Nearly 30 years ago, Joseph Rice created a trust in New York for his three children. A New York trustee was appointed, and the trust was to be governed by New York law. The trustee was given complete discretion over distributions to the trust beneficiaries. At the time that the trust was created, no beneficiary lived in North Carolina. That changed in 1997, when a daughter, Kimberly Rice Kaestner, moved to North Carolina.
Soon after that relocation, the trust was divided into three subtrusts, one for each beneficiary and his or her descendants. The trust originally provided that it would terminate when Kaestner reached age 40, but in accordance with her wishes, the trustee rolled the assets over into a new trust.
North Carolina is one of three states that impose an income tax on the undistributed income of any trust that “is for the benefit of” one of its residents. This tax applies even if no distributions are made to in-state beneficiaries. For tax years 2005 through 2008, the state taxing authorities assessed income taxes of $1.3 million on the trust. During those years neither Kaestner nor her children received any trust distributions, nor did they have the legal right to demand distributions.
The trustees paid the tax and sued for a refund, arguing that the nexus between North Carolina and the trust was too tenuous to permit taxation, running afoul of the Due Process clause of the Fourteenth Amendment. The North Carolina Courts agreed, but the state took its case to the U.S. Supreme Court.
The Supremes Speak
In a unanimous decision, the Court agreed with the taxpayer and the North Carolina Supreme Court. Justice Sotomayor outlined the two-step process for determining whether a trust has sufficient contact with a state to permit taxation within the parameters of the Due Process clause. There needs to be a definite link, “some minimum connection,” between the state and the property it seeks to tax. Second, the income attributed to the State for tax purposes must be rationally related to “values connected with the taxing State.”
In this case the trustee resided out of state. The administration of the trust was divided among two states, New York for the trust records and Massachusetts for the custody of the assets. The trustee made no investments in North Carolina during the relevant tax years.
Justice Sotomayor concluded: “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.” In this case, the trust was entirely discretionary, and the beneficiary had no ownership or right to demand the property. In such a circumstance, the demands of the Due Process clause are not satisfied, and state taxation of the trust is not permitted.
The majority decision was premised explicitly upon the narrow facts presented, specifically the fact that the North Carolina resident was a contingent beneficiary. A concurring opinion suggested that the decision should not be read so narrowly.
Estate planners have been anxiously awaiting the Court’s decision in this case, and they will be relieved by the outcome. However, there remains some ambiguity about how much connection there needs to be to permit taxation of undistributed trust income.
Justice Sotomayor noted that a tax based upon the trustee’s residence has passed constitutional muster, and the location of trust administration has similarly been held sufficient. The unanswered questions are, what if the beneficiary had the right to demand some or all of the trust income? What if the demand right extended to the trust principal?
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