In Linn v. Department of Revenue, the Illinois Fourth District Appellate Court reviewed the state’s statutory framework for taxing trusts. On constitutional grounds, the court limited Illinois’ power to impose taxes under its “once subject to tax, forever subject to tax” regime. This case creates planning opportunities to minimize Illinois income taxes.
Illinois trusts are subject to a 5 percent income tax and a 1.5 percent personal property replacement tax. A non-resident trust is subject to taxation to the extent of the income generated within Illinois or apportioned to the state. Resident trusts, on the other hand, are subject to tax on all income regardless of the source of that income. For an individual, state income taxation on a resident basis generally requires domicile or residence within the taxing state. With respect to a trust, one or more of the grantor, trustees and beneficiaries may have contacts with a state sufficient to uphold as constitutional a tax on all of the trust income.
Illinois defines a resident trust based solely on the domicile of the grantor. A “resident trust” means:
- A trust created by a will of a decedent who at death was domiciled in Illinois; and
- An irrevocable trust, the grantor of which was domiciled in Illinois at the time the trust became irrevocable. For purposes of the statute, a trust is “irrevocable” when it’s no longer treated as a grantor trust under Sections 671 through 678 of the Internal Revenue Code.
Illinois law then attempts to stretch the ordinary boundaries of nexus in forever taxing the income generated by the trust property, regardless of the trust’s continuing connection to Illinois. One can analogize the Illinois statute to a hypothetical statute providing that any person born in Illinois to resident parents is deemed an Illinois resident and subject to Illinois taxation, no matter where that person eventually resides or earns income.
Linn involved a trust established in 1961 by A.N. Pritzker, an Illinois resident. The trust was initially administered by Illinois trustees pursuant to Illinois law. In 2002, pursuant to powers vested in the trustee in the trust instrument, the trustee distributed the trust property to a new trust (the “Texas Trust”). Although the Texas Trust generally provided for administration under Texas law, certain provisions of the trust instrument continued to be interpreted under Illinois law. The Texas Trust was subsequently modified by a Texas court to eliminate all references to Illinois law, and the trustee filed the Texas Trust’s 2006 Illinois tax return on a nonresident basis. At that time:
- No non-contingent trust beneficiary resided in Illinois;
- No trust officeholder resided in Illinois;
- All trust assets were outside Illinois; and
- Illinois law wasn’t referenced in the trust instrument.
The Illinois Department of Revenue (the “IDR”) determined that the trust was a resident trust and that, as such, the trust should continue to be subject to Illinois income tax. The trustee countered that the imposition of Illinois tax under these circumstances was unconstitutional as a violation of the due process clause and the commerce clause. The court sided with the trustee based on due process grounds (not reaching the commerce clause arguments), and recited the following requirements for a statute to sustain a due process challenge: (1) a minimum connection must exist between the state and the person, property, or transaction it seeks to tax, and (2) the income attributed to the state for tax purposes must be rationally related to values with the taxing state.
This being a case of first impression in Illinois, the court cited a number of cases from other jurisdictions, including Chase Manhattan Bank v. Gavin, 733 A. 2d 782 (Conn. 1999), McCulloch v. Franchise Tax Board, 390 P.2d 412 (Cal. 1964), Blue v. Department of Treasury, 462 N.W.2d 762 (Mich. Ct. App. 1990) and Mercantile-Safe Deposit & Trust Co. v. Murphy, 242 N.Y.S.2d 26 (N.Y. App. Div. 1963). Gavin, which upheld the application of the Connecticut income tax on the undistributed income of an inter vivos trust created by a Connecticut grantor, was cited at length by the court. A critical fact in that case was that the beneficiary resided within the state for the year in question. In Linn, the court noted, there were no Illinois beneficiaries. Relying on Blue and Mercantile, the court found that a grantor’s residence within a state isn’t itself a sufficient connection to satisfy due process.
The IDR argued that significant connections with Illinois existed, maintaining that the trust owed its very existence to Illinois and listing numerous legal benefits Illinois provides to the trustees and beneficiaries. The court disagreed with the testamentary trust cases the IDR relied on, finding that an inter vivos trust’s connections with a state are more attenuated than in the case of a testamentary trust. Further, the court found that the Texas Trust wasn’t created under Illinois law, but rather by a power granted to the trustees under the original trust instrument. The court proceeded to dismiss the trust’s historical connections to Illinois and focused on contemporaneous connections finding that “what happened historically with the trust in Illinois courts and under Illinois law has no bearing on the 2006 tax year.” For 2006, the court concluded that the trust received the benefits and protections of Texas law, not Illinois law.
Steps to Consider
Although the IDR could appeal Linn or Illinois could issue a legislative response to the case, the decision provides guidance to trustees of trusts that are or could be administered outside of Illinois.
Trustees of resident trusts with limited contacts to Illinois (in particular, those trusts without trustees, assets, or non-contingent beneficiaries in Illinois) should consider:
Review state taxation: The trustee should review connections to Illinois and consider whether actions could be taken to fall within the purview of the Linn holding. Contacts with other states and those states’ rules for taxing trusts should also be reviewed.
File return with no tax due: Pending guidance from the Department of Revenue, the trustee could consider filing an IL Form 1041 referencing the Linn case and reporting no tax due. For each tax year, a tax return must be filed in order to commence the running of the statute of limitations. An Illinois appellate court decision that supports the taxpayer’s position will ordinarily provide a basis for the abatement of tax penalties.
- Amend prior tax returns: The trustee could consider filing amended tax returns for prior years. A trustee that has timely filed prior year tax returns may file an amended tax return at any time prior to the third anniversary of the due date of the tax return, including extensions. For example, the 2010 tax year return may be amended at any time prior to Oct.15, 2014.
Given the holding in Linn and uncertainty regarding trust tax law, trusts that offer flexibility and can adapt to changing circumstances may have a distinct advantage.
Officeholders: Carefully consider the residency of officeholders, and provisions regarding the appointment and removal of officeholders.
Decanting provision: Consider providing the trustee with broad authority to distribute trust property in further trust.
Inter vivos trusts: While the legal basis for the continued income taxation of a testamentary trust may also be questionable, testamentary trusts (meaning trusts established under a will that may remain subject to the supervision of a probate court) can be avoided by creating inter vivos trusts.
Situs and administration: Consider establishing and administering the trust in a state that doesn’t assess an income tax.
Governing law: Consider including trust provisions that allow the trustee to elect the laws of another state to govern the administration of the trust. (Allowing the trustee to change the law governing interpretation, validity and duration is inadvisable.)
Discretionary dispositive provisions: Consider including discretionary trust distribution provisions, as some states may tax a trust based on the residence of beneficiaries with non-contingent trust interests.
- Severance provisions: Consider including provisions authorizing a trustee to sever a trust without altering trust dispositive provisions. This type of provision may allow a trustee to divide a trust into separate trusts and isolate the elements of a trust attracting state taxation. For example, a trust may simply be divided into two separate trusts, one trust for the benefit of a child and his descendants that live in Illinois, and a second trust, not subject to Illinois taxation, for a child and his descendants that don’t live in state.
(For a more detailed analysis regarding the income taxation of trusts and constitutional limitations, see Rationalizing the State Income Taxation of Trusts - Chasing Quill Feathers in the Wind. By Carlyn S. McCaffrey and John C. McCaffrey, May 10, 2010. http://www.nycbar.org/pdf/report/uploads/20071955-HessLectureRationalizingtheStateIncomeTaxationofTrust.pdf.)