The trust in this case was created in New York. The grantor was a resident of New York, as was the original trustee, and the trust was subject to New York law. During the period at issue in the case, the trustee was a Connecticut resident. The terms of the trust agreement gave the trustee “absolute discretion” over the amount and timing of any distribution of trust assets to beneficiaries. The trust agreement provided that it would terminate when the beneficiary turned 40, but New York law allowed that the assets could be rolled over at that time into a new trust without any distribution to the beneficiary.
The beneficiary of the trust moved to North Carolina in 1997. North Carolina’s Department of Revenue determined that the trust owed more than $1.3 million of tax for the years 2005–2008 based on a state law that imposed a tax on any trust income that’s “for the benefit” of a North Carolina resident. During that period, the beneficiary didn’t receive, and had no rights to receive, any distributions from the trust. The trust had no physical presence, direct investments, or real property holdings in North Carolina.A unanimous court affirmed that, under these circumstances, the state “lacks the minimum connection with the object of its tax that the Constitution requires…”
The Supreme Court uses a two-step analysis to determine if a state tax complies with the due process clause. First, the state has to show a “definite link, some minimum connection, between a state and the person, property, or transaction that it seeks to tax.” If that link is established, the state must then show that the income attributed to the state has some rational relationship to “values connected with the taxing state.”
In this case, the court found that North Carolina never established the necessary link to get past the first step. The court held “that the presence of in-state beneficiaries alone does not empower a state to tax trust income.” The justices were clear that they are limiting this holding to the facts presented by this trust, specifically:
- The beneficiaries didn’t receive any income from the trust.
- The beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy trust assets.
- The beneficiaries couldn’t count on receiving any specific amount from the trust in the future.
Possible effects on state laws and trust plans
Given the court’s stated intent to limit its ruling to this very specific fact pattern, it’s not clear how much of an effect the Kaestner Trust case will have on tax planning that involves trusts. North Carolina is “one of a small handful” of states with laws that would tax a trust’s income based solely on the residency of a beneficiary. The state’s willingness to rely on residency “regardless of whether the beneficiary is certain to receive trust assets” makes its law even more unusual and more clearly in violation of the first step in the due process test. The Supreme Court didn’t give any hints as to how it might rule if presented with one of the more common state laws that considers beneficiary residence as one of a combination of factors used to determine the taxability of trust income.
The ruling, however, does point out the significance of considering state tax implications when creating a trust or estate plan. High-net-worth families looking to plan wealth transfers could benefit from considering low-tax states for forming and managing trusts. Beneficiaries could reduce the state tax impact on their shares by establishing residency in those states when preparing to receive distributions from the trust.
As always, the most important question to ask about such a ruling is how it affects your tax position based on your individual facts and circumstances. To learn more about what this ruling means for you and your family, please contact your Plante Moran advisor.