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...