Keystone State Strengthens Its Irrevocable Trusts With Grantor Trust Rules

Grantors of Pennsylvania irrevocable trusts may now elect to pay the income taxes on the trusts’ income under the recently-signed Act 64 of 2023, provided that such trusts qualify as “grantor trusts” under federal tax law.  For decades, Pennsylvania has deviated from federal income tax laws by specifically prohibiting grantor trust tax status for irrevocable trusts. This new Act simplifies the rules for irrevocable trusts to mirror those in other jurisdictions, and it provides an opportunity for grantors to plan for new irrevocable trusts, and for grantors, trustees, and beneficiaries to review certain existing irrevocable trusts. 

Historical and New Treatment for State Income Taxation of PA Irrevocable Trusts

Since 1971, Pennsylvania and federal laws have differed in their tax treatment for irrevocable trusts, even when the grantor retained certain powers under the trust instrument. Under federal law, a grantor of an irrevocable trust (or another person) can be taxed on the trust income to the extent that the grantor (or such other person) is deemed the “owner” of such trust under the Internal Revenue Code (the “Code”) sections 671 through 679 (the “grantor trust powers”), regardless of whether such income is distributed to the beneficiaries or accumulated.  Under prior Pennsylvania law, however, a Pennsylvania Resident Trust (or Non-Resident Trust, to the extent of its sources within the Commonwealth) was subject to tax on its income received during the trust’s taxable year at a rate of 3.07%, regardless of whether the grantor (or another person) held such grantor trust powers. 

This difference between Pennsylvania and federal law applied to a trust unless the grantor trust was a wholly revocable trust. An irrevocable trust is a trust for which the grantor has not retained the power to amend or revoke such trust. This incongruent tax treatment encouraged some grantors to consider moving their irrevocable trusts outside of the Commonwealth in order to benefit from grantor trust treatment under the state tax laws of another jurisdiction. The prior Pennsylvania law also meant that the trust beneficiaries were taxed on income required to be distributed or credited to them and the trust taxed on the remaining income, requiring the trustee to determine when, and how much, to distribute to which beneficiaries, for state income tax planning, even when, for federal income tax purposes, the grantor was treated as the owner of the trust income. 

Under Act 64 of 2023, as signed by Governor Joshua Shapiro on December 14, 2023 and as sponsored by Senator Lisa Baker, a Pennsylvania Resident Trust (or a Nonresident Trust with source income from the Commonwealth) shall now be taxable to the grantor (or another person) to the extent that such grantor (or another person) is deemed to be the owner of the trust under sections 671 through 679 of the Code. This new Act aligns the state income tax treatment of a Pennsylvania irrevocable grantor trust with the federal income tax treatment of such trust, and it conforms such laws with those of other jurisdictions in the United States. This change simplifies some matters for grantors, trustees, and beneficiaries, but also requires a careful review of prior and future planning with respect to such trusts. 

Planning for Future PA Irrevocable Trusts

Grantors of future Pennsylvania irrevocable trusts have an opportunity to review income tax planning for such trusts. Act 64 of 2023 is effective as of February 12, 2024, sixty days from the date it was enacted. This effective date, however, affects the reporting and filing requirements for Pennsylvania trusts in tax years beginning on or after January 1, 2025. Therefore, any irrevocable Pennsylvania resident grantor trusts established after such date may qualify as grantor trusts for both federal and Pennsylvania income tax purposes. The state income tax treatment for revocable trusts remains unchanged, and the grantor continues to be treated as the owner of such trust assets with the income from such assets includible in the grantor’s income taxes. For irrevocable trusts, however, a Pennsylvania resident trust is any trust created by a grantor who was a Pennsylvania resident at the time the trust was created, or a trust that consisted in whole or in part for any of the taxable year of real or personal property transferred to it by a person who was a Pennsylvania resident at the time of such transfer. Therefore, an irrevocable trust may be deemed to be a resident trust regardless of whether the grantor has since moved and changed his domicile if he or she created such trust while a resident of the Commonwealth. 

Grantors of Pennsylvania irrevocable trusts must now consider whether their income tax reporting requirements may change for tax years starting on or after January 1, 2025. For example, these irrevocable trusts may have grantor trust provisions that were included for federal income tax purposes but were not expected to apply for state income tax purposes because of the prior Pennsylvania rules. These grantors should discuss the implications of the potential additional income from these types of trusts on their own individual income tax returns, or the effects of releasing any grantor trust powers over such trusts. These new tax rules may also affect a trustee’s state quarterly estimated tax payments for these trusts, or the trustee paying tax on the income received by the trust. These changes should relieve some of the administrative burdens for the trustees and the trust beneficiaries, especially given the prior disconnect between Pennsylvania and federal tax laws. 

In addition, some Pennsylvania irrevocable grantor trusts may have intentionally qualified under the Commonwealth’s safe harbors as Nonresident Trusts after the grantor is no longer a resident of Pennsylvania, such as by appointing only the non-resident trustees and changing trust situs to another state. This planning was sometimes previously recommended when Pennsylvania did not recognize grantor trusts. These trusts may be reviewed with trust income tax planning in mind, especially if the costs for trust administration outweigh any prior income tax savings, or when the grantor’s domicile or trust assets have changed. 

Next Steps

While the new Act 64 of 2023 does not affect the trust tax planning until tax years starting on or after January 1, 2025, grantors, trustees, and beneficiaries should begin reviewing existing irrevocable trusts regarding how Pennsylvania will then treat such trusts for grantor trust purposes. Grantors, whether they live in Pennsylvania or in another state, may also consider creating new grantor trusts as Pennsylvania Resident Trusts, given the relatively low trust income tax rates compared with other neighboring states like New York and New Jersey. Finally, grantors, trustees, and beneficiaries should discuss these trusts, and their individual income tax planning, with their advisors for trust income tax planning in 2025 and beyond.