United States: Delaware Trust With Pennsylvania Settlor And Discretionary Beneficiaries Not Subject To Pennsylvania Personal Income Tax

In what may represent a sea change in Pennsylvania's long-standing reliance on a trust settlor's in-state residency to impose Pennsylvania income tax on the trust, the Commonwealth Court of Pennsylvania held the taxation of a Delaware trust to be unconstitutional even though the trust was set up by a Pennsylvania resident for Pennsylvania discretionary beneficiaries.1 The Court focused on the fact that the trust itself was the taxpayer at issue, in finding that taxation of the trust violated the Commerce Clause of the U.S. Constitution. Since the trust was governed by Delaware law and was both located and administered in Delaware, the Court found taxation inappropriate.

Tax Treatment of Inter Vivos Trusts in Pennsylvania

Pennsylvania subjects every resident inter vivos trust to the personal income tax ("PIT") on income received during the taxable year.2 The term "resident trust" includes any trust created by a person who was a resident of Pennsylvania at the time of the trust's creation.3 Pennsylvania regulations further provide that the residences of the fiduciary and the beneficiaries of the trust are immaterial for purposes of determining whether the trust is a resident trust.4

The PIT is imposed on a trust beneficiary's income if it is received by the trust for the taxable year and is required to be distributed, paid or credited to the beneficiary.5 The income or gains taxable to the trust consist of the income or gains received by it which have not been distributed or credited to the beneficiaries.6

Overview

The Court considered whether the imposition of PIT on two Delaware inter vivos trusts ("Trusts") set up by a Pennsylvania resident for Pennsylvania discretionary beneficiaries violated the Commerce Clause of the U.S. Constitution.7 For the 2007 tax year, following a distribution of $1.4 million to one of the Trusts' discretionary beneficiaries, the Pennsylvania Department of Revenue assessed $232,164 and $276,263 of PIT, interest and penalties against the respective Trusts. The Trusts, established during 1959 by a Pennsylvania resident, had no Pennsylvania income, interests or assets in 2007. The Trusts named discretionary beneficiaries that were also Pennsylvania residents.8 The Trusts had an administrative trustee that did not have offices or conduct trust business in Pennsylvania and three general trustees, none of whom were residents of Pennsylvania. Further, all of the Trusts' books and records were maintained in Delaware.

The Trusts appealed the assessments to the Pennsylvania Board of Appeals and Pennsylvania Board of Finance and Revenue,9 arguing that they were Delaware resident trusts administered in Delaware, and the imposition of PIT violated the Due Process and Commerce Clauses of the U.S. Constitution. Upon rejection by both tax authorities,10 the Trusts petitioned the Commonwealth Court for review of their position.

The Commonwealth Court based its decision on the Commerce Clause, citing the governing four-prong test enumerated in Complete Auto Transit, Inc. v. Brady11 for determining whether a state tax withstands constitutional scrutiny. Failure of any of the following four prongs renders the tax unconstitutional: (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. Citing failure of the first three prongs, the Court held that taxation of the Trusts by Pennsylvania was unconstitutional.12

Substantial Nexus

In deciding whether the Trusts had substantial nexus with Pennsylvania, the Court relied on the standard developed in Quill Corporation v. North Dakota.13 In Quill, the U.S. Supreme Court required physical presence to establish a substantial nexus with a state. Here, the Court focused its attention on the Trusts themselves as the taxpayers. It agreed that, in creating the Trusts, the settlor relinquished continuing control of appointment over the Trusts' property. In addition, the discretionary in-state beneficiaries had no current or future right to income or assets under the Trusts. The Trusts' only contacts with Pennsylvania were the residency of its discretionary beneficiaries and that of its settlor in 1959.

Notwithstanding the provision of the PIT regulation that the residence of the beneficiary is immaterial, the Commonwealth attempted to satisfy the substantial nexus requirement by arguing that the Pennsylvania residency of the discretionary beneficiaries established substantial nexus. The Court rejected the Commonwealth's argument.

Accordingly, the Trusts lacked the necessary physical presence in Pennsylvania to establish a substantial nexus with the state for the years at issue.14 Further, due to the Trusts' discretionary nature, the beneficiaries had no current or future right to the income or assets from the Trusts. The settlor chose to have the Trusts governed by Delaware law, established the administration of the Trusts in Delaware and did not reserve any continuing control or power of appointment over trust property. The Court noted that relying on the settlor's in-state presence in 1959 would be equivalent to applying the slightest presence standard rejected in Quill.

Fair Apportionment

Even though the Court had decided that the substantial nexus prong of Complete Auto had been violated, the Court continued its constitutional analysis. To satisfy the fair apportionment prong of the Complete Auto test, a tax must be both internally and externally consistent. A tax is internally consistent if it is structured so that, if every taxing jurisdiction were to apply the identical tax, the taxpayer would not be subject to double taxation. A tax is externally consistent if there is a rational relationship between the income attributed to the state and the value of the business being transacted by the taxpayer in the state.

The Court found that taxation of the Trusts was not externally consistent. It compared the Trusts to the taxpayer in Philadelphia Eagles Football Club, Inc. v. City of Philadelphia,15 which was unconstitutionally taxed when the City of Philadelphia imposed the Business Privilege Tax on 100 percent of its media receipts even though half of its media activity occurred outside the city. In comparison, the Department was trying to tax 100 percent of the Trusts' income while actually deriving none of it from Pennsylvania. Since the Trusts did not have any assets or interests in-state and had trustees, books and records in Delaware, the Court determined that Pennsylvania's taxation of 100 percent of the Trusts' income was "inherently arbitrary" and out of proportion to the Trusts' associated Pennsylvania business activities (or lack thereof).16

Fairly Related to Services

Under the third prong of the Complete Auto test, taxes are fairly related to the services a state provides where the taxpayer benefits directly or indirectly from the state's protections, opportunities and services. The Court concluded that such services include: access to the state's economic markets; the benefits and protections of the state's courts, laws and law enforcement; use of the state's roadways and bridges; and police and fire protection, the benefit of a trained work force and the advantages of a civilized society.17

Here, the Court found that Pennsylvania's imposition of PIT on the Trusts' income was not reasonably related to the benefits Pennsylvania provided to the Trusts because the Trusts had no physical presence in the state, none of their income was derived from Pennsylvania sources, none of their assets or interests were located in Pennsylvania, and the Trusts were established under and governed by Delaware law. Though the discretionary beneficiaries benefitted from Pennsylvania's societal and legal framework as Pennsylvania residents, they were not considered to be the taxpayer, and held no present or future right to distributions from the Trusts.

Commentary

This decision casts light upon Pennsylvania's current method of classifying inter vivos resident trusts. Presumably due to the unanimous holding for the taxpayer on three of the Complete Auto prongs (each of which justifies an unconstitutional result), the Department will not be appealing the decision. McNeil leaves Pennsylvania with limited avenues to tax trusts. The state may need to amend its current laws to close the gap in trust taxation since, unlike some states that tax trusts based on the location of the trustee or beneficiary, Pennsylvania bases its tax only on the location of the settlor.

In the meantime, this decision may offer a significant tax savings opportunity to many taxpayers that use trusts. While the ruling primarily acts to defer taxation since Pennsylvania resident beneficiaries are ultimately taxed on distributions made by the trust, trusts are often set up to exist for years without distributions and beneficiaries often move to other states. If a Pennsylvania beneficiary changed its residency to another state before the time of distribution, a non-taxable distribution for Pennsylvania PIT purposes may result. Similarly, to the extent income comes in the form of capital gains, it would represent an exclusion from Pennsylvania tax, as capital gains are generally only taxable to the trust. It is apparent that several planning strategies may be undertaken by taxpayers to further benefit from this landmark decision.

Regarding prior years, it is imperative that taxpayers review their trust documents for ties to Pennsylvania and protect their appeal rights for years open under Pennsylvania's statute of limitations. Timing is particularly sensitive for the 2009 tax year, which is still open for refund but will expire three years from any extended due date (i.e. no later than October 15, 2013). Pennsylvania is likely to limit the holding to the specific, taxpayer-friendly facts of McNeil at the Pennsylvania administrative appeals levels. Prospective challengers will likely have to offer very similar or better facts than the facts at issue in this decision to obtain refunds from the Department without dispute. However, any effort by Pennsylvania to limit the scope of this decision should not discourage anyone from pursuing refunds or challenging assessments.

Footnotes

1 McNeil v. Commonwealth of Pennsylvania, Pennsylvania Commonwealth Court, No. 651 F.R. 2010, May 24, 2013.

2 72 PA. CONS. STAT. § 7302(a).

3 72 PA. CONS. STAT. § 7301(s)(2).

4 61 PA. CODE § 101.1.

5 72 PA. CONS. STAT. § 7305.

6 Id.

7 The Trusts also argued that subjecting them to PIT as Pennsylvania resident trusts violated the Due Process Clause of the U.S. Constitution and the Uniformity Clause of the Pennsylvania Constitution. By concluding that Pennsylvania's PIT assessments violated the Commerce Clause, the Court noted it was not addressing the other constitutional issues.

8 Pursuant to the agreements governing the Trusts, the Trusts had no obligation to make any distribution until "20 years and 11 months after the death of the last survivor of Nancy and all my lineal descendants living at the time of creation of this trust" or "20 years and 11 months after the death of the last survivor of all my lineal descendants living at the time of creation of this trust." McNeil, No. 651 F.R. 2010, at 5.

9 The Pennsylvania Board of Appeals hears taxpayer appeals from Department of Revenue assessments. The Pennsylvania Board of Finance and Revenue is the second level of appeals, reviewing decisions of the Board of Appeals.

10 Both the Board of Appeals and the Board of Finance and Revenue noted that it did not have jurisdiction to rule upon the constitutional issues.

11 430 U.S. 274 (1977).

12 Prior to the constitutional analysis, the Court addressed the application of Pennsylvania Department of Revenue Ruling PIT-01-040 (Ruling 01-040), July 27, 2001, which was cited by the Trusts as an analogous situation. In Ruling 01-040, the Department of Revenue concluded that a resident testamentary trust, with no Pennsylvania income or administration, may change its situs to outside Pennsylvania if it obtains the appropriate order. The Court rejected use of Ruling 01-040 in this situation because the Ruling was limited to the parties named, expired five months before the 2007 tax year and contained several factual differences from the situation in McNeil.

13 504 U.S. 298 (1992).

14 In arguing for a finding of substantial nexus, states often invoke the principle of economic nexus. In states that follow this rule, a taxpayer can trigger the minimum contacts required for taxation by in-state economic activity alone. Physical presence is not necessary. Here, even if the economic nexus rule applied, neither the administrative trustee nor the general trustees established sufficient economic activity in Pennsylvania.

15 823 A.2d 108 (2003).

16 Id. at 132.

17 Exxon Corp. v. Wisconsin Department of Revenue, 447 U.S. 207, 228 (1980) (quoting Japan Line, Ltd. v. County of Los Angeles, 441 U.S. 434, 445 (1979)).

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