For Trusts With No Current Illinois Connection, Income Tax is Unconstitutional

A state’s power to tax reaches far and wide, but it’s still bounded by constitutional limits. In the words of the United States Supreme Court, “The simple and controlling question is whether the state has given anything for which it can ask in return.” [1] This basic principle applies equally to the taxation of trust income. For decades, courts across the country have grappled with whether state taxes on trust income violate due process. In December 2013, the Illinois Appellate Court in Linn v. Dep’t of Revenue, 2013 IL App (4th) 121055, entered the debate and held that taxing the income of a trust with no current connection to Illinois was unconstitutional.

The facts in Linn begin in 1961. In that year, an Illinois resident established an inter vivos trust — governed by Illinois law, with an Illinois trustee, for trust property located in Illinois. Id. at ¶ 4. The trust agreement provided for a power of appointment to distribute trust assets to a different trust or trustee. In 2002, new trustees (also residing in Illinois) distributed the assets to create a new trust now governed by Texas law with a new trustee residing outside of Illinois. By 2006, none of the beneficiaries or the trustee of the new trust resided in Illinois, and none of the trust assets were located there. Id. at ¶ 9. When the State of Illinois sought to tax the new trust’s income, the trustee brought suit seeking a declaration that the tax was unconstitutional. Id. at ¶ 11. The trial court ruled in favor of the state, finding that the tax was constitutional. The appellate court reversed.

The appellate court first reviewed case law in which testamentary trusts had sufficient contacts to a state so that taxation was constitutional. The court contrasted these cases with inter vivos trusts, which do not owe their existence to a probate court and for which any connection to the state may be “more attenuated.” Id. at ¶ 25-28. The court cited other decisions holding that the grantor’s residence by itself was not enough of a contact for an inter vivos trust. Thus, in this case, the original grantor residing in Illinois was “not a sufficient connection to satisfy due process.” Id. at ¶ 29.

The court also stated that the focus should only be on the connections to Illinois for the tax year in question, and “what happened historically with the trust in Illinois has no bearing on the 2006 tax year.” Id. at ¶ 30. The court emphasized that for the tax year at issue, there were no longer any connections to Illinois: All of the trust’s business, assets, trustee, beneficiary, and protector — were all located outside of Illinois. Id. at ¶ 33. The court ruled that without any current connections to Illinois, taxing the trust’s income violated due process.

The Linn decision provides a good reason to re-evaluate if an Illinois trust continues to have sufficient connections to the state to be taxed. In particular, under Illinois law, if the grantor of a trust resides in Illinois when it becomes irrevocable, the state considers it to be an Illinois trust for tax purposes. See 35 ILCS 5/1501(a)(2)(D). The Linn decision effectively invalidates that position when a trust no longer has any connections to Illinois. In the wake of Linn decision, it is advisable to review any trusts established in Illinois and ask a variety of questions, including:

• Have any of the original connections — trustee, beneficiaries, or location of assets — migrated away from Illinois, so that there are no longer sufficient connections with Illinois?
• Does the trust agreement, like that in Linn, allow for a power of appointment permitting a new trustee or trust to be established outside of Illinois?
• If a trust has had no connections with Illinois for many years, but has still filed Illinois returns and paid taxes, should they file for refunds? Should such a trust file a return for 2013?
• Is a trust that is created by a revocable trust of an Illinois grantor at the grantor’s death — that otherwise has no Illinois connections — closer to a testamentary trust or inter vivos trust for tax purposes?
• If a trust’s only current connection with Illinois is a trustee who resides here, should that trustee be replaced by a non-resident?
• If a trust with some connections to Illinois is “decanted” (that is, its assets transferred) to an out-of-state trust, would that trust cease to have the minimum connections to Illinois?

The State of Illinois has until January 22, 2014 to petition the Illinois Supreme Court to review the Linn case. But unless the Supreme Court first accepts review and then overturns or alters the decision, it remains the law of Illinois. As such, if you are a beneficiary or a trustee of a trust originally created in Illinois, and there is any question as to whether the trust still has sufficient connections to Illinois to be taxed, you may wish to discuss the Linn decision with your trust lawyer at Quarles & Brady.

[1] ASARCO, Inc. v. Idaho State Tax Co’m, 458 U.S. 307, 315 (1982) (quoting Wisconsin v. J.C. Penny Co., 311 U.S. 435, 444 (1940)).