SCOTUS: States Prohibited from Taxing Trust’s Undistributed Income Solely by Virtue of Residency of Beneficiary

In a unanimous opinion affirming a decision of North Carolina’s Supreme Court, the U.S. Supreme Court ruled on June 21 in N.C. Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, U.S., No. 18-457, states do not have the right under the Due Process clause to tax trusts on undistributed trust income with respect to beneficiaries resident in that state where the beneficiaries have no right to demand that income and are uncertain to receive it. The Court’s ruling is a significant development for trust beneficiaries who reside in states that have imposed income taxes on trusts solely by virtue of the beneficiaries’ residency in that state. 

Background

A number of states currently rely on beneficiary residency as a basis for the taxation of a trust’s income. [State Income Taxation of Nongrantor Trust] These statutory regimes have come under scrutiny in recent years as trusts and estate practitioners have contended beneficiary residence in and of itself is an insufficient nexus upon which states may base the income taxation of trusts.

The trust in Kaestner was established by Joseph Lee Rice III, a New York resident, named a New York resident as trustee and provided New York law would govern the administration of the trust. One of the trust’s beneficiaries, Rice’s daughter, Kimberley, resided in North Carolina during the period 2005 through 2008, in which the state of North Carolina assessed more than $1.3 million in tax on trust income potentially distributable to Kimberley and her children, contending N.C. Gen. Stat. Ann. §105-160.2 permitted the state to assess tax on any trust income that “is for the benefit of” a state resident. 

Holding

The Court held that the residence of a beneficiary in-state does not by itself constitute sufficient nexus for a state to tax trust income that (i) has not been distributed nor is guaranteed to be distributed to the beneficiaries, and (ii) the beneficiaries have no right to demand and are uncertain to receive. The Court’s holding that Kimberley and her children had no right to demand trust income and were uncertain to receive was based on the fact the trust was totally discretionary during the 2005-2008 years at issue, even though there was a later obligatory termination date for the trust (Kimberley reaching age 40). The Court’s rationale in disregarding the age 40 termination date is not entirely clear.  In the case of Kaestner, however, after 2008 but before the Court’s Decision, the trust was decanted into another trust that eliminated that obligatory trust termination. The Court effectively held that as to a trust that could roll its assets into a new trust rather than terminating it (e.g., any trust that has the ability to decant and thus eliminate any mandatory distribution provision), the beneficiaries could not count on receiving any specific amount of income in the future. It is not clear whether the trustee’s exercise of that statutory right to decant was a key factor in the Court’s decision. 

Practical Effects

The Court explicitly stated its ruling is not intended to address scenarios wherein a trust’s beneficiaries may have greater rights over trust income—for example, the right to receive trust income, the right to demand trust income, or a vested future interest in income. Neither does the Court’s ruling address state laws that consider the in-state residency of a trust beneficiary as only one of a number of factors in establishing the state’s authority to tax trust income.

The ruling in Kaestner also aligns with other recent cases wherein trusts have challenged the taxation of the trust based on the residency of the grantor at the time of the creation of the trust. One such case, Fielding v. Comm’r of Revenue, 916 N.W.2d 323 (Minn. 2018), recently held that the grantor’s domicile on the date the trust in question became irrevocable was insufficient to establish a nexus of state taxation. The Kaestner ruling may provide further ammunition for trusts, trustees, and beneficiaries seeking to challenge these statutes on Due Process grounds.