Multistate Allocation of Trust Distributable Net Income: Income Sourcing and Apportionment

Multistate Allocation of Trust Distributable Net Income: Income Sourcing and Apportionment THURSDAY, FEBRUARY 21, 2019, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 ext.1 (or 404-881-1141 ext. 1). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. To earn full credit, you must remain connected for the entire program. FOR LIVE PROGRAM ONLY WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x1 (or 404-881-1141 x1) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

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Multistate Allocation of Trust Distributable Net Income February 21, 2019 Alison F. Egan, Of Counsel Caplin & Drysdale, Washington, D.C. aegan@capdale.com Dianne C. Mehany, Member Caplin & Drysdale, Washington, D.C. dmehany@capdale.com

Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

Alison F. Egan & Dianne C. Mehany February 21, 2019

Trust Accounting Income vs. DNI Basis for State Taxation of Trusts Taxation of Trusts at the State Level 6

Trust Accounting Income vs. DNI Calculation of DNI Under Various Scenarios Allocation of DNI Among Beneficiaries Tier I vs Tier II Distribution Requirements Basis for State Taxation of Trusts Taxation of Trusts at the State Level 7

Grantor trusts are treated as disregarded entities; the grantors (or owners ) pay tax on all trust income The majority of states have adopted federal income tax classification of grantor trusts A nongrantor trust is taxed like a separate individual, with certain exceptions The main exception is that a nongrantor trust is allowed a deduction for certain distributions it makes to beneficiaries 8

Because a nongrantor trust is allowed a deduction for distributions, another taxpayer must be responsible for paying the tax DNI (distributable net income) is a unique income tax concept that provides the accounting methodology by which income and gains are carried out to beneficiaries DNI is essentially fiduciary accounting income distributable to beneficiaries, net of trust expenses and deductions 9

Fiduciary Accounting Income (Section 643(b)) is the amount of income of a trust under the terms of the governing instrument and applicable local law Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing income and applicable local law shall not be considered income 10

For a domestic trust, DNI is taxable income (before the distribution deduction and the personal exemption and without accounting for the exclusion for qualified small business stock under Section 1202) plus tax exempt income, excluding capital gains and losses Special rule for capital gains to be included in DNI pursuant to Regulation 1.643(a)-3(b), if discretion permitted by trust document and local law in the following circumstances: Allocated to income (though if unitrust amount cannot be greater than the excess of the unitrust amount over the amount of distributable net income determined without regard to this Regulation); Allocated to principal but treated consistently by the fiduciary on the trust's books, records, and tax returns as part of a distribution to a beneficiary; or Allocated to principal but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary Capital gains for which charitable deductions are allowed may also be included in DNI 11

First calculate DNI by type Identify items of gross income (by type) Apply deductions to specific gross income items If expenses are not directly attributable to a specific class of income, allocate them to the trust as a whole Then allocate it among beneficiaries Allocation will depend on whether the trust is a simple trust or a complex trust 12

From Reg. 1.643(d)-2; terms of trust instrument provide Income to be distributed to W during her life Capital gains are allocated to principal and all expenses charged against principal Item of Income Amount Dividends from domestic corporations $30,000 Extraordinary dividends allocated to principal by trustee in good faith $20,000 Taxable interest $10,000 Tax-exempt interest $10,000 Long-term capital gains $10,000 Trustee s commissions and miscellaneous expenses allocable to principal $5,000 13

The allocations below to principal are relevant for FAI purposes; they may be relevant for DNI purposes Item of Income Amount Dividends from domestic corporations $30,000 Extraordinary dividends allocated to principal by trustee in good faith $20,000 Taxable interest $10,000 Tax-exempt interest $10,000 Long-term capital gains $10,000 Trustee s commissions and miscellaneous expenses allocable to principal $5,000 14

The following items are relevant for calculating FAI ($50,000) this is the amount distributable to W under the trust terms Item of Income Amount Dividends from domestic corporations $30,000 Extraordinary dividends allocated to principal by trustee in good faith $20,000 Taxable interest $10,000 Tax-exempt interest $10,000 Long-term capital gains $10,000 Trustee s commissions and miscellaneous expenses allocable to principal $5,000 15

But an additional item is relevant for calculating DNI ($45,000) Item of Income Amount Dividends from domestic corporations $30,000 Extraordinary dividends allocated to principal by trustee in good faith $20,000 Taxable interest $10,000 Tax-exempt interest $10,000 Long-term capital gains $10,000 Trustee s commissions and miscellaneous expenses allocable to principal $5,000 16

Terms of trust instrument and governing state law provide Income to be distributed to Z during his life Capital gains are allocated as fiduciary provides Item of Income Amount Dividends from domestic corporations $30,000 Extraordinary dividends allocated to principal by trustee $20,000 Taxable interest $10,000 Tax-exempt interest $10,000 Long-term capital gains allocated to income by trustee $10,000 Trustee s commissions and miscellaneous expenses allocable to principal $5,000 17

The following items are relevant for calculating FAI Item of Income Amount Dividends from domestic corporations $30,000 Extraordinary dividends allocated to principal by trustee $20,000 Taxable interest $10,000 Tax-exempt interest $10,000 Long-term capital gains allocated to income by trustee $10,000 Trustee s commissions and miscellaneous expenses allocable to principal $5,000 Are any others? 18

We don t know whether the trustee acted in good faith Item of Income Amount Dividends from domestic corporations $30,000 Extraordinary dividends allocated to principal by trustee? $20,000 Taxable interest $10,000 Tax-exempt interest $10,000 Long-term capital gains allocated to income by trustee $10,000 Trustee s commissions and miscellaneous expenses allocable to principal $5,000 Assuming so, FAI is $60,000 19

And DNI is equal to $55,000 Item of Income Amount Dividends from domestic corporations $30,000 Extraordinary dividends allocated to principal by trustee $20,000 Taxable interest $10,000 Tax-exempt interest $10,000 Long-term capital gains allocated to income by trustee $10,000 Trustee s commissions and miscellaneous expenses allocable to principal $5,000 Note that because state law and the trust instrument allowed the allocation of capital gains to income, it was respected 20

Simple Trust A simple trust is one whose terms require the distribution of all its income currently Generally, it cannot accumulate income, distribute out of principal, or pay money for charitable purposes If a trust distributes principal during a year, as in the year it terminates, the trust becomes a complex trust for that year Complex Trust A complex trust is any trust that does not meet the requirements for a simple trust Complex trusts may accumulate income, distribute amounts other than current income and, make deductible payments for charitable purposes 22

For simple trusts, allocate ratably amongst beneficiary distributions For complex trusts, allocate according to the terms of the trust document 23

Allocation of DNI for complex trusts uses a tier system There are two tiers of distributions Tier I distributions are all mandatory income (i.e., FAI) distributions Tier II distributions are non-required income distributions or distributions that must be paid out of income or principal and were paid out of income To be a Tier II distribution, the amount must be properly paid, credited, or required to be distributed currently If the amount of Tier I distributions exceeds DNI, then all DNI is allocated to those distributions If DNI remains after Tier I distributions, the remaining DNI is allocated proportionately among those receiving Tier II distributions, based upon the amount of trust property received by each 24

Trust Accounting Income vs. DNI Basis for State Taxation of Trusts How States Determine Trust Residency Due Process and Commerce Clause Questions Taxation of Trusts at the State Level 25

States classify trusts as resident or nonresident In general, states tax resident trusts on all income and nonresident trusts on income sourced from that state However, there are some circumstances in which trusts that are classified as resident by a state will not be subject to tax on all their income Currently, Alaska, Florida, New Hampshire, South Dakota, Texas, Washington, and Wyoming impose no state tax at the trust level 26

States assert one or more of the following bases for classifying trusts as resident: For testamentary trusts, residence of settlor at time of death CT, NY, NJ For inter vivos trusts, residence of settlor at time of settling the trust CT Administration of trust HI, IN Residence of trustee CA, OR Residence of beneficiary CA, DE, NC (under challenge) Some of these bases for taxing jurisdiction have been subject to constitutional challenges 27

Must carefully consider the provisions of each state in which the trust has a connection, as rules vary significantly Sampling of state provisions In Virginia, a trust can be a resident trust if a trustee is resident there but may not be a resident trust if there is another trustee not resident there In California, trust is a resident if either trustees or non-contingent beneficiaries of the trust are residents of the state North Carolina formerly classified a trust as NC resident based solely on a beneficiary being a NC resident In 2018, state supreme court struck down the statute U.S. Supreme Court has granted cert 28

A terrific resource for beginning a determination of whether a state will assert taxing jurisdiction over a new or existing trust is https://www.actec.org/assets/1/6/nenno_state_nongrantor_tax_survey.pdf 29

New York Primarily considers the domicile of settlor in order to determine residency However, declines to tax resident trusts that have no other minimum contacts with the state ( resident exempt trusts ) Must satisfy a strict three part test that considers residence of trustee, location of assets, and source of income Therefore, important to consider additional contacts that can trigger tax on all income NY law suggests that only $1 of New York sourced income could subject a formerly non-taxable trust to full NY taxation Planning solution? 30

Due Process clause of 14 th Amendment: No state shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any state deprive any person of life, liberty, or property, without due process of law... Commerce Clause: Congress shall have the power to regulate commerce... among the several States.... 31

When considering the nexus of a trust, an ordering of factors seems likely Factors with the strongest pull to a state Location of administration of the trust assets (regardless of where trust assets are physically located) Residency of the trustee North Carolina case law, and the grant of cert by the U.S. Supreme Court, has firmly called into question the strength of the residence of a beneficiary when establishing minimum contacts 32

The Kimberly Rice Kaestner 1992 Family Trust Trust created in NY and trustee resident in CT However, North Carolina imposed tax solely because beneficiaries were resident in NC There is a split among states as to whether they are allowed to tax based on the residence of the beneficiary Four states have concluded it is constitutionally permissible Five states have concluded it is not 33

Trust Accounting Income vs. DNI Basis for State Taxation of Trusts Taxation of Trusts at the State Level Allocations in multistate contact circumstances Sourcing Issues Active Business Income States That Deviate from Federal Grantor Trust Rules 34

Ask questions each year about the trustees, the beneficiaries, and administration of the trust Ask about what the plans are for the upcoming year (including expected income and distributions) Keep state income tax considerations prominent in clients minds 36

Utilize strategies to reduce taxation Change trustees Divide the trust Set up new trusts Change where administration occurs (may require petitioning a local court) Fiduciaries do have a duty to minimize taxes Surcharge cases have been brought by beneficiaries when fiduciaries have failed to take reasonable actions to minimize tax 37

Testamentary trust settled by Connor, who was domiciled in NY at death Three beneficiaries are Connor Jr. (CA), Amaya (VA), and Greg (NY) Trustees are Amaya s husband Romeo (VA) and Manhattan Beach Trust Company (CA) Trust owns partnerships that generate source income in CA, PA, VA, and NY 38

Which states will assert authority to tax the trust? 39

Which states will assert authority to tax the trust? California (resident trustee, resident beneficiary) 40

Which states will assert authority to tax the trust? California (resident trustee, resident beneficiary) New York (settlor was domiciled in NY and earns NY-source income) resident and not resident exempt 41

Which states will assert authority to tax the trust? California (resident trustee, resident beneficiary) New York (settlor was domiciled in NY and earns NY-source income) resident and not resident exempt Virginia (two trustees, only one of whom is in VA, but some trust assets may be located in VA if partnership generates VAsource income) could be resident 42

Which states will assert authority to tax the trust? California (resident trustee, resident beneficiary) New York (settlor was domiciled in NY and earns NY-source income) resident and not resident exempt Virginia (two trustees, only one of whom is in VA, but some trust assets may be located in VA if partnership generates VAsource income) could be resident Pennsylvania non-resident 43

Evaluate whether a credit is available (either for all taxes paid to another state or for taxes paid on income sourced from another state) Determine how to mitigate the taxing situation Hive off the partnership generating NY source income and the partnership generating VA source income (if VA would exert taxing authority) by dividing the trust 44

If half the income is distributed to Connor Jr. on his federal K-1 from the trust, income sourced to which state(s) will pass out to him? And what happens if the trust s share of state-sourced income exceeds its federal income? 45

In most states, there is not much guidance, and the key is to find a defensible method New York offers some guidance NY source income is allocated based on the percentage of DNI distributed versus remaining in trust If there is no DNI, then NY source income is based on a percentage of the income distributed (as income determined under local law) 46

Categories of state-sourced income Real or tangible property located within the state Some states (like NY) include certain gains or losses from the sale or exchange of an interest in an entity that owns real property in that state A business, trade, profession or occupation carried on in the state Taxpayer s distributive share of partnership income or gain 47

Different regimes be wary Three factor: property located in state, sales made to state residents, payroll paid to state residents Single factor: just sales Market-based sourcing vs cost-of-performance based sourcing Sourcing income on sale of partnership interest 48

Treat trusts that are grantor trusts under federal law as their own taxpayers Pennsylvania Treat trusts that are non-grantor trusts under federal law as owned by the settlor New York 49

Alison F. Egan Of Counsel Caplin & Drysdale, Chartered 202-862-7860 aegan@capdale.com Dianne C. Mehany Member Caplin & Drysdale, Chartered 202-862-5068 dmehany@capdale.com Disclaimer This communication does not provide legal advice, nor does it create an attorney-client relationship with you or any other reader. If you require legal guidance in any specific situation, you should engage a qualified lawyer for that purpose. Prior results do not guarantee a similar outcome. Attorney Advertising It is possible that under the laws, rules, or regulations of certain jurisdictions, this may be construed as an advertisement or solicitation. 2018 Caplin & Drysdale, Chartered All Rights Reserved. 50