The Pennsylvania Department of Revenue recently changed its instructions for filing of an income tax return for trusts and estates. While many people are aware that an individual must file Form 1040, a trust or estate will typically file IRS Form 1041. On the state level, corollary returns are prepared for state income tax purposes, that being the New Jersey “NJ-1041” or for Pennsylvania residents, the Form “PA-41.”
While the tax “residence” of an individual can be a nebulous and questionable concept in some circumstances, determining the appropriate jurisdiction for a trust tax obligation is even more speculative and uncertain. Is the trust subject to taxation in the jurisdiction where the creator or testator resided? Should the trust be taxed where the trustee resides? Should the residence of the beneficiary or beneficiaries be the most important factor? Does it matter where the assets are located or where the income was earned? Most recently, however, the issue was raised by a change to the instructions for Form PA-41. In the “What’s New” provisions, the Commonwealth is seeking to mandate that a nonresident estate or trust with a Pennsylvania resident beneficiary is required to file PA-41.
The issue of trust residence has been addressed in two high profile state cases in our region in Kassner Residuary Trust A v. Director, 27 NJ Tax 68 (Tax 2013) and in McNeil v. Commonwealth, PA Comm. Court, No. 651 FR 2010, 173 FR 2011 (May 24, 2013). These court cases address the issue of tax residency of a trust. This change to the tax filing obligations may be the direct result of the McNeil case cited above. It is possible that the Commonwealth may be expanding its tax reporting obligations so that it can make independent determinations of whether a trust is a Pennsylvania trust or as reported, a nonresident.
In McNeil, trusts were created by the one-time Pennsylvania resident, Robert L. McNeil, Jr. who had amassed a fortune through the creation of McNeil Labs, Inc. (the maker of Tylenol). Under Pennsylvania statute, a resident trust is any trust, inter vivos or testamentary, that was created by a Pennsylvania resident or Pennsylvania resident decedent. The McNeil case found, based upon the theory of constitutional commerce clause that Pennsylvania had no basis to collect income tax from this trust because it had insufficient “nexus” to Pennsylvania. The court concluded that because the trust had no Pennsylvania “situs” assets, was not governed by Pennsylvania law, was administered outside of Pennsylvania and did not conduct business within Pennsylvania, the state did not have the authority to apply to Pennsylvania income tax.
This decision follows along precedent which was decided in New Jersey more than 30 years ago. In two landmark cases, Pennoyer v. Director, 5 NJ Tax 386 (Tax 1983), the NJ Tax Court and Potter v. Director, 5 NJ Tax 399 (Tax 1983) held that that due process rules of the United States Constitution prevented New Jersey from taxing trust income if the trustee, assets and beneficiaries were all located outside of New Jersey. In Pennoyer and Potter, the Court dealt with a testamentary trust and an intervivos trust and concluded that state income tax could not be imposed.
In Pennoyer and Potter, the courts determined that the income of a trust with no continuing contacts with New Jersey could not be subject to New Jersey income tax. The court opined that availability of the state courts to enforce or interpret the testamentary trust or irrevocable intervivos trust, without additional connection, was insufficient to support the assessment of the New Jersey Gross Income Tax on undistributed trust income. N.J.S.A. Const. Art. 1, par. 1; U.S.C.A. Const. Amend. 14; N.J.S.A. 54A:1-2(o)(2).
Statutorily in New Jersey, there is a gross income tax on the income or gains received by a trust which has not been distributed or credited to the Trust beneficiaries. N.J.S.A. § 54A:5-3. All such income and gains of a “resident” trust are taxable wherever the income is derived. A nonresident trust is subject to tax to the extent that the items of income or gain are derived from New Jersey sources. N.J.S.A. § 54A:5-8. A “resident trust” is a trust, or a portion of a trust consisting of property transferred by will of a decedent who at his death was domiciled in this State···.” N.J.S.A. § 54A:1-2(o)(2). A nonresident trust is a trust which is not a resident trust. N.J.S.A. § 54A:1-2(p).
While the change to the Pennsylvania form PA-41 signifies an effort on the part of the Commonwealth to police trusts which claim nonresidency status, it is interesting to note that the New Jersey rule has long required some nonresident estates and trusts to file form NJ-1041. However, the New Jersey rules mandate that the nonresident estate or trust must derive income from New Jersey sources. Income from New Jersey sources could result from the disposition of real estate in New Jersey, income derived from a trade or profession in New Jersey, business income or New Jersey gambling winnings. (See 2014 Form NJ-1041 instructions pages 1 and 2). By contrast, New Jersey requires NJ partnerships with out of state partners to file a partnership return.
The degree to which New Jersey has jurisdiction over a trust was called into question in another significant 2013 decision, Kassner Residuary Trust A v. Director, 27 NJ Tax 68 (Tax 2013) where a trust was created under the Will of a New Jersey resident and the trust owned a New Jersey S corporation. The trust was a shareholder in an S-corporation that conducted some of its business in New Jersey. Due to a share of corporate income being derived in New Jersey, the trust filed and paid income tax on its pro rata share of New Jersey source income. In Kassner Residuary Trust A, the trustee did not pay tax on its pro rata share of income allocated outside New Jersey, nor did it pay tax on its interest income. The Division of Taxation challenged the taxpayer’s position and the Court held that because the trust was not administered in New Jersey and because the trustee was a resident of New York, the trust could be deemed to own assets in New Jersey merely because it was a shareholder in S corporations that own New Jersey assets. Thus, it should not be required to pay tax on its undistributed out-of-state income. The New Jersey Tax Court based its decision on the aforementioned Pennoyer and Potter decisions from 1983. The Director attempted to cite out of state decisions from the District of Columbia and Connecticut, but the arguments were unsuccessful in the challenge.
The degree to which the state taxing authorities can invoke a tax or tax filing obligations on nonresident trusts remains very much in question. There are a variety of factors that can be involved in trusts administration so there is no bright line test. However, by seeking to impose filing requirements on nonresident trusts, Pennsylvania has raised an additional issue for the Courts. The United States Supreme Court recently weighed in on nexus issues in the decision Direct Marketing Association v. Brohl, No. 13-1032 (US Supreme Court March 3, 2015). While not exactly on point, in this case the Supreme Court held that the “Tax Injunction Act” does not bar federal courts from exercising jurisdiction over a suit to enjoin notice requirements imposed by state law. The “Tax Injunction Act” provides that the District Courts “shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law where plain, speedy and efficient remedy may be held in the courts of such State.” 28 USC §1341. The Direct Marketing Association had filed a federal action to invalidate a Colorado state law which did not impose a tax but instead imposed notice and reporting requirements on out-of-state retailers. The District Court granted the petitioner’s summary judgment request and enjoined the imposition of the notice and reporting requirements. However, the Federal District Court decision was reversed by the 10th Circuit Court of Appeals. In the United States Supreme Court, the District Court decision was reinstated, meaning that the Direct Marketing Association, on behalf of out-of-state retailers, could prevent the tax filings from moving forward under the “Tax Injunction Act.” The Supreme Court held that the Tax Injunction Act did not apply to a person where the person was not subject to tax in the state and the state was not attempting to collect a tax. There, a state was requiring an out of state person to provide information showing other (potential) taxpayers. Query whether the same agreement could be made to challenge Pennsylvania’s requirement that a trust, otherwise not subject to tax in the state, notify the Pennsylvania Department of Revenue about its beneficiaries. Colorado had failed to raise the Comity doctrine which would counsel the federal court to resist being involved in certain circumstances surrounding the fiscal operation of the State. Thus, the case was remanded to the 10th Circuit to determine, on remand, if Comity is an available alternate argument. The issue of “business nexus” has also been a hotly debated issue for a number of years particularly in light of internet marketing and interstate commerce due to internet selling.
While New Jersey has issued rulings that restate the rulings in Pennoyer and Potter, New Jersey has not issued regulations. Some commentators have questioned whether the United States Supreme Court decision in Quill Corp. v. North Dakota 504 U.S. 298 (1992) has undermined the due process reasoning relied upon by the Pennoyer and Potter courts. Specifically, under Quill, Court’s analysis of the federal Due Process Clause lessened connections between a taxpayer and a state which may support the state’s taxing authority. Quill Corporation, an office supply retailer, had no physical presence in North Dakota but it had a licensed computer software program allowing Quill’s customers (some in North Dakota) to check inventory and place orders. North Dakota attempted to impose a use tax on Quill, which was struck down by the Supreme Court on nexus grounds. Indeed, after Quill, Connecticut and the District of Columbia addressed a state’s power to tax a trust with little continuing connection to the taxing state. Both cases involved Chase Manhattan Bank. Chase Manhattan Bank v. Gavin, 733 A2d 782 (Conn 1999) and District of Columbia v. Chase Manhattan Bank, 689 A2d 539 (DC 1997).
In Gavin the Connecticut Supreme Court determined that continuing jurisdiction of the Connecticut probate court over the trust (to settle accounts and to otherwise act with respect to the trust) was a sufficient “minimum contacts” to support Connecticut taxation under the Due Process Clause as interpreted by Quill. The District of Columbia decision similarly applied the holding of Quill in the case the trust created by the will of a District of Columbia domiciliary. The court accepted the taxing authority’s analogy it drew between trusts created under authority of local law and corporations created under authority of local law. The court found that neither the Due Process Clause nor the Commerce Clause presented a bar to local taxation of the trust.
In sum, the change to the Pennsylvania filing obligations for non-resident trusts seems to be an attempt by the Commonwealth to obtain information from taxpayers about their claim to residency or more specifically, non-residency. Without the filing of a return, such a position for non-residency may never be known. However, in light of recent defeats the taxing authorities in both McNeil and Kassner Residuary Trust A, and with analogy to Direct Marketing Association, the ability of the Commonwealth to succeed in their efforts may be called into doubt. However, many Trustees will simply file nonresident returns to avoid the fight and possible penalties which, no doubt, will be less than the legal fees of a challenge.
 “Who Must File? Every partnership that has income or loss derived from sources in the State of New Jersey, or has a New Jersey resident partner, must file Form NJ-1065. A partnership must file even if its principal place of business is outside the State of New Jersey. Form NJ-1065 is no longer solely an information return. A filing fee and tax may be imposed on the partnership. Partners subject to the gross income tax still must report and pay tax on their share of partnership income or loss.” Page 2, 2014 Form 1065 Instructions.
Glenn A. Henkel is a shareholder in the firm and earned his J.D. degree at Rutgers University School of Law, where he graduated with honors and was awarded the Prentice Hall Award for outstanding performance in the area of taxation. He earned his LL.M. in Taxation at New York University. Mr. Henkel’s particular areas of expertise include complex estate planning, tax-exempt organizations and Probate, Trust and Estate Law.