New Jersey Court Decision: Personal Income Tax: Undistributed Income of Trust Not Subject to Tax

Court Decision: A testamentary trust did not owe New Jersey income tax on its undistributed trust income because it would have violated the due process requirements of the U.S. Constitution. The resident trust was created by a New Jersey domiciliary for the benefit of his descendants and owned cash, bonds and stock. The trust was allocated income as a result of its ownership of stock in four S corporations because each of the S corporations conducted some business inside New Jersey.

In 2006 the trust did not pay tax on the interest income or on the net pro rata share of S corporation income that was allocated outside New Jersey. Following an audit, the trust was assessed a deficiency because the Director of the Division of Taxation concluded that the trust was taxable on 100% of its undistributed income, including its net pro rata share of S corporation income that was allocated outside New Jersey.

Precedent barred New Jersey from taxing the undistributed income of a trust if the trustee, assets and beneficiaries are located outside New Jersey. The trustee argued that since he was not a New Jersey resident, and no assets were located in New Jersey, the trust lacked sufficient contacts with New Jersey for the state to tax the trust as a resident trust. The director argued that the trust had the requisite contacts with New Jersey to be taxed because it filed a New Jersey return and did so using a New Jersey address. However, simply using a New Jersey address on the return did not create the required contacts between the trust and New Jersey for the director to overcome the due process threshold that would otherwise permit the imposition of tax.

Further, owning stock in the four S corporations that conducted business in New Jersey did not mean that the trust could be treated as owning the assets of those corporations in order to create the requisite nexus to subject the trust to tax on its undistributed non-New Jersey income as the director argued. The director was incorrectly conflating pass-through taxation with ownership of the underlying assets, but the owner of stock in an S corporation does not own or hold title to the underlying assets of the corporation.

Lastly, the director asserted that the trust was subject to taxation on its out-of-state income, but the trust did not have sufficient contacts with New Jersey to satisfy due process requirements. Similarly, the trust did not owe taxes on its interest income for 2006 either.  Residuary Trust A v. Director, Division of Taxation, New Jersey Tax Court, No. 000364-2012, January 3, 2013.