Another recent court decision has looked at the constitutionality of the State imposing state income tax on an irrevocable trust. Last year, the Court in McNeil v. Commonwealth of Pennsylvania held that Pennsylvania’s attempt to tax the McNeil trusts, whose connection to Pennsylvania was (1) the residency of the settlor at the time the trust was created and (2) the residency of the trust’s discretionary beneficiaries was an unconstitutional violation of the Commerce Clause of the United States Constitution.
Like Illinois and many other states (see our recent posts, Do You Know Which States are Trying to Tax Your Trust and Illinois Income Taxation of Trusts: Minimum Contacts Besides Settlor’s Residency at Trust Creation Required), Pennsylvania imposes state income tax on all the income of “resident trusts”, and statutorily defines a “resident trust” (Section 301(s)(2) of the Pennsylvania Tax Code) as any trust created by a person who was a Pennsylvania resident at the time of creation. The regulations issued by the Pennsylvania Department of Revenue (the “Department”) stated that this was the sole controlling factor and that the residence of the trustees and beneficiaries “shall be immaterial.”
The Court ruled that the statute failed to satisfy any of the requirements of the Commerce Clause to withstand constitutional scrutiny in this case.
Robert McNeil, Jr. created two inter vivos trusts in 1959. Although McNeil was a Pennsylvania resident at that time, the Trust Agreements appointed only Delaware trustees and provided that the Trusts were to be governed, administered, and construed under the laws of Delaware.
In 2007, the tax year at issue in this case, the Trusts had no income or assets in Pennsylvania.
The only connection the Trusts had with Pennsylvania in 2007 was the residency of the Trusts’ discretionary beneficiaries. The trustees of one of the Trusts did make a discretionary income distribution in 2007.
Pennsylvania imposed income tax on the remaining undistributed income of the Trusts and the trustee objected, arguing that (1) the Trusts were non-resident trusts that had no Pennsylvania source income and no Pennsylvania trustees, (2) the imposition of State income tax on these Trusts violated the Due Process Clause and the Commerce Clause, and (3) it was contrary to the Department’s own rulings.
In determining whether Pennsylvania’s taxation of the Trusts violated the Commerce Clause of the United States Constitution, the Court relied on a four prong test that
(1) the taxpayer must have a substantial nexus to the taxing jurisdiction;
(2) the tax must be fairly apportioned;
(3) the tax being imposed upon the taxpayer must be fairly related to the benefits being conferred by the taxing jurisdiction; and
(4) the tax may not discriminate against interstate commerce.
The Court found that Pennsylvania failed the first three prongs in its attempt to tax these Trusts.
Substantial Nexus Test
While noting that “substantial nexus” is not the same thing as “minimum contacts,” the Court found that the only physical presence of the Trusts in Pennsylvania was
(1) the settlor’s residency in 1959 when the Trusts were created; and
(2) the current Pennsylvania residency of the discretionary beneficiaries.
The Court ruled that neither of these connections meets the substantial nexus requirement.
The settlor’s residence in Pennsylvania when he created the Trusts was not sufficient to provide the “physical presence necessary to establish a substantial nexus “ because the settlor (1) established the Trusts in Delaware, (2) with Delaware law applying, and (3) did not reserve any control over the Trusts that could be viewed as providing a “physical presence” in Pennsylvania.
Furthermore, according to the Department’s own regulations, the residence of beneficiaries is immaterial when determining if a trust is a “resident trust”, and even if it were relevant, the in-state beneficiaries are discretionary and have no current or future entitlement to actually receive the Trusts’ income or assets.
Fair Apportionment Test
Next, in order to be fairly apportioned, a state tax must only be levied on that portion of the revenue that bears a rational relationship to Pennsylvania. Here, the stipulated facts were that the Trusts did not derive any income from Pennsylvania and had no assets or interests in Pennsylvania. Imposition of PIT on all of the Trusts’ income violates the fair apportionment prong, when the Trusts’ income was not connected with Pennsylvania.
Fair Relation to Benefits Received Test
The Court also rejected the Department’s argument that the taxes are fairly related to the services Pennsylvania provides in protecting the rights of the beneficiaries. While the discretionary beneficiaries undoubtedly received benefits from Pennsylvania because they reside in Pennsylvania, the benefits that they have received and are receiving do not relate to the Trusts. Furthermore, the beneficiaries themselves pay tax on any distributions that they receive from these Trusts, which do fairly relate to the benefits they are receiving from Pennsylvania.