Based on a recent U.S. Supreme Court decision, your clients who use trusts for wealth transfer should watch their state-level tax authorities.
In what at first appears a victory for taxpayers, the court recently held in North Carolina Department of Revenue v. Kimberly Kaestner 1992 Family Trust that a state’s attempt to tax undistributed trust income based on a beneficiary living in that state violated the Due Process Clause of the 14th Amendment because, in the high court’s opinion, the trust had no nexus in North Carolina.
Where the beneficiaries lived
The trust was established New York, while the primary beneficiaries were the settlor’s descendants, none of whom lived in North Carolina at the time of the trust’s creation. In 1997, Rice’s daughter, Kimberley Rice Kaestner, moved to North Carolina.
The state soon tried to tax the trust, which had been formed for Kaestner and her children, under a law authorizing the state to tax any trust income that is “for the benefit of” a state resident. North Carolina levied more than $1.3 million for 2005 through 2008. As the Supreme Court later observed, the state argued that “‘a trust and its constituents’ are always ‘inextricably intertwined,’ and thus, because trustee residence supports state taxation, so too must beneficiary residence.”
But, during those years, Kaestner had no right to and received no distributions from the trust. The trust also had no physical presence, made no direct investments or held any real property in North Carolina. The trustee sued the Department of Revenue and won in several state courts.
Still, the case went to the Supreme Court, which ruled on June 21, 2019, 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.”
What defines residency?
Kaestner makes a statement concerning limits on a state’s ability to levy income tax on a resident on undistributed trust income. It does not give clear answers for all trust and tax nexus situations. Some experts have called it a narrow ruling based on unusual facts.
Helping manage clients’ trusts now means keeping up on diverse tax rules and updating administrators on rapid changes. Details of the Kaestner trust, for instance, spanned four states: North Carolina, Connecticut, Massachusetts, and New York.
States use varying rules and methods to determine if the trust itself “resides” in a state, but common factors often include residency of:
- Grantor: The most-common factor used to determine residency, when the state examines where the settlor of the trust lived when the trust became irrevocable.
- Trustee: To meet this requirement, at least one fiduciary must reside in the state. Some states, if there are multiple fiduciaries some of whom are residents when others aren’t, may require the trust apportion its income.
- Beneficiary: States that use this factor also tend to use either the residency of the grantor or the residence of the trustee as well.
Some states use location of the trust administration to determine residency. The type of trust can also change residency factors in a few states.
Generally, all trust income is taxed in a resident state. In a non-resident state, only a portion of income sourced to that state will be taxed. Often, trusts can be moved or decanted into new trusts with stronger provisions against state-level taxes.
Questions to ask
Trusts should review where trustees and beneficiaries live and where the trust is administered. As you help clients with the tax aspects of trusts, also help them watch constantly for a beneficiary moving to a different state – easier said than done in our mobile society. Trusts may also investigate restricting beneficiaries’ access to distributions.
You should also be prepared to ask:
- Are family members – often the ones chosen as trustees – the best choice, especially if they live in a taxing state? What if the trustee is institutional? Where is the trust protector? Trust investment director? One possible answer: Have the trust name an LLC or similar entity (formed in a tax-friendly state) as trust protector or investment advisor.
- Does the trust rent or own an office or real property in the taxing state? Does it have direct investments in the taxing state?
- Where are the trust records? In these digital times, how will cloud storage of documents change states’ tax claims? And the location of trustee and beneficiary meetings was noted in Kaestner. How might web-based meetings soon figure in a trust’s nexus?
Most likely, you have a number of clients who have trusts, so brush up on the treatment of trusts and educate your clients on this latest ruling.