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A Supreme Court Ruling to Highlight the State Income Taxation of Trusts Beyond NC

By now, you may have heard about the recent Supreme Court Decision on Friday, June 21st in Kaestner v. North Carolina.  We have even referenced it in a recent SALT post as many states continuously seek to assert nexus over multi-state entities as a means to raise revenue. 

The U.S. Supreme Court decision rules against the North Carolina Department of Revenue stating ‘the presence of in-state beneficiaries alone does not empower the state to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain to receive it.’  This [particular] connection between in-state beneficiaries and the state does not rise to a level sufficient for the state to impose tax under the Due Process Clause of the 14th amendment.

The opinion of the high court is considered very narrow by many within the Trust and Estate industry and limited to the specific set of facts argued in the case.  It does, however, shine a light on the importance of reviewing the trust documents and administration of the trust to best determine the state income taxation of trusts.

There are four key questions that often determine whether a state will consider a [nongrantor] trust a resident trust for income tax purposes:

  1. Was the grantor domiciled within the state at the time of creation, either at death via will or through an inter vivos transfer?
  2. Is the trust administered within the state?
  3. What state does the trustee(s) reside?
  4. What state does the beneficiary(s) reside?

There is no one-size fits all model for determining state income tax nexus for trusts as each state imposes tax in all, some, or none of the instances above when the answer is ‘yes’.

It is primarily this last question at the crux of the Kaestner case.  A quick summary of the Kaestner case fact pattern is as follows:

  • The Kimberly Rice Kaestner 1992 Family Trust was created by a New York Resident (#1)
  • The Trust was principally administered outside of North Carolina and maintained no physical presence in the state, held no direct investments or real property in North Carolina (#2)
  • The trustees were at one time New York residents and later succeeded by a Connecticut resident (#3)
  • The beneficiaries lived in North Carolina BUT had no right to, did not receive distributions during the period of time in question, and could not rely on ever receiving distributions from the trust (#4). The Trustee held absolute discretion on distributions.

Justice Sotomayor made specific reference to the fact the beneficiaries had no right to demand income, did not receive distributions during the period of time in question, and could not rely on ever receiving distributions from the trust as a basis for the decision since a beneficiary’s place of residence is not a significant reason alone to assess tax.

In dissecting the ruling compared to the myriad of ways a trust can operate and distribute, it becomes clearer just how narrow the ruling is.  Although the recent denial to hear a Minnesota Trust case by the U.S. Supreme Court, Bauerly v. Fielding, on June 28th, may expand the reach of the Kaestner decision.  In Bauerly v. Fielding, the Minnesota Supreme Court ruled in favor of the Trust citing the residence of the grantor at the time the trust is funded does not establish a resident trust under Minnesota law when the trustees, beneficiaries and the administration of the trust is maintained outside the state.  Seemingly administration of the trust and beneficial enjoyment of the trust property are prioritized when establishing state nexus.

In the end, the recent case law does encourage a review of any current trust document and administration along with a prospective analysis of potential state income tax issues for yet-to-be funded trusts.

Author: William Thomas, CPA  |  wthomas@withum.com

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