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Pennsylvania Rules Concerning Resident Trusts - McNeil Case

Tax

By Marko Zivanov

In Pennsylvania, every resident trust is subject to personal income tax. A resident trust is a trust created by a person who at the time of the trust’s creation was a resident. [1] Under the Pennsylvania Department of Revenue’s (DOR) regulations, [2] the residence of the settlor is the ‘single controlling factor’ in determining if a trust is a resident trust.  However, a recent Pennsylvania case, McNeil, [3] has overturned this concept.

In 1959, Robert McNeil, Jr., a resident of Pennsylvania, created two trusts that were to be governed and administered under the laws of Delaware. A Delaware corporate trustee was appointed as the administrative trustee. The trust’s assets were in Delaware, and the trust did not have any income from Pennsylvania sources. The only connections to Pennsylvania were settlor’s residence at the time the trust was created and the residency of discretionary beneficiaries.

The DOR applied its ‘single controlling factor’ test, and it assessed state income tax because the trust was created by a Pennsylvania resident. The taxpayer appealed, arguing that the trust did not have sufficient physical presence in Pennsylvania,

The Pennsylvania Commonwealth Court applied the test articulated by the U.S. Supreme Court in Complete Auto. [4] Under Complete Auto, a state tax had to satisfy a four-prong test to survive constitutional scrutiny: (1) the taxpayer must have a substantial nexus to Pennsylvania; (2) tax must be fairly apportioned; (3) the tax may not discriminate against interstate commerce; or (4) tax must be fairly related to benefits conferred by Pennsylvania.

The court held that the state tax violated three of the Complete Auto’s four prongs. Therefore, the court went on to state that the imposing of the Pennsylvania income tax on the McNeil trust was unconstitutional because it violated the Commerce Clause. The Commonwealth of Pennsylvania did not appeal this decision to the Pennsylvania Supreme Court.

The McNeil decision weakens the Pennsylvania’s control over the taxation of trusts, and it offers significant state tax planning opportunities for Pennsylvania resident trusts. Many trusts can claim refunds for past years. McNeil also creates an unsettled area of the law concerning trust residency.

[1] 72 P.S. Section 7301 (s)

[2] 61 Pa. Code Section 101.1

[3] McNeil v. Commonwealth of Pennsylvania, 67 A.3d 185 (Pa. Commw. Ct. 2013)

[4] Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977)

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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.

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© 2018 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.

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