State Income Tax of Trusts and Estates Late 2020 Update


A couple of years ago, I wrote about the state income taxation of trusts.[1] Since that time, there have been some significant developments relating to the issues raised in that writing. Primary among those developments include the United States Supreme Court decision in the Kaestner[2] case and the United States Supreme Court’s decision to deny certiorari in the Fielding[3] case.

To understand the importance of the concepts relevant for a state’s basis for imposing income tax on a trust, it is important to have a basic understanding of state allocation and apportionment of income. Generally, income is divided between “business income” and “non-business income.”[4] Business income is subject to apportionment between the states where the income is generated based on certain apportionment factors.[5] Business income is taxed to the state to which such income is allocated. Non-business income is subject to allocation whereby the income is allocated to the state where the taxpayer is a resident.

As a result, it is critical to determine: (a) whether income is business vs. non-business, and (b) where a taxpayer is a resident. The outcome of those determinations inform which state will tax income. These two issues have arisen specific to the state income taxation of trusts. States have multiple different tests to determine the residency of trusts.[6] Also, trusts often own pass-through entities generating apportionable business income, such as entities taxed as partnerships or S corporations. A question that arises often is what happens when the trust sells equity interests of that pass-through entity. Will states to which the entity’s business income is apportioned be able to tax such income or, alternatively, will this be non-business income allocated to the state of the trust’s residence? While this article will address some cases illustrating results in certain states, the law is not uniform but rather subject to potential significant variation among the states.[7]

United States Supreme Court: Kaestner and Fielding

We previously have written about the Kaestner case.[8] Also, there are numerous other resources discussing the outcome in Kaestner. As such, I do not intend to give a detailed discussion of that opinion here. However, briefly, the decision of the U.S. Supreme Court is extremely limited. On its face, the outcome is limited to the facts of the case. Based on this limited holding, all we can really say from the Supreme Court’s decision is that states do not have the right to tax trusts solely on the basis of the residency of a discretionary beneficiary who received no distributions. The facts of Kaestner were that the trust was subject to New York law, the trust was established by a New York grantor, no trustee resided in North Carolina, the trust held no North Carolina investments or property, and the North Carolina beneficiary was only entitled to distributions at the discretion of the trustee and received no such distributions. Nevertheless, the State of North Carolina sought to tax the trust’s income. The U.S. Supreme Court found that, based on those facts, the trust had insufficient contacts with North Carolina to satisfy the “minimum contacts” required for taxation.[9] In the end, we now know that the residency of a discretionary beneficiary alone is insufficient for states to tax a trust’s income where the beneficiary receives no trust distributions. We do not know what level of connections beyond that may be sufficient. As such, the law remains largely unsettled even after the Supreme Court’s decision.

As stated above, in addition to the Kaestner opinion, the U.S. Supreme Court also denied certiorari in Fielding. I wrote about Fielding in a previous article.[10] The basic facts are that four trusts sold interests in a Minnesota S corporation which was doing business in Minnesota. Neither the trustee nor any of the beneficiaries resided in Minnesota. Although the trust was formed in Minnesota, by a Minnesota grantor, using a Minnesota law firm, there were insufficient continuing contacts to consider the trust a resident trust of Minnesota. A sale of the S corporation’s equity interests was the sale of an intangible non-business asset which was allocable to the residency of the taxpayer, the trust. Minimum contacts did not exist to consider the trusts a Minnesota taxpayer on the facts presented. Given the U.S. Supreme Court’s denial of certiorari, it may be that the facts of this case can be taken as additional guidance (in addition to Kaestner) regarding the boundaries of when states may consider a trust a resident taxpayer with sufficient minimum contacts to the state.

Case Law Update: Paula Trust and Noell Industries

The Paula Trust[11] case has been extensively written about as a significant state income tax of trust case out of California. The issue in Paula Trust involved statues determining California income tax liability on trust income when there are multiple trustees. At issue was the California state income tax on the trust’s pass-through income from the sale of stock in corporations held by a partnership in which the trust was a partner.

In Paula Trust, there were two trustees. One was a resident of California. The other was not. According to the trust’s interpretation of relevant state statutes, California statues that determine a nonresident’s source income do not apply because the definition of “resident” under state statute only applies to individuals or natural persons.[12] As a result, sourcing rules do not apply to trusts. Only a specific state statute authorizing taxation based on the residency of trustees and non-contingent beneficiaries applied.[13] Since there were two trustees only one of which was a California resident and there were no non-contingent California beneficiaries, only one-half of the trust’s income should be taxable.

The California Franchise Tax Board argued that the statutes dealing with residency of trustees and non-contingent beneficiaries was merely to determine taxability of non-source income by considering a trust a partial resident for income tax purposes. Under that method, non-sourced income would be taxable based on the number of trustees and non-contingent beneficiaries. Sourced income would be fully taxable.

Ultimately, the California Court of Appeal, First Division, District 3 sided with the Franchise Tax Board in reviewing the statutes.[14] As such, the trust is fully taxable on all California source income. However, the Court of Appeal sided with the trust that the beneficiary’s interest was contingent rather than non-contingent. As a result, non-source income is apportionable based on the residency of the trustees. The case was remanded for the trial court to determine tax liability based on its holdings.

The Noell Industries[15] case does not deal with the taxation of trust income. However, it is very instructive for trustees. As previously mentioned, trusts quite often hold passive interests in various types of pass-through entities. The trust may be a resident of one particular state (based on the various factors which determine residence of trusts), while the business operations of a pass-through entity owned by the trust may be conducted in another state or states. What state, then, may tax the trust’s sale of its equity interests in the pass-through income? Noell Industries revolved around the taxation of a parent corporation’s state income tax from the sale of its interest in a pass-through entity subsidiary, much the same issue as the sale of a trust’s interest in such an entity.

The Idaho Supreme Court, in Noell Industries, evaluated the various basis for taxation under Idaho’s UDITPA statutes as applied against the Commerce and Due Process Clauses of the U.S. Constitution. The relevant legal question was whether the sale of equity interests in a pass-through entity constituted “business income” apportionable to Idaho rather than allocated to the state of the parent corporation’s residency, Virginia.

In rending its decision, the Idaho Supreme Court analyzed applicable U.S. Supreme Court authorities in determining the extent to which the “unitary business” test applies to determine the taxability of a multi-state businesses income.[16] If there is a “unitary business” between two taxpayers, then their income may be aggregated in apportioning income. The Idaho State Tax Commission argued that the parent corporation and the subsidiary were a single, unitary business. The hallmarks of a unitary business are functional integration, centralized management, and economies of scale.[17] The facts of Noell Industries were that there was no centralized management, oversight, or headquarters. The only transactions between the parent and subsidiary were the original transfer of assets to from the parent to the subsidiary, rental of parent company property by the subsidiary, and a sale of subsidiary equity.

Beyond determining the parent corporation was not in a unitary business with its subsidiary, the court also determined that the sale of equity interests in the pass-through subsidiary was not “business income” under either: (a) a “transactional test,” or (b) the “operational test” and “functional test” (tested together as required by relevant U.S. Supreme Court authority[18]). Under the “transactional test” business income arises “from transactions and activity in the regular course of business of the taxpayer’s trade or business.”[19] The court found the clear facts illustrated that the parent company did not have any regular course of business in selling equity interests of subsidiaries. It held only two subsidiaries, and this was the only sale. As such, it could not be said the sale occurred in the parent’s regular course of business.

Under the operational test, income may be considered business income if the intangible assets serve as “an integral, functional, or operative component to the taxpayer’s trade or business.”[20] Under the “functional test” if the sale of equity was “a necessary part” of the subsidiary’s business or “income that arose from property managed as a necessary part” of the subsidiary’s business, then it would constitute business income. Here, the court found the parent was a mere holding company. Its activities or assets were not involved with the business operations of its subsidiary. The intangible equity interests in the subsidiary were mere passive investments of the parent. In the end, the equity sale was not taxable by the State of Idaho. The outcome of this case seems somewhat similar to the outcome in Fielding although the legal issues were different.[21]


Since I last wrote on the topic of state income taxation of trusts, developments have continued to illustrate the complications involved with state income taxation of trusts. We have had U.S. Supreme Court action on two cases, but with likely limited utility. Other cases which inform as to the taxation of trusts, particularly the sale of equity interests in closely-held, pass-through businesses owned by trusts, reach varying results on a variety of fact patterns and under different state statutory regimes.

The law remains largely unsettled, especially as it relates to more complex trust structures. For example, if a state statute bases taxation, at least in part, on the location of the trustee, what about trusts with trustees serving in different capacities (distribution trustee, administrative trustee, investment trustee, etc.). How will those differing roles be considered? What about trust advisors such as trust protectors? Will they be considered trustees? Does it matter if they serve subject to fiduciary duties? For states that base taxation on the location of trust administration, what about a corporate fiduciary with offices in the state but which outsources administrative functions among a number of offices around the country? The law has simply yet to catch up with, or answer, a number of common scenarios.

While state income taxation can be complex and varied around the country and differing rules regarding the state residency of trusts only serves to further the complexity, it is important that trustees and their advisors analyze how to minimize state income tax on trust income, which may include a change in trustee. There can be fiduciary duties violated for failure to do so.[22] Trustees already have plenty of potential liability. A trustee should not open themselves up to additional liability by failing to consider how to minimize state income tax.

Beyond the need of trustees to consider state income tax consequences of trusts, grantors, beneficiaries, tax counsel, attorneys, and other advisors should consider the planning opportunities presented through proper trust planning in advance of equity sales. If passive interests in a pass-through entity can be held in a trust which is a resident of a state without an income tax prior to an equity sale, resulting in non-business income allocable to the resident state, significant tax savings can be achieved. This is especially true for high income tax jurisdictions such as California and New York (even more so if New York City tax is included). For those armed with knowledge of this area of law, who are willing to engage in proactive planning, the benefits can be substantial. While the law is complex and evolving, there are opportunities to structure ownership to provide significant tax savings.

[1] Edmondson, Gray, “Where Does Your Trust Reside? State Tax Implications,” Aug. 14, 2018,

[2] North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, 139 S.Ct. 2213 (2020).

[3] Fielding v. Commissioner of Revenue, 916 N.W.2d 323 (Minn. 2018), cert. denied 139 S.Ct. 2773 (2019). 

[4] See the Uniform Division of Income for Tax Purposes Act (“UDITPA”) which has been adopted by approximately half of the states. Most other states’ laws embody similar concepts.,his%20or%20her%20net%20income.

[5] Those factors generally are sales, property, and payroll. However, states apply those factors differently by allocating different weight among the factors and/or not using all of such factors in calculating apportionable income.

[6] See supra note 1.

[7] See, e.g., Bloomberg’s 2020 Survey of State Tax Departments under “Pass-Through Entities” illustration the variety responses to questions raised to state departments of revenue. An executive summary can be found at the following location:

[8] Sage, Joshua, “Kaestner: Trust’s Beneficiary Residency Alone Insufficient Grounds for State Taxation,” Jun. 21, 2019,

[9] See International Shoe Co. v. Washington, 326 U.S. 310 (1945).

[10] See supra note 1.

[11] Steuer v. Franchise Tax Board, 51 Cal.App.5th 417 (Jun. 29, 2020).

[12] Cal. Rev. & Tax. Code, §§ 17041 and 17051.

[13] Cal. Rev. & Tax. Code, § 17743.

[14] There was also a dispute about whether the trust’s beneficiary was contingent or non-contingent. The Court of Appeal agreed with the trust that the beneficiary’s interest was contingent upon the discretion of the trustee.

[15] Noell Industries, Inc. v. Idaho State Tax Commission, 470 P.3d 1176 (Idaho 2020).

[16] See MeadWestvaco Corp. ex rel. Mead Corp. v. Illinois Dep’t of Revenue, 128 S.Ct. 1498 (2008).

[17] Id.

[18] Id.

[19] I.C. § 63-3027(a)(1); IDAPA

[20] IDAPA

[21] For other cases addressing similar issues see Xylem Dewatering Solutions, Inc. v. Director, Div. of Taxation, 30 NJ Tax 41 (2017) (treating as business income the sale of equity interests in an S corporation electing to treat the sale as an asset sale under I.R.C. § 338(h)(10) to be apportioned under a unique statute apportioning all income from the sale of intangibles to the state where headquarters are located, in this case New Jersey); and Corrigan v. Testa, 73 N.E.3d 381 (Ohio 2016) (Ohio Supreme Court unanimously held unconstitutional, due to lack of requiring minimum contacts, a statute requiring sale of pass-through entity by a 20% or greater individual owner to be subject to apportionment as applied to the facts of the case where a non-resident sold stock outside of Ohio).

[22] See Uniform Probate Code § 7-305, Restatement (Third) of Trusts § 76(2)(c) (and comments), and Scott on Trusts, §§ 613-615.


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