Illinois Trust Taxation Deemed Unconstitutional

Ruling creates planning opportunities to minimize income taxes.

In Linn v. Department of Revenue, the Illinois Fourth District Appellate Court reviewed the state's statutory framework for taxing trusts. Linn v. Department of Revenue, 2013 Il App (4th) 121055. On constitutional grounds, the court limited Illinois' power to impose taxes under its "once subject to tax, forever subject to tax" regime.

This case creates planning opportunities to minimize Illinois income taxes. However, it should be noted that the Linn case applies to trusts that pay Illinois income tax on trust dividends, interest, capital gains or other income retained by the trust and not distributed to a beneficiary. This case does not apply to income distributed to an Illinois beneficiary; that income clearly can be taxed by Illinois.

Illinois Trusts

Illinois trusts are subject to a 5 percent income tax plus a 1.5 percent personal property replacement tax. A nonresident trust is subject to taxation only on income generated within Illinois or apportioned to the state. Resident trusts, on the other hand, are subject to tax on all income, regardless of the source of that income. For an individual, state income taxation on a resident basis generally requires domicile or residence within the taxing state. With respect to a trust, one or more of the grantor, trustees and beneficiaries may have contacts with a state sufficient to uphold as constitutional a tax on all of the trust income.

Illinois defines a resident trust based solely on the domicile of the grantor. 35 ILCS 5/1501(a)(20). A resident trust means:

A trust created by a will of a decedent who at death was domiciled in Illinois or An irrevocable trust, the grantor of which was domiciled in Illinois at the time the trust became irrevocable. For purposes of the statute, a trust is irrevocable when it's no longer treated as a grantor trust under Sections 671 through 678 of the Internal Revenue Code. The Illinois statute would forever tax the income generated by the trust property, regardless of the trust's continuing connection to Illinois. One can analogize the Illinois statute to a hypothetical statute providing that any person born in Illinois to resident parents is deemed an Illinois resident and subject to Illinois taxation no matter where that person eventually resides or earns income. Many lawyers believe that the Illinois statute is unconstitutional.

Linn

Linn involved a trust established in 1961 by A.N. Pritzker...