Multi-State Taxation of Trusts and Estates: Residency, Sourcing, and Planning

Trusts and estates face a unique set of multi-state tax rules that combine the complexity of trust taxation with the complexity of state residency and income sourcing. A single trust can be a resident of one state, have a grantor domiciled in another state, have a trustee in a third state, and have beneficiaries in five more states. Each state's claim on the trust income depends on its own residency and sourcing rules, producing a patchwork of filing obligations and credit calculations. The throwback rule, the federal estate tax exemption sunset, and the state-by-state variation in estate and inheritance taxes add further complexity.

This guide covers trust taxation basics, trust residency determination, income sourcing for trusts, the throwback rule, state-specific trust rules (California, New York, Delaware, South Dakota), three worked examples spanning the most common scenarios, the difference between inheritance tax and estate tax, the state estate tax landscape, and the federal estate tax exemption sunset. Every rule cited is current as of 2025, with references to the controlling IRC sections, Treasury Regulations, and state statutes.

Trust taxation basics: simple vs complex; grantor vs non-grantor

Trusts are classified as simple or complex for federal tax purposes. A simple trust under IRC §651 must distribute all income annually, may not distribute principal, and may not make charitable contributions. The trust deducts the income distribution, and the beneficiaries report the income on their own returns. A complex trust under IRC §661 is any trust that is not a simple trust: it may accumulate income, distribute principal, and make charitable contributions. The trust pays tax on undistributed income at compressed trust tax rates under IRC §1(e).

Trusts are also classified as grantor or non-grantor. A grantor trust under IRC §671-679 is a trust where the grantor retains sufficient control or benefit that the trust income is taxed to the grantor regardless of distribution. The grantor trust rules are detailed: IRC §673 (reversionary interest), IRC §674 (power to control beneficial enjoyment), IRC §675 (administrative powers), IRC §676 (power to revoke), and IRC §677 (power to distribute income to grantor or spouse). If any of these powers is retained by the grantor, the trust is a grantor trust.

A non-grantor trust is a trust where the trust itself is a separate taxpayer. The trust pays tax on undistributed income at compressed trust tax rates under IRC §1(e). The trust tax brackets for 2025 are: 10% on income up to $3,100; 24% on income from $3,100 to $11,150; 35% on income from $11,150 to $15,650; and 37% on income above $15,650. The trust reaches the top 37% bracket at only $15,650 of income, compared to $626,350 for single filers. This compressed bracket structure creates a strong incentive to distribute trust income to beneficiaries in lower brackets.

Grantor trusts are commonly used in estate planning because the grantor pays the tax on trust income, effectively transferring additional wealth to the trust beneficiaries without gift tax. The IRS confirmed this treatment in Rev. Rul. 2004-64. Non-grantor trusts are used when the grantor wants to remove the trust income from their own return, but the trust pays tax at compressed rates that reach the top bracket at low income levels.

Trust residency determination

Trust residency is determined by the state using one or more of the following factors: (1) where the trustee is located, (2) where the trust is administered, (3) where the grantor was domiciled when the trust became irrevocable, and (4) where the beneficiaries are located. The state-by-state variation is significant.

California (R&TC §17014(b)) considers a trust a California resident trust if the grantor was a California domiciliary when the trust became irrevocable. The trust remains a California resident trust indefinitely, regardless of where the trustee is located or where the trust is administered. California is one of the most aggressive states in asserting residency based on grantor domicile.

New York (Tax Law §605(b)(3)) considers a trust a New York resident trust if the grantor was a New York domiciliary when the trust became irrevocable. New York applies an exemption: the trust is not subject to New York tax on non-New York-source income if (a) the trustee is not a New York resident, (b) the trust holds no New York real or tangible personal property, and (c) the trust has no New York-source income. This exemption allows New York grantor trusts to escape New York tax by relocating the trustee and assets out of New York.

Delaware and South Dakota have trust-friendly rules that allow trusts to be resident in those states if the trustee is located there, regardless of the grantor domicile. Delaware (Del. Code tit. 30 §1602) provides that a trust with a Delaware trustee is a Delaware resident trust, and Delaware does not tax non-grantor trusts on income accumulated for non-Delaware beneficiaries. South Dakota (SDCL §43-31-1) has similar rules, with no state income tax on trust income. These states are popular for "dynasty trusts" — perpetual trusts that accumulate income for multiple generations without state income tax.

Income sourcing for trusts

Trust income is sourced to states based on the type of income and the state's sourcing rules. Interest and dividends are typically sourced to the state of the trust's residency (or to the grantor's state for grantor trusts). Capital gains are typically sourced to the state of the trust's residency. Business income is sourced to the state where the business is conducted under the UDITPA three-factor formula (property, payroll, sales) or the single-factor sales formula adopted by most states.

For non-grantor trusts, the trust pays tax on undistributed income sourced to the trust's resident state and to any state where the trust has source income. Distributions to beneficiaries carry out the trust's distributable net income (DNI) under IRC §661, and the beneficiaries report the distribution on their own returns. The distribution retains the character of the underlying income (ordinary income, capital gain, tax-exempt income) under IRC §662.

For grantor trusts, the trust income is taxed to the grantor regardless of distribution. The grantor reports the trust income on their own return, sourced to the grantor's state of residence (or to any state where the trust has source income). The grantor trust is not a separate taxpayer for federal purposes, but some states have their own grantor trust rules that may differ from federal.

The "throwback rule" for accumulated distributions

The throwback rule under IRC §666 applies to non-grantor trusts that accumulated income in prior years (without distributing it) and then distribute the accumulated income in a later year. The distribution is "thrown back" to the year the income was earned, and the beneficiary is taxed as if they had received the income in that year. The rule prevents trusts from accumulating income at lower trust tax rates and then distributing the accumulated income to beneficiaries at lower individual rates.

The throwback rule applies to domestic non-grantor trusts with undistributed net income. The rule does not apply to simple trusts (which must distribute all income annually) or to grantor trusts (whose income is taxed to the grantor regardless of distribution). The rule also does not apply to distributions of current-year income (income earned in the same year as the distribution).

The beneficiary calculates the throwback tax using Form 4970, which calculates the tax on the thrown-back distribution as if the income had been included in the beneficiary's income in the year earned. The beneficiary gets a credit for any tax the trust paid on the accumulated income, so the rule prevents double taxation but recovers the tax at the beneficiary's rate. The throwback rule is most relevant for foreign trusts (which have a more aggressive throwback rule under IRC §668) but also applies to domestic trusts in some cases.

State-specific trust rules

California trust rules are particularly aggressive. California (R&TC §17014(b)) considers a trust a California resident trust if the grantor was a California domiciliary when the trust became irrevocable, regardless of where the trustee is located or where the trust is administered. California taxes the resident trust on worldwide income, with no exemption for non-California-source income. This means a California grantor trust with a Nevada trustee and Nevada assets is still subject to California tax on all income. The only escape is to have the trust become irrevocable while the grantor is a non-California domiciliary.

New York trust rules (Tax Law §605(b)(3)) are similar but with an exemption. A New York resident trust (grantor was a New York domiciliary when the trust became irrevocable) is exempt from New York tax on non-New York-source income if (a) the trustee is not a New York resident, (b) the trust holds no New York real or tangible personal property, and (c) the trust has no New York-source income. This exemption allows New York grantor trusts to escape New York tax by relocating the trustee and assets out of New York. The exemption is not available to California resident trusts.

Delaware and South Dakota are the most trust-friendly states. Delaware (Del. Code tit. 30 §1602) provides that a trust with a Delaware trustee is a Delaware resident trust, and Delaware does not tax non-grantor trusts on income accumulated for non-Delaware beneficiaries. South Dakota (SDCL §43-31-1) has similar rules, with no state income tax on trust income. Both states allow perpetual trusts (no rule against perpetuities), making them attractive for dynasty trusts. Both states also have strong asset protection laws for trusts.

Worked example 1: CA grantor trust with NV trustee

A California domiciliary creates an irrevocable grantor trust, naming a Nevada corporate trustee. The trust holds $5 million of marketable securities. Annual trust income: $200,000 (interest and dividends). The trust is a grantor trust, so the grantor reports the $200,000 of income on their personal return. The grantor is a California resident, so California taxes the $200,000 at California rates (approximately 9.3% to 13.3% depending on the grantor's other income). California tax on $200,000: approximately $18,600 to $26,600.

The Nevada trustee does not change the California residency of the trust, because California determines trust residency by grantor domicile (R&TC §17014(b)), not by trustee location. The grantor pays California tax on the trust income regardless of the Nevada trustee. The only way to escape California tax on the trust income is to have the trust become irrevocable while the grantor is a non-California domiciliary — for example, the grantor moves to Nevada, then creates the trust, or the trust is created as a revocable trust and becomes irrevocable only after the grantor's Nevada domicile is established.

If the grantor moves to Nevada before the trust becomes irrevocable, the trust is a Nevada resident trust (no state income tax). The grantor pays $0 California tax and $0 Nevada tax on the trust income. The savings is approximately $18,600 to $26,600 per year. Over a 20-year trust term, the savings is approximately $372,000 to $532,000, plus the compounding effect of the tax savings remaining in the trust.

Worked example 2: NY non-grantor trust distributing to FL beneficiary

A New York domiciliary creates an irrevocable non-grantor trust, naming a New York individual trustee. The trust holds $5 million of marketable securities. Annual trust income: $200,000 (interest and dividends). The trust distributes $100,000 annually to a Florida beneficiary. The trust is a non-grantor trust, so the trust pays tax on undistributed income ($100,000), and the beneficiary reports the distributed income ($100,000) on their personal return.

The trust is a New York resident trust (grantor was a New York domiciliary when the trust became irrevocable). New York taxes the trust on worldwide income, but with an exemption for non-New York-source income if the trustee is not a New York resident, the trust holds no New York real or tangible personal property, and the trust has no New York-source income. In this case, the trustee is a New York resident, so the exemption does not apply. The trust pays New York tax on the undistributed $100,000 at New York trust tax rates (top rate 10.9% above $25 million, but 6.85% above $215,400 single, with trust rates reaching top bracket at $12,500 of income). New York trust tax on $100,000: approximately $7,200.

If the trustee is replaced with a Connecticut individual trustee (or a corporate trustee outside New York), the New York exemption applies. The trust pays no New York tax on the undistributed $100,000. The trust pays federal tax on $100,000 at trust tax rates (37% above $15,650), or $37,000 federal tax. The beneficiary pays no New York tax on the $100,000 distribution (Florida resident, no state income tax). The savings from replacing the trustee is approximately $7,200 per year. Over a 20-year trust term, the savings is approximately $144,000.

The federal treatment is the same in both cases. The trust pays federal tax on the undistributed $100,000 at trust tax rates. The beneficiary reports the $100,000 distribution on their federal return, with the trust getting a deduction for the distribution. The New York trustee replacement affects only the New York state tax.

Worked example 3: Estate with multi-state real estate

A decedent dies a California domiciliary, owning $5 million of California real estate, $3 million of Florida real estate, and $7 million of marketable securities. Total estate: $15 million. The estate is a California resident estate (decedent was a California domiciliary). California estate tax: California does not have a state estate tax (repealed in 2005), so no California estate tax. Florida estate tax: Florida does not have a state estate tax. Federal estate tax: the federal estate tax exemption for 2025 is $13.61 million, so the $15 million estate exceeds the exemption by $1.39 million. Federal estate tax: approximately $528,000 (40% × $1.39 million taxable estate).

If the decedent had moved to Florida before death and established Florida domicile, the estate would be a Florida resident estate (no state estate tax). The federal estate tax would be the same $528,000. The state estate tax savings is $0 in this case (neither California nor Florida has a state estate tax), but the multi-state real estate would not trigger any state estate tax filing requirements.

If the decedent had moved to New York before death and established New York domicile, the estate would be a New York resident estate. New York estate tax (Tax Law §952) exemption for 2025 is $7.16 million. The $15 million estate exceeds the New York exemption by $7.84 million. New York estate tax: approximately $1.0 million (using the New York estate tax rate schedule, with marginal rates from 3.06% to 16%). The federal estate tax would be the same $528,000. Total estate tax: approximately $1.53 million. The New York domicile produces approximately $1.0 million more in state estate tax than the California or Florida domicile.

The planning implication: for an estate of this size, the domicile at death determines the state estate tax. A move from New York to Florida before death saves approximately $1.0 million in New York estate tax. The move must be completed and documented before death; a deathbed move is unlikely to withstand audit.

INHERITANCE tax vs ESTATE tax

Inheritance tax is levied on the recipient of inherited property, based on the value received and the relationship to the deceased. Six states levy an inheritance tax as of 2025: Iowa (fully repealed for deaths on or after January 1, 2025), Kentucky (KRS §140.070), Maryland (Md. Code, Tax-Gen. §13-202, also has an estate tax), Nebraska (Neb. Rev. Stat. §77-2001), New Jersey (N.J.S.A. §54:34-1, estate tax repealed 2018 but inheritance tax retained), and Pennsylvania (72 P.S. §9116). The inheritance tax rates vary by relationship: spouses typically exempt; lineal descendants typically 0-4.5%; siblings typically 12-15%; others typically 15-18%.

Estate tax is levied on the estate of the deceased person, based on the total value of the estate above an exemption threshold. The federal estate tax under IRC §2001 applies to estates above $13.61 million per person in 2025. Twelve states and DC levy a state estate tax with their own exemptions (typically $1 million to $5 million, with Connecticut and Hawaii matching the federal exemption). The state estate tax exemptions are typically much lower than the federal exemption, so moderate estates can face state estate tax even with no federal estate tax.

The two taxes are mutually exclusive in most states: a state has either an estate tax or an inheritance tax, not both. Maryland is the exception: Maryland has both an estate tax (exemption $5 million) and an inheritance tax (with exemptions for spouses, lineal descendants, and siblings). The federal estate tax and the state inheritance tax can apply to the same estate: the federal estate tax is levied on the estate, and the state inheritance tax is levied on the recipient.

State estate tax

Twelve states and the District of Columbia levy a state-level estate tax as of 2025. The state exemptions and rates vary widely:

Connecticut (Conn. Gen. Stat. §12-391): exemption $13.61 million in 2025 (matching federal), rates from 7.2% to 12%. Hawaii (HRS §236D): exemption $5.99 million, rates from 10% to 20%. Illinois (35 ILCS 405/2): exemption $4 million, rates from 0.8% to 16%. Maine (36 M.R.S. §4102): exemption $7.16 million, rates from 8% to 12%. Massachusetts (M.G.L. c.65C): exemption $2 million, rates from 0.8% to 16%. Minnesota (M.S. §291.005): exemption $3 million, rates from 13% to 16%. New York (Tax Law §952): exemption $7.16 million in 2025, rates from 3.06% to 16%. Oregon (ORS 118.010): exemption $1 million, rates from 10% to 14%. Rhode Island (R.I.G.L. §44-22-2.1): exemption $1.96 million, rates from 0.8% to 16%. Vermont (32 V.S.A. §7112): exemption $5 million, rates from 16%. Washington (RCW 83.100.020): exemption $2.193 million, rates from 10% to 20%. DC (D.C. Code §47-3702): exemption $5 million, rates from 11.2% to 16%.

The state estate tax is levied on the estate, not the recipient. The estate files a state estate tax return (separate from the federal estate tax return Form 706) and pays the state estate tax before the assets are distributed to the beneficiaries. The state estate tax is deductible on the federal estate tax return (Form 706), reducing the federal taxable estate.

The federal estate tax exemption

The federal estate tax exemption under IRC §2010 is $13.61 million per person in 2025 ($27.22 million for married couples with portability under IRC §2010(c)(2)). The exemption is scheduled to sunset on December 31, 2025, returning to approximately $7 million per person (adjusted for inflation) on January 1, 2026. The sunset is a result of the Tax Cuts and Jobs Act reconciliation rules, which required the exemption increase to sunset after 2025.

The IRS confirmed in Treasury Regulation §20.2010-2 (the "anti-clawback" regulation) that gifts made before the sunset will not be clawed back. A taxpayer who makes a $10 million gift in 2025 (using $10 million of the $13.61 million exemption) and dies in 2026 (when the exemption is $7 million) will not have the gift clawed back. The estate will have $7 million of remaining exemption (the 2026 amount), plus any unused exemption from the gift (the gift used $10 million, but the estate only "needs" $7 million of the pre-sunset exemption to cover the gift, so no clawback).

High-net-worth individuals should consider making large gifts in 2025 to lock in the higher exemption before the sunset. The gift can be made outright, to a trust, or to a dynasty trust in Delaware or South Dakota. The gift uses the 2025 exemption, and the appreciation on the gifted assets is removed from the estate. The sunset may be extended by legislation, but planning should assume the sunset occurs.

Common mistakes

The most common trust and estate tax mistake is failing to relocate the trustee of a New York resident trust to escape New York tax. The New York exemption (Tax Law §605(b)(3)(D)) requires the trustee to be a non-New York resident. Many New York grantor trusts continue with a New York trustee for years, paying New York tax on income that could be exempt. The fix is to replace the New York trustee with a non-New York individual or corporate trustee, removing the New York real and tangible personal property, and ensuring no New York-source income.

The second most common mistake is creating an irrevocable trust while still domiciled in California. California (R&TC §17014(b)) considers the trust a California resident trust if the grantor was a California domiciliary when the trust became irrevocable, regardless of the trustee location. The fix is to have the trust become irrevocable only after the grantor establishes a non-California domicile — for example, by creating a revocable trust that becomes irrevocable at death, after the grantor has moved.

The third common mistake is failing to plan for the federal estate tax exemption sunset. High-net-worth individuals with estates above $7 million should consider making large gifts in 2025 to lock in the $13.61 million exemption before the sunset. The anti-clawback regulation (Treas. Reg. §20.2010-2) protects pre-sunset gifts, but post-sunset gifts will use the lower $7 million exemption. The planning should be done with an estate planning attorney, because the gift may have income tax consequences (carryover basis versus stepped-up basis at death) and may affect Medicaid eligibility.

Audit defense

Trust and estate tax audits are common, particularly for trusts with multi-state connections and for estates above the state estate tax exemption. The audits typically focus on (1) trust residency classification, (2) trust income sourcing, (3) estate tax valuation, and (4) the deduction of distributions to beneficiaries. California FTB and New York DTF have dedicated trust and estate audit teams.

The defense is the contemporaneous documentation package: the trust agreement (showing the trustee, the grantor, the beneficiaries, and the trust terms), the trust accounting records (showing income, deductions, distributions, and accumulated income), the trust tax returns (Form 1041 for federal, Form 541 for California, Form IT-205 for New York), the estate tax return (Form 706 for federal, Form 706-CA for California, Form ET-706 for New York), and the valuation appraisals for non-marketable assets. The documentation must be assembled at the time of the trust or estate event, not reconstructed years later.

If the audit produces a deficiency, the taxpayer can appeal through the state administrative process and then to state court. The appeals process can take 2-3 years. Interest accrues on the deficiency during the appeal. For high-stakes audits (deficiency above $500,000), engage a tax attorney with trust and estate litigation experience; the attorney-client privilege protects communications and is not available with a CPA.

What to do next

Open the WithholdRight calculator to project your federal and state tax liability under your current trust and estate structure. Identify the highest-impact strategy for your situation: relocating the trustee of a New York resident trust, restructuring a California grantor trust, making large gifts before the federal estate tax exemption sunset, or establishing a dynasty trust in Delaware or South Dakota.

For trust residency planning, review the trust agreement to determine the residency classification under each state's rules. For New York resident trusts, evaluate the exemption by relocating the trustee and assets out of New York. For California grantor trusts, evaluate restructuring the trust to become irrevocable only after a non-California domicile is established.

For estate tax planning, evaluate the federal estate tax exemption sunset and the state estate tax exemptions. Make large gifts in 2025 to lock in the $13.61 million exemption before the sunset. Consider a dynasty trust in Delaware or South Dakota for perpetual wealth transfer. Every trust and estate decision should be evaluated with a licensed tax professional and an estate planning attorney. The WithholdRight calculator handles the projection; the planner handles the strategy and the documentation. Use both.