On June 21, 2019, the U.S. Supreme Court issued a unanimous decision that may help some trusts and their beneficiaries avoid state income tax. Although the Court’s decision was very narrow, the Supreme Court determined a state does not have the right to tax the income of a trust if the only connection between the state and the trust is a beneficiary’s residence in the state and:
- the trust’s income has not been distributed to the “in-state” beneficiary; and
- the “in-state” beneficiary has no right to demand a distribution of trust income (and the beneficiary is uncertain ever to receive it).
The Court’s decision clarifies planning opportunities that may allow wealthy families to minimize state income tax by locating a trust in a state, such as Delaware, that does not tax undistributed trust income attributable to beneficiaries who reside outside of Delaware.
Facts of the Case
In North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, the U.S. Supreme Court held that North Carolina had violated the U.S. Constitution’s Due Process Clause by taxing a trust’s income based solely on the fact that several of the trust’s beneficiaries lived in the state.
The original trust was established by Joseph Lee Rice III (Mr. Rice), a resident of New York. The trust was governed by New York law, and the trust instrument named a New York resident as the trustee. The primary beneficiaries of the trust were the descendants of Mr. Rice. None of the primary beneficiaries lived in North Carolina at the time the trust was created. In 1997, Mr. Rice’s daughter, Kimberley Rice Kaestner (Ms. Kaestner), moved to North Carolina.
The trustee of the original trust divided it into three separate trusts. One of the trusts, the Kimberley Rice Kaestner 1992 Family Trust (the Kaestner Trust), benefited Ms. Kaestner and her three children. Under the terms of the Kaestner Trust, which followed the terms of the original trust, the trustee had absolute discretion to distribute trust assets to the trust beneficiaries and was not required to make any distributions. Also, the trustee used New York’s so-called “decanting” law, which gave the trustee the power to extend the trust’s duration so that none of the Kaestner Trust’s beneficiaries could count on receiving trust income in the future.
The administration of the Kaestner Trust had no connection to North Carolina:
- The trust was governed by New York law.
- No trustee resided in North Carolina.
- The trust maintained no physical presence in North Carolina.
- The records of the trust were kept in New York.
- The custodians of the trust’s assets were located in Massachusetts.
- The trust did not make any direct investments in or hold any real property in North Carolina.
As conceded by North Carolina, the only connection between the trust and the state was the North Carolina residence of Ms. Kaestner and her children.
The trustee chose not to make any distributions to Ms. Kaestner during tax years 2005–08. Instead, the trustee accumulated the trust income in the trust. North Carolina nevertheless assessed a tax against the Kaestner Trust of more than $1.3 million for that time period. North Carolina took the position that it had authority to tax the trust’s income under a North Carolina law authorizing the state to tax any trust income that “is for the benefit of” a resident of the state.
The trust paid the tax under protest and then sued the North Carolina Department of Revenue for a refund, alleging the state had violated the Fourteenth Amendment’s Due Process Clause by applying the tax to a trust when the only connection to the state was the beneficiary’s in-state residence. The trust argued North Carolina lacked the necessary minimum contacts with the trust to assert taxing authority. The North Carolina Supreme Court agreed with the trust, holding the beneficiaries and the Kaestner Trust were “separate ‘taxable entities’” and that the Kaestner family’s connections to North Carolina “cannot establish a connection between the Trust ‘itself’ and the State.” Thus, the North Carolina Supreme Court determined the mere presence of a trust beneficiary in the state, when no distributions had been made from the trust to the beneficiary, was insufficient nexus to North Carolina to satisfy the due process requirements that would allow the state to impose an income tax on the trust.
North Carolina appealed the case to the United States Supreme Court, and the Court agreed to hear the case “to decide whether the Due Process Clause prohibits States from taxing trusts based only on the in-state residency of trust beneficiaries.” The case was argued before the Supreme Court in April 2019. The Court issued its unanimous decision on June 21, holding that the presence of a beneficiary in the state alone does not empower a state to tax trust income that has not been distributed to such beneficiary, particularly when the beneficiary does not have a right to demand the income and where it is uncertain whether the beneficiary will ever receive any income from the trust. The Court stated the “residence of the Kaestner Trust beneficiaries in North Carolina alone does not supply the minimum connection necessary to sustain the State’s tax.”
Implications and Planning Opportunities
The Supreme Court was careful to limit the scope of its holding, although it will affect other states that tax the income of trusts based solely on the beneficiary’s residence. Further, the limited holding in this case makes it likely litigation over state taxation of trusts will continue. As the Supreme Court stated, “In limiting our holding to the specific facts presented, we do not imply approval or disapproval of trust taxes that are premised on the residence of beneficiaries whose relationship to trust assets differs from that of the beneficiaries here.”
It may be the Supreme Court in the Kaestner decision has provided a “floor” for defining when a state lacks sufficient connection to a trust to impose an income tax. The Court’s decision listed many factual situations wherein it had previously found a state may impose a tax on trust income. Further, the Court left open the possibility of other situations where a beneficiary’s rights and powers over trust assets may allow the beneficiary’s state of residence to tax the trust’s income. It is likely that there will be additional litigation surrounding this issue, and it will be up to a future court to further refine the level of a trust’s connections to a state or the level of a beneficiary’s powers over trust assets which provides sufficient connection to allow a state to impose a tax on the trust.
It’s important to note that laws vary from state to state. Because of these differences, planning opportunities for wealthy families seeking to reduce their income tax burden abound; choosing the right state in which to create and administer a trust is one such planning opportunity. For example, a settlor could minimize or potentially avoid state tax by situating a trust in a state such as Delaware, which does not impose a state income tax on trust income accumulated for distribution in future years to nonresident beneficiaries. The trust could further minimize taxation by delaying distributions until the beneficiary has moved to a low-tax state. This strategy could help reduce or eliminate state income tax on the trust’s income, allowing it to grow over its lifetime from a larger compounding base without diminution each year by state income taxes.
The Supreme Court’s decision also reinforces the importance of good trust planning to minimize connections between a trust and any state other than the state in which the trust is located.
Using a corporate trustee to locate and administer a trust in Delaware can reduce the nexus between the trust and other states, making it harder for such states to impose an income tax on the trust.
A family should consider a host of factors — including tax consequences — when choosing to include trusts in the family’s overall wealth plan. We encourage you to contact your legal and tax advisors to determine the best course of action for you and your family.
For more information, please contact your PNC advisor.