• Illinois Appellate Court holds Illinois can’t tax trust under due process clause—In Linn v. Department of Revenue (2013 Ill. App. (4th) 121055), an Illinois Appellate Court held that a trust wasn’t subject to Illinois income tax under the due process clause. The trust at issue was created when the trustees of an irrevocable inter vivos trust exercised their power to distribute trust property to a new trust. The original trust was established in 1961 by A.N. Pritzker, when he was an Illinois resident, and the original trust was subject to Illinois law by its terms. The trustees and beneficiaries of the original trust were also Illinois residents. However, the trustees exercised their power to transfer assets to or in trust for the beneficiaries to establish a new trust. The new trust stated that it was to be construed and regulated under Texas law, except for the interpretation of the terms “income,” “principal” and “power of appointment” (POA) and the provisions relating to such terms. Later, the trustees obtained an order from the Texas probate court reforming the trust to be subject to Texas law in all respects, as long as the reformation didn’t jeopardize the generation-skipping transfer tax status of the trust.
The trustee of the new trust resided in Texas, and it was administered there. None of the beneficiaries of the new trust were Illinois residents, and it had no assets in Illinois. In 2006, the trustee filed a non-resident Illinois income tax return, reporting no income from Illinois sources and no Illinois tax. However, the Department of Revenue reclassified the trust as an Illinois trust and taxed 100 percent of its income. The trustee appealed.
The trial court held for the Department of Revenue that the new trust was subject to Illinois law under the trust agreement of the original trust from which it was created and that being subject to Illinois law was a sufficient contact to allow Illinois to tax the trust under the due process and commerce clauses of the U.S. Constitution. The trustee appealed again.
A trust is subject to Illinois tax if the grantor is domiciled in Illinois when the trust becomes irrevocable (the Illinois statute says a trust is considered irrevocable to the extent that the grantor isn’t treated as the owner of the trust under Internal Revenue Code Sections 671 through 678). On appeal, the parties agreed that Pritzker, the grantor of the original trust, is considered to be the grantor of the new trust as well. The main issue, therefore, was a constitutional one: Could Illinois tax the new trust if the only contact with the state was the resident grantor of the original trust?
The Illinois Court of Appeals held that Illinois couldn’t tax the trust. The due process clause requires there to be minimum contacts between the state and the person or property it taxes. The Department of Revenue argued that even though the trustee, beneficiary, trust protector and assets were all outside of Illinois, the new trust owed its existence to Illinois law and that Illinois provided legal benefits and opportunities to the trust. However, the court disagreed and held that the residence of the grantor alone was insufficient to establish a minimum connection that would permit Illinois to tax the trust. The court reasoned that the trust owed its existence to the exercise of a POA under the original trust agreement—not to Illinois law. It also noted that for the tax year in question, the new trust was subject to Texas law exclusively and would receive benefits and protections of Texas law.
The case is interesting, as decanting and exercises of POAs are becoming more common for income tax planning. The court noted that the trustees created the new trust by using a provision of the original trust, not by the Illinois decanting statute. It’s, therefore, not clear if the result would be the same if the trustees had relied on a state statute to decant the trust.
• Bankruptcy Court denies bankruptcy trustee’s access to debtor’s spouse’s revocable trust—In In re Reuter (499 B.R. 655, Sept. 12, 2013), the U.S. Bankruptcy Court for the Western District of Missouri held that the assets of a debtor’s wife’s revocable trust weren’t an asset of the bankruptcy estate.
Nathan Reuter and his wife Kathleen established revocable trusts in 2005. Nathan was a trustee and beneficiary, along with Kathleen, of both trusts. The bankruptcy trustee sought a declaratory judgment that Nathan’s powers over and interests in Kathleen’s revocable trust caused the property of her trust to be included in his bankruptcy estate.
However, the Bankruptcy Court held that the assets weren’t reachable by the trustee. First, Nathan was a discretionary beneficiary of the trust. Discretionary interests aren’t interests in property subject to the claims of the bankruptcy trustee.
Second, Nathan didn’t have the right to revoke the trust; under the terms of the trust agreement, only Kathleen could revoke her trust. The bankruptcy trustee unsuccessfully tried to argue that the Missouri Uniform Trust Code (MUTC) granted Nathan the power to revoke because he was a “settlor” of Kathleen’s revocable trust. The MUTC provides that a settlor of a revocable trust can revoke the trust with regard to the property attributable to her respective contribution. However, the definition of “settlor” under the MUTC turns on the right to revoke: It provides that each person who contributes property to a trust is a settlor of the property he contributes, but not if another person has a power to revoke that portion of the trust pursuant to the trust terms. Therefore, although Nathan had contributed property to Kathleen’s trust, he wasn’t a settlor of the trust under the MUTC because Kathleen retained the sole right to revoke the trust. Therefore, as a non-settlor, he couldn’t revoke the trust under the MUTC. The court distinguished this case from others in which the debtor shared the power, in some manner, to revoke the trust with a spouse.
Third, the trust contained a valid spendthrift clause, which restricted the transfer of Nathan’s beneficial interest in the trust. The court refused to accept the bankruptcy trustee’s argument that the spendthrift clause shouldn’t apply due to Nathan’s dominion and control over the trust assets, noting that Nathan served as a co-trustee with Kathleen and that the trust agreement required the trustees to act by majority decision. Lastly, the court refused to grant the bankruptcy trustee any equitable relief.
The holdings regarding Nathan’s beneficial interests and powers as trustee aren’t surprising. The key to the spendthrift protection in the case turned on the interpretation of Missouri law that Nathan wasn’t a settlor of the trust.