Supreme Court issues trust-friendly state income tax nexus decision

The U.S. Supreme Court ruled that a North Carolina statute imposing income tax on a trust based solely on the residency status of the trust’s beneficiaries violated the due process clause of the 14th Amendment to the U.S. Constitution as applied to the “specific facts presented.”

In North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, U.S., No. 18-457, 6/21/19, the geographic footprint of the Kaestner trust spanned four states. The beneficiaries were residents of North Carolina; the trustee was located in Connecticut; the assets (all intangibles) were located in Boston; the settlor was a New York resident at the time the trust was created; the books and records, tax returns, legal documents were kept in New York; and the trust itself was governed under New York law. The trustee filed a $1.3 million refund on behalf of the trust for tax years 2005 through 2008, asserting that North Carolina could not impose income tax based solely on the beneficiaries’ residency status.

North Carolina Code section 105-160.2 states in relevant part: “The tax is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of this State … ”

The court noted that “when a State seeks to base its tax on the in-state residence of a trust beneficiary, the Due Process Clause demands a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State’s tax.”

The court emphasized the following key factors in rendering its opinion:

• the beneficiaries did not receive any income from the trust during the years at issue
• the beneficiaries had no right to demand trust income or otherwise control, possess or enjoy the trust assets in the tax years at issue
• the decision of when, whether and to whom the trustee would distribute the trust’s assets was left to the trustee’s absolute discretion
• the trust agreement explicitly authorized the trustee to distribute funds to one beneficiary to the exclusion of others with the effect of cutting one or more beneficiaries out of the trust
• the agreement authorized the trustee, not the beneficiaries, to make investment decisions regarding trust property
• the trust agreement prohibited the beneficiaries from assigning to another person any right they might have to the trust property

The court noted that its decision only addressed “the circumstances in which a beneficiary receives no trust income, has no right to demand that income, and is uncertain necessarily to receive a specific share of that income.”

While limited in scope, the Kaestner ruling may present refund opportunities in North Carolina or other states with similar imposition statutes for similarly drafted trusts. We advise reviewing any trust agreement with your advisor to see if the decision affects your trust. The case also provides some planning opportunities in North Carolina particularly as concerns the beneficiaries’ rights to income and trustee powers as granted by the trust documents.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.