North Carolina Department of Revenue vs. Kimberley Rice Kaestner 1992 Family Trust A Partial Answer To The Income Taxation of Trusts By: I. Richard Ploss
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Executive Summary: The United States Supreme Court rules that states cannot use a “Beneficiary Focused” basis for taxing trust income if the following factors are present: (1) The Trustee is not a resident of the taxing state; (2) The trust is not administered under the laws of the taxing state; (3) The trust owns no assets in the taxing jurisdiction; (4) No aspects of trust administration occur in the taxing state; (5) The beneficiary who resides in the taxing state has no unilateral right to compel the Trustee to make distributions to the beneficiary; and (6) The beneficiary who resides in the taxing state will not receive a terminating distribution from the trust during his/her lifetime.
Executive Action Item: Trustees and beneficiaries should review all existing trusts to determine if there are potential strategies for minimization of state income tax.
Analysis: On June 21, 2019, in a unanimous opinion, the U.S. Supreme Court ruled that a state’s attempt to tax the accumulated income of a non-resident non-grantor trust based solely on a beneficiary’s residency in the taxing jurisdiction is unconstitutional and violates the Due Process Clause of the Fourteenth Amendment of the U.S.
VS. KIMBERLEY RICE KAESTNER 1992 FAMILY TRUST
Constitution. The case, North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust (Slip Opinion No. 18-45), was the most highly anticipated tax case of the court’s recently completed term. The facts are relatively straight forward. In 1989, a New York domiciled Grantor created an irrevocable trust to benefit his children. The trust governing instrument granted the Independent Trustee the “absolute discretion” to distribute trust income and principal to the beneficiaries in “such amounts and proportions” as the Trustee might from “time to time” decide. When the trust was created, none of the Grantor’s children resided in North Carolina, the Trustee did not reside in North Carolina, nor did the trust own any North Carolina situs property. The trust governing instrument specifically stated that all trusts were to be governed under the laws of New York. In 1992, the trust divided into separate trusts to benefit each of the Grantor’s children and their children (Grantor’s grandchildren). Each trust was to terminate upon a child’s attaining the age of forty (40) years and the remaining assets were to be distributed to the child who was a beneficiary of such trust. In 1997, one of the Grantor’s children, Kimberley, permanently moved to North Carolina. With Kimberley’s consent, the Trustee, utilizing New York’s decanting statute, transferred the assets in the trust for her benefit into a new trust which, while retaining the Trustee’s absolute discretionary authority over distributions, eliminated the age forty (40) trust termination provision. During the tax years from 2005 to 2008, the Trustee made no distributions of income or principal to Kimberley or her children. Furthermore, the Trustee was a New York resident, the trust corpus was held in a Massachusetts
PORZIO, BROMBERG & NEWMAN, P.C.
A PARTIAL ANSWER TO
THE INCOME TAXATION OF TRUSTS
investment account, and the Trustee never met with Kimberley in North Carolina. However, the North Carolina Department of Revenue, relying on a North Caroline statute which authorizes the State to impose an income tax on any trust income that “is for the benefit of a state resident”, asserted that ALL of the income recognized by the Trustee was subject to North Carolina income tax. The North Carolina Department of Revenue claimed that the trust owed a tax liability of more than $1.3 million. The Trustee paid the tax and sued the North Carolina Department of Revenue in state court asserting that the state’s tax system violated the Fourteenth Amendment. The North Carolina Supreme Court, affirming a lower court decision, ruled for the taxpayer. Not to be denied, the North Carolina Department of Revenue appealed the decision to the U.S. Supreme Court, which granted certiorari and heard oral arguments in April 2019.
transaction it seeks to tax; and that the income attributed to the state for tax purposes must be rationally related to the values connected with the taxing state. In the trust beneficiary context, this link and rational relationship focuses on the beneficiary’s right to control, possess or enjoy trust assets. As applied to the facts in Kaestner, since Kimberley received no income from trust, had no right to demand trust income or otherwise control, possess or enjoy trust assets, and could not count on receiving any specific amount of future income from the trust, the court found that North Carolina’s statute violated the Fourteenth Amendment.
State income taxation of trusts has become a very important issue in recent years due to the difference in tax rates among U.S. jurisdictions. Some states do not impose state income tax on resident trusts, while others states impose significant tax burdens on trusts that In writing for the court, Justice have a connection (nexus) to the state. Sotomeyer held that in order for a state’s Complicating the issue even further is the taxing system to not violate the Fourteenth rationale that states utilize in determining Amendment’s Due Process Clause, there if there is sufficient nexus to cause the must be some definite link between entire trust to be subject to the taxing the state and the person, property or state’s income tax system. Some states PORZIO, BROMBERG & NEWMAN, P.C.
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VS. KIMBERLEY RICE KAESTNER 1992 FAMILY TRUST
(such as Maine) view the domicile of the Grantor (Trust Creator) when the trust was created, as the determining factor for state taxation (“Grantor Focused”). Other states (such as California) take the position that the domicile of a Trustee is the determining factor (“Trustee Focused”). Other states (such as Louisiana) will base the imposition of tax on the governing law as contained in the trust instrument (“Governing Law Focused”). Still, other states (such as Illinois and Missouri) weigh a series of factors (such as residency of the Trustee, residency of the beneficiaries, location (situs) of trust property, place of administration (i.e. where meetings with beneficiaries are held) and the governing law as contained in the trust instrument (“Factors Focused”). Finally, a few states (such as Georgia and North Carolina) have claimed that the residency of the beneficiary is the sole determinative factor for imposing state income tax on the trust (“Beneficiary Focused”). Tax advisors have consistently raised the Fourteenth Amendment Due Process Clause as a potential defense as to whether a state’s income tax system is constitutional and thus sustainable. However, the U.S. Supreme Court has not ruled on a case that would bring certainty to this area of taxation. The Kaestner decision provides that a Beneficiary Focused state income tax system will not survive the Due Process Clause. However, the court specifically limited the applicability of its opinion to the facts in the case. The Kaestner decision stands for the proposition that with a purely discretionary trust, a Beneficiary Focused tax system will not satisfy the scrutiny of the Due Process Clause if these factors are present: (1) The Trustee is not a resident of the taxing state; (2) The trust is not administered under the laws of the taxing state; (3) The trust owns no assets in the taxing jurisdiction; (4) No aspects of trust administration occur in the taxing state; (5) The beneficiary who resides in the taxing state has no unilateral right to compel the Trustee to make distributions to the beneficiary; and
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(6) The beneficiary who resides in the taxing state will not receive a terminating distribution during his/her lifetime. Interestingly enough, in reaching its decision, the court did not consider that the trust was decanted into a new trust that eliminated Kimberley’s right to receive principal at a specific age, as being adverse to the taxpayer. Based on this decision, Trustees (and beneficiaries) should have legal counsel review all existing trusts to determine if there are potential strategies for minimization of state income tax.
I. Richard Ploss Counsel Porzio, Bromberg & Newman, P.C. 973.889.4087 irploss@pbnlaw.com
I. Richard Ploss is Counsel to Porzio, Bromberg & Newman P.C. and a member of the firm’s Trusts and Estates Department. Mr. Ploss concentrates his practice primarily on estate planning for high net worth individuals and their businesses, estate administration, probate litigation and fiduciary income taxation in New Jersey and throughout the East Coast. He has extensive experience advising individual clients in the areas of wealth transfer planning and the preparation of estate planning documents. Mr. Ploss is a Certified Public Accountant (CPA) in the state of Georgia, a Certified Financial Planner™ (CFP®) and a Professional Registered Trust and Estate Practitioner (TEP). He frequently publishes articles and speaks on trust and estate matters. Mr. Ploss currently serves as an Adjunct Professor, teaching Trusts & Estates at the University of Maine Law School. He has previously taught classes in estate planning at Boston University, Fordham University, Fairleigh Dickinson University and Georgetown University.