Where Your Trust Pays
Income Tax

The clause that does not do what people think

Every trust agreement names a governing law — the choice of law or situs provision. Many go further and let the trustee move the trust's situs over time. If the trust is ever litigated, that clause decides which state's law applies.

For state income tax purposes, that clause is irrelevant. This is the single most common misunderstanding we encounter in trust planning, and it is an expensive one.

What actually matters is where the grantor was domiciled on the day the trust became irrevocable. That fixes the trust's residency for income tax purposes permanently. Create a trust while living in New Jersey and it is a New Jersey resident trust forever. Move to Florida the next year, amend the situs clause, appoint a Nevada trustee — still a New Jersey resident trust. The residency is sticky, and it never changes.

Why states cannot simply tax it anyway

For years the same trust could be taxed by several states at once — one claiming the grantor, another the trustee, a third a beneficiary. Taxpayers pushed back on constitutional grounds: a state needs a real connection before it can tax. The courts largely agreed, most prominently in North Carolina Department of Revenue v. Kaestner Family Trust (2019), where the Supreme Court held that a beneficiary's residence, standing alone, was not enough.

The result is a patchwork — every state draws its own line. The workable news for our clients is that New York and New Jersey draw theirs in nearly the same place.

The exemption, and its three tests

Both states start from the same position: a resident trust is taxable on its income. Both then exempt it if the trust keeps sufficient distance from the state. In broad terms:

1. No in-state trustee. Every trustee domiciled outside the state.
2. No in-state assets or source income. No real property in the state, no income generated from within it.
3. No distributions to in-state residents — or, more precisely, distributions managed so they do not trigger tax. In-state beneficiaries are fine; it is distributions to them that create the problem.

New York codifies its version at Tax Law § 605(b)(3)(D). Meet all three tests and the trust's income — including a large capital gain — escapes the state income tax entirely. This is the machinery behind the completed gift non-grantor trust.

Working around the hard parts

In-state beneficiaries. A child living in Manhattan does not disqualify the trust. The trustee simply must not make distributions to them while they live there. Loans repayable at death work; so does deferring distributions until a beneficiary relocates. Neither is exotic — both need to be planned rather than improvised.

In-state source income. This is the genuine constraint. Rental real estate in the state produces in-state source income and there is no drafting around it. An operating business is more forgiving: where a company has some in-state income and much that is not, it can often be bifurcated — in-state operations into one entity, everything else into another — so the sale of the second entity falls outside the state's reach. That restructuring takes real lead time, which is the argument for starting this conversation years before a sale rather than weeks.