Continued Ramifications of Kaestner for Trust Taxation
By: Juliya L. Ismailov and Daniel J. King
Whether a state has jurisdiction to tax a taxpayer might be summed up in the question: has the State given that taxpayer anything in return? In the case of U.S. trusts being subject to state income tax, the constitutional question is whether the trust has derived any benefits from a given state as to create a link or nexus with that state.
How does the trust derive benefits? Most states have enacted statutes to answer this question. n.1 These statutes present some combination of four (4) factors establishing a trust’s presence in the state for tax purposes. These factors are: (1) residence of the trust’s grantor or settlor; (2) administration of the trust in the state; (3) residence of trustee(s); and/or (4) residence of a trust beneficiary.
It is the last factor, the residence of the beneficiary, that was the subject of recent controversy in a case that was heard by the U.S. Supreme Court and decided this year against the State and in the trust-taxpayer’s favor. Specifically, on June 21, 2019, in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, the U.S. Supreme Court held that the State of North Carolina (the “State”) had violated the Due Process Clause of the Fourteenth Amendment in the taxation of a trust based purely on the beneficiary’s residence in the state.
North Carolina assessed more than $1.3 million of income tax against The Kimberley Rice Kaestner 1992 Family Trust (“Trust”) over the span of tax years 2005 – 2008. The original trust, from which the present Trust had later sprung, was formed in year 1992 by a New York resident, Joseph Lee Rice III (the “grantor”), appointing a New York resident as the trustee (“Trustee”). The Trustee had absolute discretion to distribute assets of the Trust to the beneficiaries, which means this trust is classified as a fully discretionary trust.
Around year 2000, the New York Trustee used his discretion to divide the initial trust into separate sub-trusts, of which the Trustee acted as trustee. The trusts were for the benefit of the grantor’s children, including Kimberley Rice Kaestner (“Kaestner”). Kaestner had moved to North Carolina from New York in 1997. The sub-trust in question, the Kimberley Rice Kaestner 1992 Family Trust, was governed by the same trust agreement as the original trust. As a fully discretionary trust, during the period at issue, 2005 – 2008, Kaestner as the sub-trust’s beneficiary had no right to demand, and did not receive, any distributions. Other than Kaestner’s residence in North Carolina, the Trust had no contacts, investments or real property holdings in the State. The Trustee’s contacts with Kaestner were infrequent, the Trust was subject to New York law, the New York Trustee kept the Trust documents and records in New York, and the Trust’s asset custodians were located in Massachusetts. The Trust paid the tax assessed by North Carolina under protest and then challenged the tax in state court.
Specifically, North Carolina’s statute at issue provides that tax is imposed on the income of a trust “that is for the benefit of a resident of this State.” See N.C. Gen. Stat. Section 105-160.2. North Carolina Supreme Court interpreted the statute to allow North Carolina to tax a trust solely based on a trust beneficiary’s residence in the State. By comparison, for example, New York taxes trusts created by a resident of New York, but there is an exemption for trusts where: (i) all of the trustees are domiciled outside of New York, (ii) all of the property held in the trust is located outside of New York, and (iii) the trust cannot receive any New York source income. See N.Y. Tax Law 605(b)(3)(D)(i).
The U.S. Supreme Court unanimously decided in favor of the Trust, in an opinion delivered by Justice Sonia Sotomayor, stating that in-state residence of trust beneficiaries, without more, did not supply the “minimum connection” under the Due Process clause of the U.S. Constitution to justify the State’s imposition of tax on trust income. That said, the Court was clear that this ruling was not indicative of reform and was narrow in scope. Justice Sotomayor wrote that “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.”
Despite the Supreme Court’s disapproval of taxation solely based on a beneficiary’s presence in the state without any other contacts, Kaestner is far from being the be-all-end-all decision on trust tax issues. For example, in states that impose tax on trusts based on the trustee’s residence, attorneys have creatively set up a member-managed, wholly-owned, out-of-state LLC to act as trustee. In such case, would the state take the position, and would such position be upheld in court, that the trust is subject to tax in the LLC manager’s state of residence on the premise that such manager is the de facto trustee? Or, can an investment advisor or distribution advisor of a Delaware directed trust, who lives in another state, be deemed a trustee and cause the trust to be taxed in that state?
The Kaestner effect is that at least each state is on notice that it will need to make a substantive case of the trust’s contacts in the state creating a nexus for tax purposes —not just establish the bare fact that a grantor, trustee or beneficiary lives there. Unfortunately, ensuring such a thorough approach by a state’s taxing authorities may yet require further litigation.
1. Exceptions are Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington, Wyoming because these states do not impose income tax on trusts.