MANAGING TAXES

Taxation of resident trusts, jurisdictional planning after Kaestner

An in-depth perspective on how this case sets trust planning precedence.

Late last week, the United States Supreme Court issued its decision in North Carolina Department of Revenue vs. Kimberly Rice Kaestner 1992 Family Trust (“Kaestner”). The Supreme Court ruled that the Due Process Clause prevents a state from taxing the income of a trust in situations where the sole connection of the trust to the state is via a contingent beneficiary maintaining a presence in the state.

Background

Kaestner involves a beneficiary of a trust who resided in North Carolina from 2005 through 2008. During this period, the trust made no distributions to the North Carolina domiciled beneficiary, with administration of the trust occurring in another jurisdiction, and the settlor residing in another jurisdiction. North Carolina’s Department of Revenue asserted the power to tax the trust’s entire income, with the only contact between the trust and North Carolina being that a contingent beneficiary of the trust was a North Carolina resident during the tax years at issue. North Carolina’s position was that its tax code reads that trusts are taxed on the amount of income that is for the benefit of a state resident, subjecting the entire trust’s income to North Carolina tax by virtue of having a resident beneficiary. It is important to note that the North Carolina resident beneficiary’s interest in the trust was contingent upon the trustee’s sole and absolute discretion to distribute trust property, income or principal, to the beneficiary.

The trustee agreed to pay taxes to the North Carolina Department of Revenue under duress and then pursued legal remedies in the North Carolina courts. In April 2015, the North Carolina court ruled in favor of the trust and held that due process prevented North Carolina from taxing the trust.1 Specifically, the court ruled that residency of a trust’s beneficiary in North Carolina alone is not sufficient under the Constitution to subject a trust to state income tax. The court went on to note that the trust, an entity distinct and separate from any beneficiary, did not establish contacts with North Carolina and administration and control of the trust resided with the out of state trustees. This fact pattern led the court to conclude that the tax failed to meet the requirements of the Due Process Clause as there was no significant activity within the state and tax on the trust was not rationally related to any benefits to the trust from the state. Essentially, the trust engaged in no activities in North Carolina and had no presence in the state. As such, the tax did not reasonably represent any benefits conferred by North Carolina as the trust did not benefit from any services or legal framework afforded by the state.

In response to the ruling, the North Carolina Department of Revenue petitioned the United States Supreme Court for a writ of certiorari, which was granted in January 2019.

United States supreme court ruling

On June 21, 2019, the United States Supreme Court unanimously affirmed in a decision written by Justice Sonia Sotomayor, 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 ever receive it.”2

In accordance with almost 100 years of precedent, the Court decided that due process requires a somewhat straightforward and pragmatic review of what exactly a beneficiary controls or has right to control and how that relates to what is purportedly subject to taxation by a state taxing authority. The Court is of the position that in order to justify taxing a trust based on the presence of a beneficiary, said beneficiary must “have some degree of possession, control, or enjoyment of the trust property or a right to receive that property”.3 The Court found that under the facts presented, there was simply insufficient relationship between the contingent beneficial interests of the beneficiary and North Carolina to justify a tax on the trust. As such, the Due Process Clause prevents North Carolina from taxing the trust.

Analysis

The Supreme Court’s ruling in Kaestner is seemingly limited to the facts of the case. The Court expressly declined to address the somewhat abstract issue of what degree of “possession, control, or enjoyment would be sufficient to support taxation” based on the residency of a beneficiary.4 The Court also did not determine whether “personal jurisdiction” and “tax jurisdiction” correspond, which was a question presented in the briefing. Such a determination may have been useful for providing a state taxing authority with greater clarity on the parameters for a position of appropriate state taxation.

The facts as ruled on in Kaestner seem to focus on the fact that the beneficiary was a contingent beneficiary, with no inherent current beneficial rights to trust assets, with the trustee having sole and absolute discretion to distribute either income or principal to the beneficiary.

The case omits any opinion or ruling on whether a state may tax a trust based on the residency of a non-contingent beneficiary. California’s statutes mandate trusts to pay tax on the basis of residency of non-contingent beneficiaries. In McCullough vs. Franchise Tax Board, the California Supreme Court ruled that the State could constitutionally tax a trust on the basis of having a resident non-contingent beneficiary.5 Though the resident beneficiary was also a trustee, a differentiating fact from Kaestner, it would most likely survive the Due Process challenge, the court noted that this reinforced the state’s independent basis for taxing the trust because of the beneficiary’s state of residence. The California Franchise Tax Board reinforced this position earlier this year by way of a Tax Information Letter clarifying that it still follows California Tax Code 17742(a), the state statute that subjects the entire taxable income of a trust to California tax in the event that the non-contingent beneficiary is a resident of California.

Importance of trust planning

The important thing to glean from Kaestner, the case in California, and cases elsewhere, is that understanding the importance of jurisdictional planning can have a meaningful impact on the taxability of assets held in trust. Finding expert guidance to assist you in navigating through the nuances of state statute and constitutional law relating to trust residency is integral to successful tax and estate planning.

Gerald Baker is the head of Trust & Fiduciary Services and co-head of the Center for Wealth Planning Excellence at SVB Private.

The views expressed in the article are those of the author and/or person interviewed and do not necessarily reflect the views of SVB Private or other members of Silicon Valley Bank Financial Group. The materials on this website are for informational purposes only, are subject to change and do not take into account your particular investment objective, financial situation or need. Since each client’s situation is unique, you should consult your financial advisor and/or tax planning professional before acting on any information provided herein