A shakeup in trust taxation: Kaestner and Paula Trust

By Ashley Schmelzer, J.D., and Peter Seidel, J.D., LL.M., Los Angeles

Editor: Mark G. Cook, CPA, CGMA

The U.S. Supreme Court recently held 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 any trust income and are uncertain to ever receive any (North Carolina Dep't of Rev. v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S. 6/21/19)). The Court clarified that its opinion was limited to the facts presented in the case and expressed no opinion as to the validity of state trust statutes that rely on beneficiary residency as a sole basis for trust taxation (id., slip op. at 15-16).

California, for instance, taxes trust income on the basis of noncontingent beneficiary residency (Cal. Rev. & Tax. Code §17742(a)). As of this writing, another trust case, Paula Trust v. California Franchise Tax Board, No. CGC-16-556126 (Cal. Super. Ct. 2/6/18), appeal filed, No. A154691 (Cal. Ct. App. 4/25/18), is working its way through the California state court system and may challenge the interpretation of the state's statutes. This item discusses the implications of the Court's ruling in Kaestner and compares the issues at hand in Paula Trust.

Kaestner

In Kaestner, the trust that challenged North Carolina's tax was formed in 1992 by New York resident Joseph Lee Rice III for the benefit of his children. The trust was governed by New York law, and Rice appointed a New York resident as the trustee. The trust agreement provided that the trustee would have "absolute discretion" to distribute the trust's assets to the beneficiaries. The trustee had exclusive control over the allocation and timing of trust distributions (Kaestner, slip op. at 11). When the trust was formed, no one involved (grantor, fiduciary, or beneficiary) had a connection to North Carolina. This changed in 1997, when Rice's daughter, Kimberley Rice Kaestner, moved to North Carolina. She and her minor children were residents of the state from 2005 to 2008, the relevant period at issue in the case.

North Carolina's only connection to the trust during those years was the in-state residence of the trust's beneficiaries. From 2005 to 2008, the trustee did not make any distributions. The trust was subject to New York law, the grantor was a New York resident, and no trustee lived in North Carolina. The trust had no physical presence in North Carolina, made no direct investments in the state, and held no property there (Kaestner, slip op. at 3).

Under North Carolina law, the state taxes any trust income that "is for the benefit of" an in-state resident (N.C. Gen. Stat. §105-160.2; Kaestner, slip op. at 1). The N.C. Department of Revenue generally interprets this statute to authorize the state to tax a trust on the sole basis that the trust beneficiary resides in the state (Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Dep't of Rev., 814 S.E.2d 43, 45 (N.C. 2018)). Applying the statute, the N.C. Department of Revenue taxed the full proceeds accumulated by the trust for the 2005 to 2008 tax years, which amounted to more than $1.3 million, and required the trustee to pay it. The trustee paid the tax under protest and then sued in state court, arguing that the tax violated the Due Process Clause of the U.S. Constitution (Kaestner, slip op. at 4).

The trial court held that Kaestner's residence in North Carolina was too tenuous a link between the state and the trust to support the tax and that the taxation violated the Due Process Clause (Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Dep't of Rev., 12 CVS 8740 (N.C. Sup. Ct. (Bus.) 4/23/15)). The N.C. Court of Appeals and N.C. Supreme Court both affirmed (Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Dep't of Rev., 789 S.E.2d 645 (N.C. Ct. App. 2016), aff'd 814 S.E.2d 43 (N.C. 2018)). The state of North Carolina appealed, and the issue before the U.S. Supreme Court was whether the Due Process Clause prohibits states from taxing trusts based solely on the in-state residency of trust beneficiaries.

The Court looked to the International Shoe Co. "minimum contacts" test in its analysis of whether North Carolina had the requisite minimum connection with the trust to justify the taxation of the trust's assets (Kaestner, slip op. at 6). A state has the power to impose a tax only when the taxed entity has "certain minimum contacts" with the state such that the tax "does not offend 'traditional notions of fair play and substantial justice'" (International Shoe Co. v. Washington, 326 U.S. 310, 316 (1945)). Only entities that derive "benefits and protection" from their association with the state should owe obligations to it (id. at 319).

Cases where the trust was found to have the requisite "minimum connection" with the state to justify taxation include (1) where trust income was distributed to an in-state resident (Maguire v. Trefry, 253 U.S. 12, 16-17 (1920)); (2) where the trustee was a resident of the state (Greenough v. Tax Assessors of Newport, 331 U.S. 486, 498 (1947)); and (3) where the trust was administered in the state (Hanson v. Denckla, 357 U.S. 235, 251 (1958)). According to the Court, none of these traditional connections that are deemed sufficient for due-process purposes applied to the Kaestner trust: The trust made no distributions to any North Carolina resident during the relevant time frame, the trustee resided in Connecticut, and the trust was administered in both New York and Massachusetts (Kaestner, slip op. at 2, fn. 2, and 7).

The Court also looked at the relationship between the relevant trust constituent and the trust assets that the state sought to tax. Specifically, the Court focused on the "extent of the in-state beneficiary's right to control, possess, enjoy, or receive trust assets" (Kaestner, slip op. at 7). Here, the beneficiaries did not receive any income from the trust during the relevant period, and the Court noted that if they had, then that income would have been taxable (Kaestner, slip op. at 11). Furthermore, the beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets; this decision was in the trustee's "absolute discretion" (id.). Lastly, the beneficiaries had no definite right to receive any income in the future because the trust was set up such that the trustee could roll the trust assets into a new trust rather than terminating it and distributing the assets (Kaestner, slip op. at 12). Thus, the Court found that the beneficiaries' residence could not, in and of itself, serve as the sole basis for North Carolina's tax on the trust income (Kaestner, slip op. at 13).

Paula Trust

In California's Paula Trust case, which is currently on appeal with the California Court of Appeal, the California Franchise Tax Board (FTB) argued that California has the right to tax a trust based on both the residency of the trust's constituents and the source of the income, and set forth a combined application of both trust law and individual income tax law. In this case, the Paula Trust had two trustees, one a resident of California and one a nonresident. It had one beneficiary, who was a resident. On its original 2007 tax return, the trust apportioned all its income to California, but in 2012 the trust filed an amended tax return that apportioned only half its income to California, on the ground that only one of its two trustees resided in California (Appeal of Paula Trust, No. 759422 (Cal. Bd. Equal. 8/18/16)).

The FTB argued that a two-step methodology set forth in state regulations (Cal. Code Regs., tit. 18, §17743) applied, where the FTB first applies the nonresident individual sourcing rules in Chapter 11 of the Revenue and Taxation Code (Cal. Rev. & Tax. Code §17951 et seq.) and then, with respect to non-California-source income, applies an apportionment rule based on the state of residence of fiduciaries and noncontingent beneficiaries under Chapter 9 (Cal. Rev. & Tax. Code §§17743 through 17744).

The trust contended that the FTB's methodology contained in the regulation is contrary to the statutes governing the taxation of trust income. The trust argued that the nonresident sourcing statutes in Chapter 11 do not apply to trusts because Section 17951 (which states that in the case of nonresident taxpayers, only California-source income is included in gross income) applies only to individuals, and that under the plain language of the statutes and their legislative history, the taxability of trust income in California can by definition be determined only by the trust apportionment rules in Chapter 9, wherein the portion of income taxable by California is based on the residence of the trust's noncontingent beneficiaries and fiduciaries.

Specifically, the trust argued that the applicable statute is Cal. Rev. & Tax. Code Section 17743 ("Where the taxability of income . . . depends on the residence of the fiduciary and there are two or more fiduciaries for the trust, the income . . . shall be apportioned according to the number of fiduciaries resident in this state."). The FTB argued that this statute simply determines residency status for trusts and how non-California-source income taxed under a residency theory is to be apportioned based on this status.

The California Superior Court agreed with the trust and granted the trust's motion for summary judgment, finding that Cal. Rev. & Tax. Code Section 17951 et seq. does not apply to trusts but, rather, applies only to nonresident individuals (Paula Trust v. California Franchise Tax Board, No. CGC-16-556126 (Cal. Super. Ct. 2/6/18)). Accordingly, the court agreed with the trust that Rev. & Tax. Code Section 17743 applies, and thus the trust's taxable income is determined by apportioning its income according to the number of resident fiduciaries.

Alternatively, the FTB argued that the trust may also be taxable based on the in-state residency of the noncontingent beneficiary, even if the trust's income did not arise from a California source. The FTB claimed that the trust's beneficiary was noncontingent because the trust's language created a defined standard that the trustee must adhere to in making distributions, and that distributions may not be considered discretionary when the trust instrument contains such a standard (Cal. FTB Memorandum in Opposition of Motion for Summary Judgment, pp. 18-19 (12/5/17)). In response, the trust argued that the beneficiary was contingent because the fiduciaries were authorized to make distributions as they deemed to be in the best interest of the beneficiary, but they were not required to make any distributions (Plaintiff's Reply in Support of Motion for Summary Judgment, p. 8 (12/14/17)). The California Superior Court agreed with the trust, finding that the trust's sole beneficiary had a contingent interest in the trust and that distributions were subject to the sole and absolute discretion of the co-trustees.

Similar to North Carolina's argument in Kaestner that adopting the trust's position would "lead to opportunistic gaming of state tax systems" (Kaestner, slip op. at 16), the FTB argued that the trust's interpretation of the California statute "would produce absurd results and encourage abuse," as it would "allow nonresidents to avoid tax on gains from California real property simply by placing the property in a trust with a nonresident trustee or trustees" (Appeal of Paula Trust, No. 759422 (Cal. Bd. Equal. 8/18/16)).

Looking ahead in Paula Trust

Though the issues in Kaestner and Paula Trust are similar, it appears unlikely that the Kaestner holding will have a direct effect on the California courts as the Paula Trust case makes its way through the system. Chiefly, the U.S. Supreme Court made it clear that its ruling applied only to the circumstances in which an in-state beneficiary receives no trust income, has no right to demand income, and is uncertain to ever receive any trust income (Kaestner, slip op. at 7). The only connection with the state in Kaestner was the in-state residency of the beneficiary.

In contrast, Paula Trust involved an in-state trustee and an in-state beneficiary. The result in Paula Trust at the California Superior Court level was due also in part to a disagreement with the FTB's unique statutory interpretation (applying a combination of trust statutory provisions and personal income tax statutory provisions). Thus, at the California appellate and, potentially, California Supreme Court levels, the courts will also need to address whether the FTB's regulation goes beyond what is authorized by the statute. In contrast, the Kaestner case focused entirely on the constitutionality of a state taxing a trust based solely on the in-state residence of a beneficiary. The Kaestner Court made it clear that its opinion does not extend to noncontingent beneficiaries (see Kaestner, slip op. at 12, fn. 10), nor does it address state laws that rely only on the residency of noncontingent beneficiaries.

Thus, it is doubtful that California courts will extend the specific findings of Kaestner to the separate facts and circumstances of Paula Trust. Even if the Kaestner decision will not ultimately support the taxpayers in Paula Trust, a confirmation of the California Superior Court's holding would have the positive effects, similar to those of the Kaestner case, of (1) providing needed guidance to nonresident trusts with in-state fiduciaries or beneficiaries, and (2) clarifying that a state's aggressive attempts to reach trust income with minimal connection to the state must pass a very high level of scrutiny.

EditorNotes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

All contributors are members of SingerLewak LLP.

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