of “administration” taking place in a state, or the permanent establishment of an office through which to conduct such administration in a state);

• The state of residence or domicile of a beneficiary receiving distributions from a trust;

• Location of trust assets or source of trust income, especially as relates to real property and business interests respectively;

• While having been challenged constitutionally in the 2019 U.S. Supreme Court case of N.C. Dept. of Revenue v. Kaestner, the mere presence or domicile of a beneficiary in a state (even for income not distributed to that beneficiary); and

• For California and New York in particular, the creation of an incomplete nongrantor trust (ING) in another state (as we will discuss below).

But, much like the grantor trust rules supersede the federal income tax rules that tax trusts and their beneficiaries on distributed and undistributed income, do we encounter the same treatment for state income tax? We will discuss some of the state income tax nuances below, with bonus materials (for paid subscribers) on other state and local taxes such as sales/use taxes, ad valorem taxes, and even pass-through entity tax elections.

Note that while this article series is primarily for wealth transfer professionals, it can also have special application for M&A attorneys and advisors. Grantor trusts are often encountered in M&A transactions, and knowing how to navigate the grantor trust rules can be vital for structuring and closing a transaction. As part of this series, we will later have some special stand-alone articles dedicated to M&A issues with grantor trusts. For now, however, the issues presented in this article are also valuable in M&A transactions.

State Grantor Trust Rules

As of now, all of the states that tax the distributed or undistributed income of a trust generally recognize federal grantor trust income tax treatment. (Pennsylvania was the last holdout, but they started recognizing grantor trusts for income tax purposes in 2024.) As a result, these rules will override the general state income tax rules applicable to a trust to cause the same deemed owner for federal income tax purposes to be subject to state income tax, as if they were the ones receiving the income generated by the trust.

Of course, this is not our ending point. Again we must be general when attempting to survey all 50 states, but essentially this outcome (like with the grantor trust rules) shifts us from an analysis of taxation of trusts to taxation of individuals as deemed income tax owners. This means individual deemed owners who reside in, or are domiciled in, a state that imposes state income tax on individuals will typically be taxed on grantor trust income in that state. Additionally, income generated by property (such as real estate, or business operations) in another state may be subject to sourcing rules under which the individual grantor is taxed by the source state on that income, subject to credits or offsets when multiple states tax the same income.

This state recognition of grantor trust status covers the taxation of trust income itself. But, does the same hold true for income that might be realized by the grantor or deemed owner in transactions with the grantor trust itself?

Rev. Rul. 85-13 – A Redux

In the last article, we discussed how Revenue Ruling 85-13 somewhat “extends” grantor trust treatment beyond the mere taxation of trust income to situations where a grantor essentially deals with “themselves” in transactions with a grantor trust. This allows, for example, a sale between a grantor and a grantor trust to not be subject to income tax since the grantor is essentially selling the assets to themselves (due to the deemed ownership status). Of course, arriving at this conclusion requires, at the very least, that the grantor be the deemed owner of the exchange consideration received from the grantor trust (immediately before the exchange) and the exchange consideration relinquished in the exchange (immediately after the exchange).

To get the full protection of Rev. Rul. 85-13, it is generally advisable to have a 100% grantor trust. What does this mean? It means that the grantor or beneficiary who is dealing with the trust is treated as the deemed income tax owner of all income and corpus of the trust. How we arrive at this conclusion will be covered in subsequent articles. For the time being, however, this can present special concerns when dealing with state income tax (in addition to federal income tax). If a state department of revenue were to determine that a trust is not a 100% grantor trust, this could establish grounds for taxation of a trust (and penalties relating thereto for any failures or delays in payment and/or filing).

It is also important to note that Rev. Rul. 85-13 is a federal ruling interpreting the Internal Revenue Code, and a state’s recognition of grantor trust status does not automatically mean that a state would adopt the principles of Rev. Rul. 85-13. While I am not aware of any state income tax cases or rulings that have expressly refused to follow the principles of this Ruling, it is worth noting that there may be a non-zero risk of state income tax applying to, for example, gain and interest realized by a grantor or beneficiary in a sale to a grantor trust. On the other hand, since many states recognize grantor trust status by incorporating IRC Sections 671-679, it is likely that this incorporation would also impliedly extend to federal interpretations of these Code Sections (whether in the form of Treasury Regulations or IRS written determinations).

Ultimately, I think there is a very low risk that a state would decline to follow Rev. Rul. 85-13 for income tax purposes, but it is still worth mentioning that this is not 100% certain.

Conflicts Between States

As alluded to above, it may be the case – both for nexus rules (as applied to a nongrantor trust or portion of a trust), and state recognition of grantor trusts – that multiple states could have an interest in taxing the same trust income. This raises special issues, perhaps, when it comes to a grantor trust beyond the possibility of a grantor and nongrantor portion for a trust that is not a 100% grantor trust.

Most states refer to or incorporate, in some form or fashion, IRC Sections 671-679 in their recognition of a grantor trust. This means that IRC Section 678(b) should be recognized if, for example, you have a grantor and beneficiary who are the same deemed owners of a trust or portion thereof. Again, though, it is important to check applicable state law to make sure that this is not an issue. Otherwise, you run the risk that, for example, the state of residence or domicile of the grantor and (if different) the state of domicile or residence of a beneficiary (as deemed owner) could seek to tax the same trust income. This could even arise in situations where, for example, a Crummey power is created for a beneficiary in another state (as a Crummey power, as we will later explore, causes a beneficiary to be the deemed income tax owner of at least the property subject to that power under IRC Section 678(a)(1) and usually 678(a)(2) if not superseded by taxation of the grantor under 678(b)).

On that note, recall again that the grantor trust rules do not create a deduction for distributable net income. This doesn’t present an issue for federal income tax purposes, since only one taxing jurisdiction – the United States – is involved. But, let’s take a situation where a grantor lives in one state and a beneficiary in another state receives a distribution. Would the state in which the beneficiary resides or is domiciled (if it imposes an income tax) recognize taxation of the grantor on the income comprising that distribution in the grantor’s own state of residence or domicile? Intuitively, it seems that the answer should be yes if federal tax principles are followed. Before reaching that conclusion, however, it is important to note that the way each state’s laws recognize grantor trust status could differ – thus leading to a possible conflict in interpretation and application of the grantor trust rules in each state to undistributed versus distributed trust income.

Release of a grantor trust power can also be an issue – especially if this causes a shift of the taxation of trust income from the grantor (in their own state of residence or domicile) to a fiduciary located in another state. A real-life example of this is found in the creation of incomplete non-grantor trusts (ING trusts) by individual taxpayers in California and New York, each of which treat an ING trust as a grantor trust with respect to the individual making the incomplete gift transfer to a trust administered in another state (usually a state with no income tax). While the intersection of incomplete gift powers and grantor trust powers is a subject for a later article, it is worth noting that this perhaps presents a broader philosophical issue on states’ radars that might extend beyond just ING trusts. To pick on California further, they have proposed a wealth tax that would apply based on wealth leaving their taxing jurisdiction. While more of a hypothetical, could this wealth tax (if passed) extend to the release of grantor trust powers in the manner described above?

Conclusion

Bonus materials follow below. For now, however, note that we deal with two fundamental questions when analyzing state income taxation of trusts. First, does the grantor trust status cause the primary taxing jurisdiction to be the state of residence or domicile of a grantor or beneficiary individually? Second, to the extent the grantor trust rules don’t apply to tax a grantor or beneficiary individually, to what extent do the state nexus rules apply?

As presented above, this presents all sorts of hypothetical situations which can create conflicts between multiple taxing jurisdictions. These issues require, at a minimum, a comparison of the manner in which conflicting state tax regimes recognize grantor trusts. And, while perhaps not a significant risk, they also involve a determination of whether all federal income tax rulings and regulations regarding grantor trusts would be respected by each state having a hand in the pie, or, as a corollary, whether one state would respect grantor trust treatment in another state.

Again, these are more theoretical but still necessitate a determination of whether a trust is a 100% grantor trust. If not, you end up with a blend of grantor trust rules applying to a portion of a trust, and the state nexus rules applying to the nongrantor portion of a trust.

Recall that the grantor trust rules are a creature of income tax. Federally, they do not apply to any other transfer or excise taxes, including gift, estate, and GST taxes. So, it is natural to assume that perhaps the same would hold true for state transfer and excise taxes. As our bonus materials, let’s examine some of the taxes to be aware of.

Bonus Materials