Illinois Income Taxation of Trusts: Minimum Contacts Besides Settlor’s Residency at Trust Creation Required
June 16, 2014
Authored by: Kathy Sherby and Stephanie Moll
Last week, we discussed the important issue that settlors, beneficiaries, and trustees of a trust should be thinking about—Do You Know Which States Are Trying to Tax Your Trust? Two states’ courts have recently looked at what constitutes sufficient minimum contacts to subject a trust to the State’s income tax laws. In this blog, we will discuss Illinois’ decision in Linn v. Dep’t of Revenue. Come back next week for our discussion of Pennsylvania’s decision in McNeil v. Commonwealth of Pennsylvania.
In Linn, the Illinois Appellate Court last year held that the Illinois statute subjecting all Resident Trusts (trusts whose settlor was domiciled in Illinois at the time the trust became irrevocable) to income taxation, determined solely on the basis of the domicile of the settlor at the time the trust became irrevocable, violates the Due Process Clause of the U.S. Constitution.
In 2002, the trustees of an irrevocable trust
1. created by an Illinois settlor;
2. with an Illinois trustee; and
3. which was to be construed and administered in accordance with Illinois law
distributed trust assets to Lewis Linn, as trustee of Autonomy Trust 3 (“Trust”), and specifically provided in the new trust agreement that the Trust was to be construed and administered under Texas law, except that the principal and income of the Trust would continue to be determined in accordance with Illinois law.
As of 2006,
1. none of the beneficiaries of the Trust were Illinois residents;
2. the trustee and the trust protector did not reside in Illinois;
3. the administration of the Trust did not occur in Illinois; and
4. none of the Trust assets were held in Illinois.
Linn filed an income tax return for the Trust in 2006 as a nonresident trust, in which he reported that the Trust had no income from Illinois and paid no income tax. The Illinois Department of Revenue, however, reclassified the Trust as an Illinois Resident Trust, and imposed Illinois income tax on 100% of the Trust income.
The trial court concluded that because:
1. the original trust agreement provided that Illinois law governed the trust agreement and
2. the trust settlor was domiciled in Illinois at the time such trust become irrevocable,
the Trust was subject to Illinois income taxation.
1. that the Trust does not have sufficient contacts with Illinois for the Trust to be subjected to Illinois state income taxation and
2. that a minimal connection to Illinois is required for any such taxation to be constitutional under either the due process clause or the commerce clause of the U.S. Constitution.
In support of his argument that the Trust could not constitutionally be subjected to Illinois state income taxation, Linn presented the facts that, since 2006,
1. the Trust has been governed by Texas law, except for the determination of principal and income
2. has been administered in Texas
3. all of the Trust beneficiaries, trustee, and trust protector are not Illinois residents, and
4. the Trust had no assets in Illinois.
The Department asserted that Illinois could validly tax the Trust because the Trust owed its existence to Illinois, having been created in Illinois pursuant to the laws of Illinois, and that Illinois provides the Trust and beneficiaries with legal benefits and opportunities. Further, the settlor’s residence at the time of creation of the trust was Illinois, which is dispositive pursuant to Illinois law.
The Court reviewed the requirements of the due process clause of the constitution for taxing a trust or its property, that there must be a minimum connection between the state and the trust, and that the “income attributed to the State for tax purposes must be rationally related to values connected to the taxing State.”
Based on the nexus requirement, the Court ruled that the residence of the settlor at the time of the creation of this inter vivos Trust was not a sufficient connection to Illinois to satisfy due process. Therefore, the Trust could not be taxed in Illinois.
This Court’s decision, however, implies in dicta that, because a testamentary trust owes its existence to the State due to the fact that the trust was created through the probate of the decedent’s will in an Illinois probate court, a testamentary trust created by a decedent who was domiciled in Illinois at the time of death could continue to be subjected to income taxation in Illinois despite the later lack of all contacts with the State. We’ll have to wait and see whether this dicta becomes an issue in future cases.