States with income taxes have varying rules on when they assert authority to tax income of trusts, based on combinations of contacts with their state of settlors, trustees, Beneficiaries, assets, and management activities. In one of the more aggressive assertions of authority to tax, several states assert that they can tax the income of a trust merely because a Beneficiary resides in the state. In a challenge to North Carolina’s scheme, the U.S. Supreme Court ruled that the presence of in-state beneficiaries alone does not empower a state to tax undistributed trust income when the beneficiaries have no right to demand that income and are uncertain to receive it.
In the case, the settlor formed a trust for his children in his home state of New York. The trustee of the trust was a New York resident. Trust documents and records were kept in New York, and the asset custodians were in Massachusetts.The trust granted the trustee absolute discretion to distribute assets to the beneficiaries. One of the children moved to North Carolina, and North Carolina sought to tax all the income of a subtrust because that child was a North Carolina resident. The child had no right to, and did not receive, any distributions from the trust.
The Court based its decision on the requirements of the Due Process Clause of the U.S. Constitution, which limits states to imposing only taxes that bear fiscal relation to protection, opportunities and benefits given by the state. Some definite link, some minimum connection, is required so that the income attributed to the state for tax purposes be rationally related to values connected with the taxing state. Applied to beneficiaries, this results in taxation turning on the extent of the in-state beneficiary’s right to control, possess, enjoy, or receive trust assets.
A key aspect was that the beneficiary could not count on necessarily receiving any specific amount of the income in the future. The Court noted that the assets of the trust could end up with others, and that the beneficiary had no power to assign her interest.
Some preliminary thoughts/observations:
a. The use of a purely discretionary trust to avoid state income tax when a beneficiary resides in a state with an income tax is a valid planning mechanism, so long as no other ties and connections with the taxing state exist. It would appear that a spendthrift clause that prevents a beneficiary from assigning his or her beneficial interest is a necessary aspect of such planning. Of course, such planning has real world consequences, such as limited access to, and rights over, trust assets by the beneficiary.
b. Would a power of appointment over trust assets in a discretionary trust by the in-state beneficiary give rise to taxing jurisdiction? This was not discussed in the case. If presently exercisable in the subject tax year, then probably yes. If not presently exercisable, maybe not.
c. Would a right to receive all or a share of trust assets at a given future age give the requisite taxing nexus for an in-state beneficiary? This fact was present in the case. However, in the case there were facts that made this future right contingent which appear to have influenced the court, such as the ability for the trust to be re-written to exclude such a right under decanting provisions of law (which power was actually exercised after the tax years in issue) and that the trustee could exclude one beneficiary to the benefit of another.
d. The Court noted that tests of nexus are different as to rights of settlors, trustees and beneficiaries. For example, prior precedent confirms that a resident trustee is enough nexus for state income tax, as well as residence of a settlor (at least where the settlor retains rights over the trust assets, such as a power of revocation). I believe there is at least one state that asserts continuing taxing jurisdiction over a trust with no contacts with the state other than the settlor was a resident of the trust at creation – perhaps a challenge to that nexus authority may be forthcoming based on the principles elucidated in this case.
e. For practitioners in states without a state income tax on individuals, the case is still relevant, since in preparing or advising on a trust in your state you should still be planning for the circumstance of beneficiaries who reside in other states.
NORTH CAROLINA DEPT. OF REVENUE v. KIMBERLEY RICE KAESTNER 1992 FAMILY TRUST (U.S. Supreme Court 2019)