Pennsylvania levies a tax at the current rate of 3.07% on taxable income earned by individuals, estates and trusts.
Can a Pennsylvania resident set up a trust for the benefit of his family members (also Pennsylvania residents) in another state in a manner that will defer or avoid the Pennsylvania income tax? A recent court case shows how this may be possible.
Pennsylvania tax regulations provide that any trust created by a person residing in Pennsylvania is deemed to be a “resident trust” which is subject to Pennsylvania income tax. See 61 Pa. Code Chapter 105 and 61 Pa. Code § 101.1.
The regulations under 61 PA Code Section 101.1 provide that the single controlling factor in determining if a trust is a resident trust for Pennsylvania purposes is whether the decedent, the person creating the trust, or the person transferring the property was a Pennsylvania resident individual or person at the time of death, creation of the trust, or the transfer of the property. The residences of the fiduciary and the beneficiaries of the trust are immaterial. The Pennsylvania Department of Revenue Personal Income Tax Guide, Chapter 14: Estates, Trusts and Decedents, at pages 5-6.
If a trust is subject to PA income tax, the tax liability is allocated between the beneficiaries and the trust based upon whether the income is distributed to the beneficiary or retained by the trust. See, 61 Pa. Code §§ 105.2 - 105.4.
The above rules are clear. But a recent Pennsylvania Commonwealth Court case finds that the rules impose the state tax in a manner that can violate the Commerce Clause of the United States Constitution. McNeil Trusts v. Commonwealth of Pennsylvania, 2013 Pa. Commw. LEXIS 168 (PA Commonwealth, May 24, 2013)
In 1959 Robert McNeil, Jr. a resident of Pennsylvania created two trusts for his family members. The Trusts’ Agreements provided that they were to be governed, administered, and construed under the laws of Delaware rather than Pennsylvania. Wilmington Trust Company, located in Wilmington, Delaware was appointed as the administrative trustee.
In 2007 one of the trusts earned over a million dollars in income. The Trust retained this income and did not distribute any of it to any of the beneficiaries (all of whom were residents of Pennsylvania). The Trust paid no Pennsylvania income tax, but the PA Department of Revenue assessed state income tax on the earnings on the ground that the trust was created by a Pennsylvania resident and its beneficiaries were Pennsylvania residents.
The Trust appealed. It argued that it was a non-resident trust with no PA income, assets or trustees. It said that it was a Delaware trust, subject only to Delaware state income tax. Since Delaware has no state income tax, the trust owed no state tax to any state.
PA Cannot Tax the Trust’s Undistributed Income
The Trust argued that imposition of PA income tax on its undistributed income would violate the Commerce Clause of the U.S. Constitution. The Commerce Clause provides that “The Congress shall have Power . . . [t]o regulated Commerce . . . among the several States.”
On appeal, Pennsylvania’s Commonwealth Court agrees with the Trust. The Court notes that the U.S. Supreme Court has established a four prong test to determine whether a state tax withstands constitutional scrutiny and does not conflict with the Commerce Clause.
Those four prongs are: (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. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977).
All four prongs must be satisfied and the failure to meet any one of these requirements renders the tax unconstitutional. The Court found that under these facts, taxation of the McNeil Trust would violate the 1st, 2nd, and 3rd prongs.
In the opinion of the Court, neither the Trust creator’s residency nor the residency of the beneficiaries provides the requisite presence in Pennsylvania to establish a substantial nexus. The imposition of PA income tax on income all of which was derived from sources outside of Pennsylvania does not satisfy the fair apportionment prong. And the imposition of tax is not reasonably related to the benefits Pennsylvania provides to the Trust. Thus, the tax cannot be imposed without violating the Commerce Clause.
Implications of Court’s Holding
The Commonwealth Court is an intermediate appeals and its decision could be overturned by the Pennsylvania Supreme Court. If that does not happen, the McNeil Trusts case seems to open the door to some state income tax planning opportunities for Pennsylvania residents.
It may make tax sense for a Pennsylvania resident who intends to create a trust that will accumulate income to consider establishing the trust in Delaware or another state which does not impose income tax. The Trust should state that it is governed by that other state’s law and have a non-Pennsylvania trustee.
It is not clear how much contact with Pennsylvania will be required to allow PA income tax to be imposed on income that a trust accumulates. But, the McNeil Trust facts seem to provide a tax-avoidance safe harbor that some taxpayers may wish to consider. Avoiding (or at least deferring) a 3% tax each year can add up to significant savings.
Because the McNeil Trusts decision relies on the Federal constitution to limit state taxing power, the case may be a compelling read for estate planning attorneys in states other than Pennsylvania.