How states determine which trust income they can tax

For a trust holding a business, rental property or private investments, start by separating the questions. Who receives federal ownership treatment? What makes the trust resident in each relevant state? Where does each income item originate?

Federal ownership is a separate inquiry

For federal income tax, when the grantor or another person is treated as owner of a trust portion under the grantor trust provisions, that person's calculation includes income, deductions and credits attributable to that portion.

Inclusion extends only to items taken into account in computing an individual's taxable income or tax credits. Any remaining portion is subject to subparts A through D.

This federal ownership provision does not establish the trust's state tax residence or the effect of an individual's later move.

New York classification and exemption are different questions

Historical New York fiduciary instructions classify a trust created by a will as resident when the decedent was domiciled in New York at death.

Under those New York instructions, an irrevocable trust is resident if it consists of property transferred by someone domiciled in New York when the transfer occurred.

For a trust that remains revocable, those New York instructions use the transferor's domicile at transfer. If it later becomes irrevocable, they use the transferor's domicile when it becomes irrevocable.

Under those historical New York instructions, exemption from personal income tax requires all three conditions below:

• All trustees are domiciled outside New York.
• The entire trust corpus, including real and tangible personal property, is outside New York.
• All income and gains come from sources outside New York, determined as for a nonresident trust.

For the corpus condition, those New York instructions state the department's position that intangibles located in New York but not employed in a business carried on there are not deemed located there.

For every qualifying year, those New York instructions still require filing Form IT-205-C with Form IT-205, marking the exemption box and completing Schedules A, B and C.

They also require completing applicable additional information items A through L in Schedule C. These are historical instructions, not verification of subsequent New York law or procedure.

California separates source income from other retained income

Historical California instructions tax California source income regardless of fiduciary or beneficiary residence.

Under those California instructions, taxation of other income retained by a trust and allocated to principal depends on fiduciary and noncontingent beneficiary residence, rather than the person who established the trust.

A noncontingent beneficiary has an unconditional interest in trust income or corpus.

For mixed resident and nonresident trustees and mixed resident and nonresident noncontingent beneficiaries, those California instructions first allocate other income using the fraction of trustees who are California residents.

Next, apply the fraction of noncontingent beneficiaries who are California residents to the remaining income. Add the two allocations to determine the amount of that other income taxable by California.

Under those California instructions, all trust income is taxable if all trustees are California residents, all noncontingent beneficiaries are California residents, or all income comes from California sources.

The California apportionment described here does not apply to contingent beneficiary interests. Those interests require separate review under California Revenue and Taxation Code §17745.

Historical California source instructions locate real estate income where the property is located. Real estate outside California does not produce California source income merely because a trust owns it.

That source distinction does not establish exemption under California's separate residence and allocation rules. These California examples describe historical guidance, not verification of subsequent law.

Arizona includes a corporate fiduciary exception

In Arizona, a trust generally is resident if at least one fiduciary is an Arizona resident.

For an interstate corporate fiduciary serving alone or with a nonresident cofiduciary, Arizona resident classification instead requires that corporation to administer the trust in Arizona.

Arizona gross income starts with federal taxable income for resident trusts and federal taxable income from Arizona sources for nonresident trusts. Arizona taxable income then applies the modifications in article 3.