K-1s and State Source Income

[bmcfarland]

I have a client with a K-1 from a partnership.  The partner is actually a family trust.  The trust has never filed a tax return and the client has been treating the K-1s from the partnership as hers on her personal returns.  This year there is a large capital gain.  Should the trust have been filing a return and issuing a K-1 to the client as the trust's beneficiary?  Does the trust create Arizona source income (the trust was created in Arizona and the trustee lives there) for this client who lives in another state?

[sjrcpa]

What kind of trust is it?

It may well be Arizona income depending on the type of income. Is this a business capital gain? Or an investment capital gain?

[bmcfarland]

It's an irrevocable grantor trust . . . the fiduciary is the beneficiary, lives out of state.  The trust is a member of an LLC.  The LLC realized a capital gain, it sold it's only asset, some land.

[sjrcpa]

A grantor trust is ignored for income tax purposes. The grantor reports the income on their own tax return.

Most states are gonna tax a gain from real estate in their state. Where was the land?

[bmcfarland]

It's an irrevocable grantor trust.  The grantor is out of it.  The trust is responsible for the taxes, i.e., the beneficiary, no?  I think the trustee/beneficiary should use Option 1 reporting and as such, agree, it's disregarded from the IRS perspective.  

The land is in Arizona, the trustee/beneficiary lives in Virginia and the trust is managed there.

[sjrcpa]

How did "The grantor is out of it" happen? If death, it likely is no longer a grantor trust. Do you have the trust agreement?

It is possible for a trust to be a grantor trust with respect to someone other than the settlor, but in practice I have rarely seen it happen.

Arizona wants tax on the gain. I think AZ and VA have the backass credit situation where you claim a credit on the AZ nonresident return for tax paid to VA.

[bmcfarland]

Am I wrong?  I was thinking that once the grantee made the trust irrevocable, any tax burden passed to the trust.  In this case, then, to the fiduciary who is also the beneficiary.  

The trust uses the beneficiary's SSN for it's membership in the LLC.  The LLC, taxed as a partnership, issued it's K-1 to the trust using the beneficiary's SSN.  The trust has never filed a return but has been in existence since 2008.

[sjrcpa]

I don't have enough facts to know if what is wrong or right.

Step 1- read the trust document. Irrevocable is only one factor.