United States Supreme Court Holds That State May Not Tax Trust Due Solely to Resident Beneficiary

The Court’s unanimous decision, while expressly limited to the specific trust at issue, provides taxpayers with opportunities to obtain state income tax refunds and to engage in estate planning to minimize state income taxes utilizing properly structured trusts.

By Jeff Glickman, SALT Partner

On June 21, 2019, the United States Supreme Court issued its unanimous opinion in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust.[1]  The Court upheld a decision of the North Carolina Supreme Court that, under the Due Process Clause of the United States Constitution (i.e., the 14th Amendment), the state could not impose an income tax on a trust based solely on the fact that the beneficiary is a resident of the state.[2]

This is a favorable decision for taxpayers that provides certain trusts the ability to obtain state income tax refunds in a number of states, including Georgia, and it presents state income tax planning opportunities.  However, it is important to note that the Court’s opinion does limit the applicability of its decision as explained below.

Facts of the Case

In 1992, a New York resident (settlor) established a trust, under New York law, for the benefit of his children.  An initial trustee was named who resided in New York, but that trustee was replaced in 2005 by a Connecticut resident who remained the trustee throughout the relevant time period in question.  In 1997, one of the beneficiaries of the trust moved to North Carolina.  Subsequently, the trust was subdivided into sub-trusts, one of which was for the benefit of the North Carolina resident and her children.

Throughout the years at issue, the custodians of the trust assets were in Massachusetts and all legal records and financial documents were in New York.  According to the opinion, “The trust agreement provided that the trustee would have ‘absolute discretion’ to distribute the trust’s assets to the beneficiaries ‘in such amounts and proportions’ as the trustee might ‘from time to time’ decide.”  In addition, the trust itself did not have any presence in North Carolina and did not make any direct investments in the state.

For tax years 2005 -2008, North Carolina taxed the trust on income accumulated (even though the income was not distributed to any of the North Carolina beneficiaries) based on its statute that taxes trusts on “income . . . that is for the benefit of a resident of this State.”[3]   The trust filed for a refund of those taxes, which the North Carolina Department of Revenue denied.  The case made its way through the state court system, where the trust was victorious, before being appealed by the state to the United States Supreme Court.

Opinion and Analysis

The Court explains that in deciding whether the imposition of a state tax satisfies the Due Process Clause, there must be “some definite link, some minimum connection between a state and the person, property, or transaction it seeks to tax.”  Ultimately in the context of this case, the Court concluded that:

When a tax is premised on the in-state residence of a beneficiary, the Constitution requires that the resident have some degree of possession, control, or enjoyment of the trust property or a right to receive that property before the State can tax the asset. Otherwise, the State’s relationship to the object of its tax is too attenuated to create the “minimum connection” that the Constitution requires.

Applying that principle to the facts, the Court held that the in-state residence of the beneficiary did not supply the requisite minimum connection for several reasons.  First, the beneficiaries did not receive any income from the trust during the tax years in question.

Second, the beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue.  As noted above, the trust agreement gave the trustee absolute discretion over the trust’s assets.  In addition, the Court also noted that the trust agreement prohibited the beneficiaries from assigning to another person any interest they might have in the trust property.  However, in a footnote, the Court clarified that it was not addressing whether a beneficiary’s ability to make such an assignment “would afford that beneficiary sufficient control or possession over, or enjoyment of, the property to justify taxation based solely on his or her in-state residence.”

Finally, the beneficiaries could not count on receiving any amount of income or assets from the trust in the future.  Interestingly, the trust agreement provided that the trust terminate in 2009 on the parent-beneficiary’s 40th birthday (after the tax years at issue) and distribute all trust assets to her.  However, New York law allowed the trustee to roll over the trust assets to a new trust, which is exactly what occurred.

The Court highlights the fact that based on the features of this trust, the beneficiary’s interest is “contingent” on the exercise of the trustee’s discretion.  However, in another footnote, the Court once again limits its opinion to the specific facts in the case, stating, “We have no occasion to address, and thus reserve for another day, whether a different result would follow if the beneficiaries were certain to receive funds in the future.”

As further evidence of the Court’s desire to limit the applicability of this decision, when it was rejecting one of the state’s arguments that ruling in the taxpayer’s favor would undermine numerous state tax regimes, the Court stated:

North Carolina is one of a small handful of States that rely on beneficiary residency as a sole basis for trust taxation, and one of an even smaller number that will rely on the residency of beneficiaries regardless of whether the beneficiary is certain to receive trust assets.  Today’s decision does not address state laws that consider the in-state residency of a beneficiary as one of a combination of factors, that turn on the residency of a settlor, or that rely only on the residency of noncontingent beneficiaries. . . .  We express no opinion on the validity of such taxes.

Aprio’s Insights

This is a favorable decision for taxpayers in two respects.  First, trusts that have been paying state income taxes in a state under the same circumstances may be entitled to a refund of those taxes for all tax periods that are open under the statute of limitations.  In particular, Georgia’s law imposes income tax on trusts based on the existence of a resident beneficiary similar to North Carolina, so trusts that have paid income tax to Georgia may be eligible for refunds.

Second, taxpayers in Georgia and other states may be able to minimize state income tax liabilities through the use of trusts that are properly structured based on the guidance in the Court’s opinion.

However, as noted throughout, this opinion is a narrow one.  It does not establish a blanket rule that any state income tax imposed on a trust based solely on the existence of a resident beneficiary violates the Due Process Clause.  The Court was very careful to limit its holding to the application of North Carolina’s law to the specific trust at issue in this case.

If you are interested in more information about this case, world like to pursue a refund claim, or discuss establishing trusts as part of your estate plan and minimizing your state income taxes, please reach out to an Aprio tax advisor.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the June 2019 SALT Newsletter.

[1] Docket No. 18-457, 588 U.S. ___ (2019).

[2] For those that would like to read our article summarizing the North Carolina Supreme Court’s decision issued last year, please click here.

[3] N.C.G.S. § 105-160.2.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.