Under the Illinois Income Tax Act (“IITA”), an Illinois resident taxpayer is taxable on 100 percent of its income and a non-resident taxpayer is taxable only on Illinois source income. Until December 2013, whether a taxpayer was a resident or a non-resident was determined based on the facts for the tax year at issue for every type of taxpayer, except trusts. That status quo ended December 18, 2013, when the Fourth District Illinois Appellate Court decided Linn v. Illinois Department of Revenue.1 In Linn, the Appellate Court engaged in a fact-intensive analysis to determine that an inter vivos trust’s ties to Illinois in the tax year at issue were insufficient under the Due Process Clause of the U.S. Constitution to allow Illinois to tax the trust’s income.
The Original Trust
In March 1961, A.N. Pritzker, an Illinois resident, established trusts for the benefit of various family members with Meyer Goldman, another Illinois resident, as trustee. One of these trusts (the “Linda Trust”) had Linda Pritzker as its beneficiary. At the time that the Linda Trust became irrevocable, the grantor, the trustee and the beneficiary were all Illinois residents, the trust assets were deposited in Illinois, and the trust was created under and subject to Illinois law. The IITA provides that a trust is a “resident” of Illinois if the trust becomes irrevocable while the grantor is domiciled in Illinois.2 Although the statute does not expressly state so, the Illinois Department of Revenue (“Department”) has interpreted that provision to mean that a trust meeting that criterion is a resident in perpetuity. A.N. Pritzker died in 1986 as an Illinois resident, and his estate was probated in Illinois.
In 2002, the trustees of the Linda Trust entered into a trust agreement that created the Autonomy Trust 3 (the “Autonomy Trust”) for the benefit of Ms. Linda Pritzker, and distributed assets from the Linda Trust to Lewis Linn, as trustee of the Autonomy Trust. The Autonomy Trust was governed by Texas law, except that specific terms – “income,” “principal” and “power of appointment” – were to be interpreted under Illinois law. In February 2004, Lewis Linn filed a complaint in the probate court of Harris County, Texas, seeking reformation of the trust’s application of Illinois law to some of the terms, leaving the trust to be regulated entirely by Texas law. The probate court granted the requested relief.
In 2006, Linda and the contingent beneficiaries of the Autonomy Trust were not domiciled in Illinois, nor were they residents of Illinois for purposes of the IITA; the trustee was located in Texas and the trust was administered in Texas, and it had no Illinois assets. In April 2007, the Autonomy Trust filed a nonresident Illinois income and replacement tax return for fiscal year 2006, reporting no income from Illinois sources and remitting no tax.
Lower Court Upholds the Statutory Residency Classification
The Department reclassified the trust as an Illinois resident under section 1501(a)(20)(D) of the IITA, which defines a resident trust as an “irrevocable trust, the grantor of which was domiciled in this State at the time such trust became irrevocable,” and therefore, taxed 100 percent of the trust’s reported income and assessed a deficiency liability. The Autonomy Trust paid the deficiency liability under the State Officers and Employees Money Disposition Act (the “Protest Monies Act”), and Linn, as trustee, filed a complaint for declaratory and injunctive relief, as well as a motion for summary judgment.
Linn’s motion for summary judgment asserted that the imposition of income tax on the Autonomy Trust violated the Commerce, Due Process and Equal Protection clauses of the United States Constitution, as well as the uniformity clause of the Illinois Constitution. The state defendants’ cross-motion for summary judgment argued that the grantor of the Autonomy Trust voluntarily established the trust pursuant to Illinois law, that the Texas probate court decision was not binding on the Illinois trial court, and that the assessed tax was in accordance with Illinois statutes. The trial court agreed with the state defendants, concluding that the March 1961 trust agreement provided Illinois law was to govern the trust agreement and any trusts hereby created, which included the Autonomy Trust, and granted the state defendants’ motion for summary judgment classifying the Autonomy Trust as an Illinois resident under the IITA.
Appellate Court Finds Classification of Trust as an Illinois Resident Untenable under Due Process Clause
The Appellate Court reversed the decision of the trial court and determined that assessment of Illinois income tax on the Autonomy Trust in 2006 violated the Due Process clause of the United States Constitution. The court looked to other states’ treatment of similar inter vivos trusts. In particular, the Appellate Court focused on the Connecticut Supreme Court decision in Chase Manhattan Bank v. Gavin.3 In Gavin, the Connecticut Supreme Court held that an inter vivos trust was subject to Connecticut tax on all of its income, based on the facts that the trust’s settlor was a Connecticut resident when he established the trust and that the trust’s beneficiary was a Connecticut resident. The critical link to allow Connecticut to tax the trust was the fact that the inter vivos trust’s non-contingent beneficiary was a Connecticut resident during the tax year in question, and the beneficiary’s right to receipt and enjoyment of the income was protected by Connecticut law as long as the beneficiary remained a resident of the state.4
The defendants argued that the fact that the grantor of the Autonomy Trust’s had been an Illinois domiciliary at the time the trust became irrevocable was sufficient to establish a minimum contact with Illinois. The court rejected this argument, noting that because the Autonomy Trust was an inter vivos trust, and not a testamentary trust, its connection with the state was more attenuated. The court opined that an irrevocable inter vivos trust does not owe its existence to the laws and courts of the state of the grantor in the same way as a testamentary trust does, and therefore, does not have the same permanent tie. To the court, the critical link in the Connecticut case between the state and the inter vivos trust was that the trust’s non-contingent beneficiary was a Connecticut resident during the tax year in question, and that link, the court found, was not established for the Autonomy Trust.
The state defendants argued that the Autonomy Trust only existed because of Illinois law, establishing a permanent and sufficient minimum contact for the Autonomy Trust with Illinois. The court, however, noted that the Autonomy Trust resulted from a January 2002 exercise of the limited power of appointment by the trustees of the Linda Trust. Moreover, the court distinguished that the focus of the due process analysis is on the tax year in question, so the historic events had no influence on determining the residency of the Autonomy Trust for the 2006 tax year. The Autonomy Trust was an inter vivos trust rather than a testamentary trust, and it was not in existence when A.N. Pritzker died, so it was not part of the Illinois probate case. Furthermore, the court noted that after the November 2005 Texas reformation order, the Autonomy Trust choice of law provision provided for only the application of Texas law.
Implications for Prior and Future Tax Years
The state may seek to appeal the decision to the Illinois Supreme Court. However, it is within the discretion of the Illinois Supreme Court whether to hear such an appeal, because the Appellate Court did not invalidate section 1501(a)(20)(D).
Although section 1501(a)(20)(D) was not invalidated by the Appellate Court‘s decision, trusts should be reexamining their classification as an Illinois “resident” under the IITA for the current and prior tax years, based on the actual contacts that the trusts had with Illinois for those tax years. Trusts that have previously filed Illinois resident returns simply because of the definition of a resident trust in section 1501(a)(20)(D) of the IITA should look at the facts for each filing tax year and determine whether to file an amended return, for open tax years, to withdraw the determination of residency, and claim a refund of any resulting overpayment.
Reed Smith’s State Tax and Wealth Planning attorneys work collaboratively to provide integrated analysis and advice on residency issues for trusts. If you are interested in more details on the Illinois income tax filing and refund options for trusts in light of the Linn decision, please contact one of the authors of this alert, or the Reed Smith attorney with whom you normally work. For more information on Reed Smith’s Illinois tax practice, visit www.reedsmith.com/iltax.
1. 2013 IL. App. (4th) 121055.
2. 35 ILCS 5/1501(a)(20)(D).
3. Chase Manhattan Bank v. Gavin, 733 A.2d 782 (Conn. 1999).
4. Gavin, 733 A.2d at 802 (emphasis added).