Editor: Mark Heroux, J.D.
The U.S. Supreme Court recently addressed the circumstances in which a state may levy income tax on a trust that has only minimal connection to the state. The high court held in North Carolina Dep't of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S. 6/21/19), that North Carolina violated the Due Process Clause by taxing a nongrantor trust based solely on the fact that the trust's beneficiaries were state residents, under the specific facts presented.
As background to Kaestner, recall that under federal and state law, nongrantor trusts are taxable entities separate and apart from their beneficiaries. For income tax purposes, nongrantor trusts are treated similarly to individuals and under Sec. 641 are taxable on their current-year income. Secs. 661 and 651 authorize a deduction for income that is distributed to beneficiaries in the same year that it is realized by the trust.
Also recall that state taxation of trust income generally conforms to the federal income tax. However, there are two major distinctions. First, the Due Process Clause of the U.S. Constitution prohibits states from imposing tax on trusts that do not have nexus with the state. Whether a trust has nexus with a state generally depends on the amount and nature of contacts that the trust has with the state (e.g., whether the trust has tangible assets located in the state or whether the trust is resident in the state). The second important distinction is that the resident status of the trust affects the amount of income subject to tax. Resident trusts are subject to tax on their undistributed income. Nonresident trusts are only taxable on undistributed income that is sourced to the state.
The Kaestner case
The Supreme Court in Kaestner addressed whether North Carolina could constitutionally impose income tax on a trust based solely on the resident status of the trust's beneficiaries. The geographic footprint of the case spanned four states. The beneficiaries were residents of North Carolina. The trustee resided in Connecticut. The custodians of the trust's assets (intangibles) were located in Massachusetts. The settlor was a New York resident at the time the trust was created. The trust's records were kept in New York. The trust itself was governed under New York law. The crux of the dispute here was whether North Carolina could collect more than $1.3 million in tax on the trust's income.
N.C. Gen. Stat. Section 105-160.2 is the taxing statute at the center of Kaestner. It states in relevant part: "The tax is computed on the amount of the taxable income of the estate or trust that is for the benefit of a resident of this State" (emphasis added).
The Supreme Court explained how it would approach the question of whether North Carolina could constitutionally tax the trust:
The Court applies a two-step analysis to decide if a state tax abides by the Due Process Clause. First, and most relevant here, there must be some definite link, some minimum connection, between a state and the person, property or transaction 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. [Kaestner,slip op. at5—6, internal quotation marks omitted]
Referring to long-standing precedent, the Supreme Court noted that "when a State seeks to base its tax on the in-state residence of a trust beneficiary, the Due Process Clause demands a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State's tax." Further, "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" (Kaestner, slip op. at 9−10).
The Supreme Court observed that the beneficiaries of the Kaestner trust did not receive any income from the trust during the years in question, nor did they have a right to demand trust income.
The decision of when, whether, and to whom the trustee would distribute the trust's assets was left to the trustee's "absolute discretion." In fact, the Trust agreement explicitly authorized the trustee to distribute funds to one beneficiary to "the exclusion of other[s]," with the effect of cutting one or more beneficiaries out of the Trust. The agreement also authorized the trustee, not the beneficiaries, to make investment decisions regarding Trust property. The Trust agreement prohibited the beneficiaries from assigning to another person any right they might have to the Trust property, thus making the beneficiaries' interest less like "a potential source of wealth [that] was property in [their] hands."[Id.at 11, internal citations omitted]
The Supreme Court emphasized that its decision only addressed the circumstances in which a "beneficiary receives no trust income, has no right to demand that income, and is uncertain necessarily to receive a specific share of that income." The Court anticipated that its decision would have limited effect on other state trust tax regimes because few states rely solely on the beneficiary's resident status as the basis for trust taxation. Footnote 12 of the Court's opinion refutes the notion asserted by North Carolina that Montana, North Dakota, and Georgia impose taxation on trusts based purely on in-state resident status of the beneficiary. The Court specifically noted that California (unlike North Carolina) applies tax on the basis of the beneficiary's resident status but only if the beneficiary is not contingent. North Carolina did not cite a single example of a state that imposes tax on a trust based solely on the in-state residency status of a contingent beneficiary (id. at 15−16).
While limited in scope, the Kaestner ruling may present refund opportunities in North Carolina, or other states with imposition statutes, for similarly situated trusts. The case may also provide some planning opportunities in North Carolina with respect to the beneficiaries' right to income and trustee powers as granted by the trust documents. While not part of the binding holding in Kaestner, the Supreme Court noted that "when assessing a state tax premised on the in-state residency of a constituent of a trust — whether beneficiary, settlor, or trustee — the Due Process Clause demands attention to the particular relationship between the resident and the trust assets that the State seeks to tax" (id.at 10). This suggests that nexus planning in states that use the resident status of the settlor, trustee, and beneficiaries, or some combination thereof, should give consideration to the powers and rights granted by the trust document to the constituents of the trust relating to the corpus and income. For example, in states where resident trustees are an indicia of nexus, the risk of nexus may be reduced by limiting trustee powers over trust assets and limiting trustee discretion to make income distributions.
North Carolina refund claims
The North Carolina Department of Revenue (NCDOR) issued "Important Notice: Decision in the Kaestner Case" on July 2, 2019, to alert taxpayers to the deadline for filing refund claims based on the Kaestner decision. Taxpayers who submitted a "Notice of Contingent Event" while Kaestner was being litigated have until Dec. 21, 2019, to file refund claims (six months from the date of the Supreme Court decision (June 21, 2019)) (N.C. Gen. Stat. §105-241.6(b)(5)). The Notice of Contingent Event must have been filed with the NCDOR prior to the expiration of the regular statute of limitation for refunds (i.e., the later of three years after the due date of the return or two years after the tax payment date) (N.C. Gen. Stat. §105-241.6(a)). Taxpayers who did not file a Notice of Contingent Event are still permitted, of course, to file refund claims prior to the expiration of the regular statute of limitation.
Mark Heroux, J.D., is a principal with the Specialty Tax Services Group at Baker Tilly Virchow Krause LLP.
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