The Supreme Court unanimously held in North Carolina Dept. of Revenue v. The Kimberly Rice Kaestner 1992 Family Trust that the presence of in-state beneficiaries alone does not empower a 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.
Here, North Carolina attempted to impose income tax on a trust where all of the beneficiaries were residents of North Carolina, but the grantor of the trust was a resident of New York, the trust was governed by New York law, and no trustee lived in North Carolina. The trustee had "absolute discretion" over the distributions to the beneficiaries, and did not make any distributions to the beneficiaries in the years at issue. Furthermore, the trust asset custodians were located in Massachusetts, and the trust had no physical presence in North Carolina and no direct investments or real property there. Based on these facts, the Supreme Court held that North Carolina's tax violated the Due Process Clause of the Fourteenth Amendment. The Supreme Court's due process analysis of state trust taxation focuses on the extent of the in-state beneficiary's right to control, possess, enjoy, or receive the trust assets. Applying this analysis, the Court concluded that the residence of a trust beneficiary alone is an insufficient level of possession or control to support the minimum contacts necessary to uphold the state's income tax on a trust.
The Court was explicit that its opinion is limited to the specific facts presented to it. No assurance thus results as to the permissibility of trust taxes when based on the residence of a beneficiary whose relationship to the trust assets differs from the very limited rights of the Kaestner beneficiaries to control, possession, and receipt of trust assets. Thus, the Court's opinion leaves unanswered whether a state can tax trust income based solely on the residency of a beneficiary in the state when the beneficiary has any control over trust investments or distribution of trust income, any ability to demand the current distribution of trust assets, the right to assign trust assets or income, or any assurance of receiving trust income in the future.
Although the ruling is narrow, the Kaestner case was an important win for trust taxpayers. In addition, the ruling may provide some simplification for trust administration, because tracking the residence of beneficiaries would be a burdensome task for a trustee due to the increasing ease of interstate mobility. The ruling will clearly impact not only states where tax is imposed on a trust based solely on the residence of the beneficiary, but also those states where the residence of a beneficiary is one of a number of factors affecting the imposition of state tax.
The Court's decision leaves open for future resolution whether any of the other bases on which states assert the right to tax trust income fail to satisfy the "minimum contacts" standard. Next in line for consideration based on the relative weakness of its contacts would seem to be taxes based on the grantor of a trust being domiciled in the state at the time when the trust was created. In Fielding v. Commissioner of Revenue, 916 NW2d 323 (2018), the Minnesota Supreme Court held that the domicile of the grantor at the time of a trust's creation alone was not a sufficient basis to permit Minnesota to tax all of the income of the trust for the year at issue. The decision applies only for purposes of Minnesota tax law and thus has no direct effect on the many other states that use similar standards based on the residence or domicile of a trust's creator in the state to subject a trust to state income taxation. Request has been made for the U.S. Supreme Court to hear the Fielding case on appeal, and, if it is taken up by the Court, another significant decision on state income taxation of trusts could be issued by the Court within the next year or two.
We encourage clients to contact us to discuss the impact of this ruling on the administration of trusts going forward. If you have any questions, please contact the authors or any member of Venable's Tax and Wealth Planning Group.